9 ms·

The ETF Tax Dodge

103 points by howard941 8y ago

sokoloff 8y ago
It seems to me that this "tax dodge" means that ETFs work the same way basically every investment in the world works (under US taxation). You invest money in a thing, thing goes up and you hold: you pay no taxes; you sell the thing: you pay taxes on the gain. Redeeming ETF into and holding shares of the underlying index also acts the same way: you pay taxes on any gains when you eventually sell the underlying shares. I'm not seeing a "dirty little secret" here. That Fidelity's mutual fund is not able to accomplish the same level of tax efficiency as the SPDR or iShares ETFs reads to me like a flaw in Fidelity's execution, not an illegal dodge on State Street's or Blackrock's side, IMO.
- icedchai 8y ago
  Except these institutions are not paying taxes on the gain?? > Typically, when you sell a stock for more than you paid, you owe tax on the gain. But thanks to a quirk in a Nixon-era tax law, funds can avoid that tax if they use the stock to pay off a withdrawing fund investor.
  - jayess 8y ago
    The person who initially invested does. I don't see at all how this is a tax dodge.
    - URSpider94 8y ago
      The person who individually invested doesn’t have to pay the tax until they sell their shares in the ETF, perhaps decades later. That’s generally considered a tax dodge because deferral of taxes lets you keep that money and compound it. $10 of taxes deferred for 30 years at a modest interest rate of 2% puts an extra $8 in the investor’s pocket that should have gone to the government.
      - sokoloff 8y ago
        I'm not sure that's a "generally considered" definition. By that definition, I'm dodging taxes every year I don't sell my shares that I hold in my brokerage account.
        URSpider94 8y ago
        From your other comments, I see why you don’t want it to be this way, which is a valid philosophical point. However, this is how the tax code treats any transaction today. You’re right you don’t owe tax if you hold a single company’s stock, but you do if you hold a mutual fund that trades its underlying shares during the year, or if you trade one stock in your portfolio for another. You owe it even if you sell a stock for a net profit and buy it back for exactly the same price ten minutes later. ETF’s are treated differently ...
        icedchai 8y ago
        Please explain. Just holding a mutual fund won’t generate any taxable events... except for dividend/distributions... just like a stock. Buying and selling ETFs are also treated just like a stock.
        URSpider94 8y ago
        Not true. Every year, a mutual fund is required to distribute an amount equal to the capital gains realized by the fund in that year. For a mutual fund that trades actively, that could be a sizeable fraction of the amount you have invested. This is cap gains, not a dividend. Stocks and ETF’s don’t do that. https://www.investopedia.com/terms/c/capitalgainsdistribution.asp https://www.investopedia.com/terms/c/capitalgainsdistributio...
        icedchai 8y ago
        Good to know! My funds generate relatively small capital gains distributions (most of what I see on my 1099's is from dividends) so I never noticed it. Edit: Though now that you mention it, I think I must've known this at some point in the past: that ETFs had preferential tax treatment. A while back, I moved my most recent investments to ETFs, even for the "same" fund (example: Vanguard Tech VITAX mutual fund vs VGT ETF) ... Still, how are ETFs treated differently from a stock?
    - DamnYuppie 8y ago
      Agreed I see this more as a transfer than a dodge.
  - vxNsr 8y ago
    The underlying investors do when they cash out.
  - gph 8y ago
    Yes, but the investor will pay more in taxes when they sell the actual ETF. It's more like deferring taxes than avoiding them. Think of it this way, if the fund paid these taxes when they sell their various holdings, that less tax amount would be baked into the ETF valution, which would carry over to a smaller tax bill when an investor sells their ETF shares and pays taxes. That's still advantageous in many ways, but I think people in this topic are thinking this is some kind of complete tax avoidance. It isn't.
    - icedchai 8y ago
      Yes, I do agree the end result is likely beneficial to the average Joe trading ETFs...
  - menage 8y ago
    Presumably the withdrawing investor also gets the fund's cost basis in the stock, so they'll be on the hook for the fund's capital gains themselves when they sell the stock. (The article didn't explicitly mention it, nor does the relevant statute https://www.law.cornell.edu/uscode/text/26/852#b_6 https://www.law.cornell.edu/uscode/text/26/852#b_6, but that's the standard way that stock transfers work.)
    - zaroth 8y ago
      I think the basis stays with the fund, and the capital gains are due when the ETF holders sell their shares. The bank does not get hit with any capital gains due to the lower basis of the fund. The bank has their own basis in the shares that they brought into the fund which when traded for the other shares may trigger its own separate capital gain. The shares the bank gets back at the end should have price equal to basis by that point I would think.
    - toast0 8y ago
      I'd like to see details on that part. My guess is each side of the exchange keeps their cost basis and just divides it over the new to them shares -- like in an untaxed merger stock transaction. Otherwise, it would be a competition to send the other party stocks with the lowest cost basis.
  - sokoloff 8y ago
    Suppose you and I take $100K each and mutually invest 50:50 in something together. Maybe we bought two identical houses for $200K total (or even bought a duplex together). Later on, the houses have gone up in value to $300K, even later I decide that I want out, we look things over and decide that the fair thing is for me to take one of the houses. At the moment that we take that action, no tax is (nor ought to be, IMO) due. Later, when/if I sell the house, tax is due on the $50K in gains. Just like in the ETF case. In the alternate treatment seemingly contemplated by the article, we could instead agree to sell one of the houses, jointly pay taxes on $50K in gains, and give me the sum of $150K-taxes, the gains of which I'd pay taxes upon again. You'd also have effectively paid taxes when you hadn't done anything but invest and hold. There's a pretty good argument this is unfair to me (to tax me twice on one gain); there's an almost ironclad argument that it's unfair to you. It's no surprise that the treatment that is both more reasonable and more profitable is the one that ETFs seek to implement. (Fees and other weirdnesses around real-estate ignored above for simplicity.)
    - URSpider94 8y ago
      You may decide that tax ought not to be due when you take one of the houses, but under the law it IS due. For me to take one of the houses, we would have to change the ownership structure and there would be a transfer price for that.
      - credit_guy 8y ago
        > change the ownership structure and there would be a transfer price for that The transfer price in gp’s example would be zero, wouldn’t it.
        URSpider94 8y ago
        Probably not. If the transfer price is zero, then that now becomes my tax basis in the property. So assuming again that I put in $100k originally, and now take out one house worth $150k, then sell it, I’m going to pay capital gains on the full $150k, not just my $50k gain. What probably happens is that I sell you my share in the holding entity for $150k, and the entity sells me the house for $150k. There are cases where you could simply dissolve the entity and distribute the assets, which would avoid the sale and resulting taxes, in which case you’re just re-titling it and not selling it. Tl;dr: this gets complicated really quickly.
  - vmarsy 8y ago
    > Except these institutions are not paying taxes on the gain?? Why should they? They are not people. When you buy an item for $50 at a store, as a consumer you would pay sales tax on it. But every transaction made from the buying of raw materials up to the time the store sold you the item is done tax free by the businesses, only at the time of sale to the final consumer, a tax is due. Here ETF is kind of similar, except that the consumer provides the raw materials: A consumer buys the ETF at a share price of $100, and sells it once the ETF reaches $150: $50 should be taxable to the consumer. Instead of it being categorized as "sales tax" it's "income tax" or "LTCG tax", but the principle is the same. If the institution made money off that transaction, by charging someone a $5 fee for instance, then tax should be paid on those $5 by the institution, but I don't see why amount the fund grew should have an impact. It goes both way obviously, if the consumer buys an ETF a $100 but sells it at $75, the institution should not be able to claim a loss on those $25, but that doesn't seem to be something claimed by the article.
- URSpider94 8y ago
  You could make the same argument about buying into a mutual fund, yet mutual funds have to distribute capital gains every year. Similarly, if I tried to re-create an index in my own account with individual stocks, I would end up incurring cap gains as I had to add and remove stocks when the index changes. For whatever reason, we seem to feel like ETF’s deserve different treatment.
  - AnthonyMouse 8y ago
    The real question is why we don't treat other things the way we treat ETFs, which is more efficient. If you own Stock A and it has appreciated significantly over the years, but now you think Stock B is a better choice, the fact that trading one for the other is a tax realization event may cause you to not do it. This doesn't get the government any revenue this year, and it costs the government revenue in the future if you were right that Stock B is now the better choice, because you'll have less taxable appreciation when you finally do cash out during your retirement. It also makes the economy less efficient in general by locking up capital in whatever people invested in years ago.
    - cheerlessbog 8y ago
      If I sell my car and buy another for the same price, should I avoid sales tax? Making it possible to trade stocks without tax consequences may make it easier to better deploy capital, but it would also have a destabilizing effect, because it could make the markets more exposed to emotional reactions and poor information.
      - AnthonyMouse 8y ago
        > If I sell my car and buy another for the same price, should I avoid sales tax? Did the person you sold your old car to have to pay an equal amount of sales tax? Because in that case yes. > Making it possible to trade stocks without tax consequences may make it easier to better deploy capital, but it would also have a destabilizing effect, because it could make the markets more exposed to emotional reactions and poor information. This sounds like the argument a monopolist makes for why competition is bad.
patrickg_zill 8y ago
should be... "One of Wall Street's Dirty Little Secrets" note: title was changed from its original posting of "ETF Tax Dodge is Wall Street's Dirty Little Secret"
cheez 8y ago
That's brilliant. Love the visualization as well.
cletus 8y ago
I'm willing to join in the outrage at Wall Street (a|im)morality but this one doesn't particular bother me. Let me explain why. So imagine an S&P 500 ETF went from a $10B valuation to $15B in 5 years. Lots of transactions took place as the index gets rebalanced. Companies leave the index. Others take their place. No tax is paid by the fund. You're tempted to be outraged. Let's say that the offset tax amounts to $1B for simplicity. But consider: someone invested $10k in that fund and held for 5 years. They sell and owe taxes on $5k. If the ETF had been paying taxes that $15B would be $14B and the seller would owe taxes on $4k instead of $5k. In Australia, when you hold a company and it, say, pays dividends. It typically pays corporate taxes on that. As a stockholder you not only receive that dividend but you receive a credit for taxes paid (called "franking credits"). If the dividend is fully franked (meaning the full corporate tax rate was paid) then you might receive a $700 dividend and $300 (30% of the gross $1000 dividend) in franking credits. When you do your taxes, if your tax rate is higher than 30% you pay the difference. If it's less you'll get a refund. This is to avoid double taxation, basically. In the US, you don't have this. Earn income through a company, it pays taxes, it pays a dividend and you pay taxes again. This was the whole reason for the (misguided) passthrough entity tax break with the Trump tax cuts. It would be a lot easier if US dividends were just taxed at source and they came with a tax credit that could be applied to, say, US tax liabilities. So, you can view heartbeat trades as simply a way of avoiding double taxation. It's at least debatable. After all, if you invest in a company you only pay taxes when you sell on the gain (dividends notwithstanding) so this is really just treating ETFs the same way.
- loeg 8y ago
  Heatbeats don't avoid double taxation. They just defer capital gains incurred by fund turnover in an ETF.
- cheerlessbog 8y ago
  It's only double taxation if you arbitrarily consider the transfer of the dividend from the company to yourself to be a non taxable event. Until that point the money isn't "yours" in the full normal sense. If I buy 1% of Exxon I don't have the legal right to extract 1% of its income. Another argument for "double" taxation : corporations are artificial entities created by law with significant privileges, such as shielding owners from direct liability in most cases. That's a privilege society extends and it is arguable reasonable that it is subject to a different tax regime than capital which is owned directly by the individual.
supercanuck 8y ago
>Imagine that a grocer got a tax deduction every time someone returned a box of cornflakes to his store. Heartbeats are when the grocer asks a friend to buy all the boxes and return them, just to pocket more deductions. >Fund managers and bankers say the trades are perfectly legal... How is this legal, this seems to me to be fraud?? If this was small town grocer and John Doe, how would this not be rolled up into a defrauding the government? https://www.justice.gov/jm/criminal-resource-manual-923-18-usc-371-conspiracy-defraud-us https://www.justice.gov/jm/criminal-resource-manual-923-18-u...
- loeg 8y ago
  It's a poor metaphor.
OscarCunningham 8y ago
But don't investors eventually pay the tax when they sell the ETF?
- lixtra 8y ago
  Yes, but meanwhile the deferred taxes compound. The question is wether rebalancing an ETF should trigger taxes or not.
doctorpangloss 8y ago
Taxes have an outsize impact on markets. People shouldn’t really care about the difference between 15 versus 25 percentage point taxes if they feel they’re timing the market right. But if you look at a chart of redemptions and CG taxes (check Wikipedia), it turns out a 5-9 percentage point decrease occurs around 9-40x increases in redemptions during the low tax period. This is basically why you observe Republican (i.e. low tax) administrations experience traditionally low stock market prices—everyone is selling and turning their imaginary paper into cash! Capital gains taxes are essentially the free shipping of equities. They totally distort people’s behavior disproportionate to their impact on returns, most of all by discouraging normal (retail) investors from selling when their gut tells them to, and then they bear most of the losses. Obviously a more equitable scheme would make capital gains taxes progressive instead of time based. Just to make it clear about the article, if you made ETFs pay the taxes we’d get even more correlation and asset inflation. The best example of that is the cryptocurrency market.
- ISL 8y ago
  To address the timing problem, one could make capital-gains taxes time-independent, or smoothly-varying with time. Making capital-gains taxes progressive would address an entirely different set of concerns, and applies a different set of forces onto the market.
  - loeg 8y ago
    Cap gains are taxed in progressive brackets on an annual basis.
stochastician 8y ago
Matt Levine has an excellent explanation of why this isn't as big of a deal as it seems (read down to Heartbeats) [1] > On the other hand I am not convinced that one should look at the transaction in isolation here. My view of the situation is not only that “an ETF is a mutual fund that doesn’t pay taxes,” but also that everyone accepts that. There just seems to be broad agreement among investors and regulators and policymakers that an ETF is supposed to be tax-efficient, that ETF investors get to defer capital gains until they sell their shares. (Again: This is a very widely advertised benefit of ETFs. 7 ) Some ETFs ran into a bit of a technical problem that might have required them to pay taxes, and so they developed a very technical solution that fixed it. The fact that the solution is a little shammy-looking would be a problem if everyone expected them to pay the taxes, but since people don’t expect that, any old solution will do. [1] https://www.bloomberg.com/opinion/articles/2019-03-29/deals-on-the-train-are-everyone-s-business https://www.bloomberg.com/opinion/articles/2019-03-29/deals-...
- lconstable613 8y ago
  With respect to Matt Levine, the exact opposite is true. ETFs were a tax dodge that became embedded in the system. To get technical, Congress enacted §311(b) exemptions in 1986, exempting gain recognition for in-kind distributions for Subchapter M companies as §852(b)(6). At the time, mutual funds rarely distributed property in kind. The first ETF appeared in 1993, and the spectacular tax advantage is a big reason for its success. Given their popularity, ETFs are also given regulatory exemptive relief from parts of the '33 and '40 Acts. I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free. Credential - I'm a lawyer and value investor @ https://lembascapital.com/ https://lembascapital.com/ and I spend a great deal of time looking at fund structures. PS Other smart mutual funds began distributing in kind once they realized this tax structure was sufficiently embedded. See e.g. Sequoia Fund, the famous value investing mutual fund (at least pre Valeant) - https://www.wsj.com/articles/SB921028092685519084 https://www.wsj.com/articles/SB921028092685519084
  - benj111 8y ago
    I didn't read the Levine article as stating where ETFs games from, rather where they are today. "I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free." Isn't that what Levine is also arguing? Realpolitik as tax law.
mruts 8y ago
Every cent that is not taken by the government and instead retained by investors is a win in my book. Better that the money is only taxed once instead of twice. Even better if it's not taxed at all! No one wants to pay taxes, and everyone tries to use every loophole they can find to get out of them. The only reason your average Joe finds this upsetting is because he doesn't have as many loopholes to exploit. And when he loses a loophole, like the state income tax deduction, he gets pissed!
- colejohnson66 8y ago
  So how do you propose the government pay for anything without taxes?
  - walshemj 8y ago
    The USA pays quite a lot of taxes.
- dang 8y ago
  We've already asked you not to post ideological flamebait to HN. If you want to have generic ideological arguments, please do that on another site. Because such discussions are predictable, they do not count as interesting and therefore are off topic here. https://news.ycombinator.com/newsguidelines.html https://news.ycombinator.com/newsguidelines.html
gok 8y ago
How would ETFs (and passive investment systems in general) work without this trick? If there were no tax free way to do rebalancing, how could you really track the exchange?
- loeg 8y ago
  Mutual funds do this by distributing capital gains to investors annually. Yes, that would be one reason they might lag the index.
URSpider94 8y ago
People are missing the point. This is not a tax dodge in the sense that you never pay the taxes. It’s a tax dodge in the sense that you postpone paying taxes in the year when they are due (which is the most common kind of tax dodge). It’s absolutely correct that the ETF shareholders will pay the tax one way or another, either now on an annual cap gains distribution, or when they sell the shares later. It is NOT double taxation, because you either pay now or later, not both. The issue is that the government cares deeply that you pay taxes in the year that you incur them. The US government, as you may know, has massive debt, and so getting the tax later costs it money in interest payments. They care about this so much that if you owe a lot in taxes, you actually have to pay them in quarterly installments, so the Feds don’t have to wait a whole year to get your money. Since ETF’s are buy-and-hold investments, it could literally be decades before you actually send in a check for taxes that would ordinarily be due today.
- AnthonyMouse 8y ago
  > The issue is that the government cares deeply that you pay taxes in the year that you incur them. The US government, as you may know, has massive debt, and so getting the tax later costs it money in interest payments. They care about this so much that if you owe a lot in taxes, you actually have to pay them in quarterly installments, so the Feds don’t have to wait a whole year to get your money. Which is very silly, because the government pays a lower interest rate on its debt than the average returns from the stock market. So the government would actually come out ahead to carry more debt now and allow you to accrue more taxable appreciation, because the tax paid on the market gains from the money not paid in tax until later are more than the interest the government has to pay on its debt in the meantime.
  - cheerlessbog 8y ago
    I may equally lose that money. There's a reason that government debt pays less. The sooner they get their money, the less time it is exposed to that risk.
    - AnthonyMouse 8y ago
intopieces 8y ago
If ETFs are able to dodge taxes that mutual funds cannot, why do people still invest in mutual funds? Different risks?
- greenyoda 8y ago
  One disadvantage of an ETF is that you have to pay a brokerage commission each time you trade it. Many mutual funds have no fees for buying/selling shares. If you have a savings strategy like automatically investing a percentage of every paycheck, the commissions on ETF trades could add up quickly.
  - loeg 8y ago
    Brokerage commissions are $0 for Vanguard ETFs in a Vanguard brokerage or Fidelity ETFs in a Fidelity brokerage, etc. This isn't a real downside unless you want to trade ETFs in a brokerage account unaffiliated with the ETF.
- loeg 8y ago
  ETFs only trade interday; mutual funds only trade end of day. It can be more convenient to automatically invest some portion of your pay in a mutual fund than an ETF. (Also, Vanguard mutual funds are shares classes of their ETFs, so they have the same tax benefit ETFs do here.)
- twiceaday 8y ago
  You can buy fractional shares of mutual funds. Vanguard only lets you auto-invest on a schedule into mutual funds. Mutual funds trade once a day, at the end of the day, for the intra-day-valume-based average cost so you are not timing the hour.
jannotti 8y ago
When all is said and done, this ends up seeming like pretty much the exact same treatment that "like-kind exchange" gives to Real Estate. In both cases you're allowed to swap an asset without capital gains at the swap time (but your basis stays at the low old price, so you eventually will). I'm not sure how much I like these rules, but either they're both "dodges" or neither is.

103 points by howard941 8y ago

It seems to me that this "tax dodge" means that ETFs work the same way basically every investment in the world works (under US taxation). You invest money in a thing, thing goes up and you hold: you pay no taxes; you sell the thing: you pay taxes on the gain. Redeeming ETF into and holding shares of the underlying index also acts the same way: you pay taxes on any gains when you eventually sell the underlying shares. I'm not seeing a "dirty little secret" here. That Fidelity's mutual fund is not able to accomplish the same level of tax efficiency as the SPDR or iShares ETFs reads to me like a flaw in Fidelity's execution, not an illegal dodge on State Street's or Blackrock's side, IMO.

icedchai 8y ago
Except these institutions are not paying taxes on the gain?? > Typically, when you sell a stock for more than you paid, you owe tax on the gain. But thanks to a quirk in a Nixon-era tax law, funds can avoid that tax if they use the stock to pay off a withdrawing fund investor.
- jayess 8y ago
  The person who initially invested does. I don't see at all how this is a tax dodge.
  - URSpider94 8y ago
    The person who individually invested doesn’t have to pay the tax until they sell their shares in the ETF, perhaps decades later. That’s generally considered a tax dodge because deferral of taxes lets you keep that money and compound it. $10 of taxes deferred for 30 years at a modest interest rate of 2% puts an extra $8 in the investor’s pocket that should have gone to the government.
    - sokoloff 8y ago
      I'm not sure that's a "generally considered" definition. By that definition, I'm dodging taxes every year I don't sell my shares that I hold in my brokerage account.
      - URSpider94 8y ago
        From your other comments, I see why you don’t want it to be this way, which is a valid philosophical point. However, this is how the tax code treats any transaction today. You’re right you don’t owe tax if you hold a single company’s stock, but you do if you hold a mutual fund that trades its underlying shares during the year, or if you trade one stock in your portfolio for another. You owe it even if you sell a stock for a net profit and buy it back for exactly the same price ten minutes later. ETF’s are treated differently ...
        icedchai 8y ago
        Please explain. Just holding a mutual fund won’t generate any taxable events... except for dividend/distributions... just like a stock. Buying and selling ETFs are also treated just like a stock.
        URSpider94 8y ago
        Not true. Every year, a mutual fund is required to distribute an amount equal to the capital gains realized by the fund in that year. For a mutual fund that trades actively, that could be a sizeable fraction of the amount you have invested. This is cap gains, not a dividend. Stocks and ETF’s don’t do that. https://www.investopedia.com/terms/c/capitalgainsdistribution.asp https://www.investopedia.com/terms/c/capitalgainsdistributio...
        icedchai 8y ago
        Good to know! My funds generate relatively small capital gains distributions (most of what I see on my 1099's is from dividends) so I never noticed it. Edit: Though now that you mention it, I think I must've known this at some point in the past: that ETFs had preferential tax treatment. A while back, I moved my most recent investments to ETFs, even for the "same" fund (example: Vanguard Tech VITAX mutual fund vs VGT ETF) ... Still, how are ETFs treated differently from a stock?
  - DamnYuppie 8y ago
    Agreed I see this more as a transfer than a dodge.
- vxNsr 8y ago
  The underlying investors do when they cash out.
- gph 8y ago
  Yes, but the investor will pay more in taxes when they sell the actual ETF. It's more like deferring taxes than avoiding them. Think of it this way, if the fund paid these taxes when they sell their various holdings, that less tax amount would be baked into the ETF valution, which would carry over to a smaller tax bill when an investor sells their ETF shares and pays taxes. That's still advantageous in many ways, but I think people in this topic are thinking this is some kind of complete tax avoidance. It isn't.
  - icedchai 8y ago
    Yes, I do agree the end result is likely beneficial to the average Joe trading ETFs...
- menage 8y ago
  Presumably the withdrawing investor also gets the fund's cost basis in the stock, so they'll be on the hook for the fund's capital gains themselves when they sell the stock. (The article didn't explicitly mention it, nor does the relevant statute https://www.law.cornell.edu/uscode/text/26/852#b_6 https://www.law.cornell.edu/uscode/text/26/852#b_6, but that's the standard way that stock transfers work.)
  - zaroth 8y ago
    I think the basis stays with the fund, and the capital gains are due when the ETF holders sell their shares. The bank does not get hit with any capital gains due to the lower basis of the fund. The bank has their own basis in the shares that they brought into the fund which when traded for the other shares may trigger its own separate capital gain. The shares the bank gets back at the end should have price equal to basis by that point I would think.
  - toast0 8y ago
    I'd like to see details on that part. My guess is each side of the exchange keeps their cost basis and just divides it over the new to them shares -- like in an untaxed merger stock transaction. Otherwise, it would be a competition to send the other party stocks with the lowest cost basis.
- sokoloff 8y ago
  Suppose you and I take $100K each and mutually invest 50:50 in something together. Maybe we bought two identical houses for $200K total (or even bought a duplex together). Later on, the houses have gone up in value to $300K, even later I decide that I want out, we look things over and decide that the fair thing is for me to take one of the houses. At the moment that we take that action, no tax is (nor ought to be, IMO) due. Later, when/if I sell the house, tax is due on the $50K in gains. Just like in the ETF case. In the alternate treatment seemingly contemplated by the article, we could instead agree to sell one of the houses, jointly pay taxes on $50K in gains, and give me the sum of $150K-taxes, the gains of which I'd pay taxes upon again. You'd also have effectively paid taxes when you hadn't done anything but invest and hold. There's a pretty good argument this is unfair to me (to tax me twice on one gain); there's an almost ironclad argument that it's unfair to you. It's no surprise that the treatment that is both more reasonable and more profitable is the one that ETFs seek to implement. (Fees and other weirdnesses around real-estate ignored above for simplicity.)
  - URSpider94 8y ago
    You may decide that tax ought not to be due when you take one of the houses, but under the law it IS due. For me to take one of the houses, we would have to change the ownership structure and there would be a transfer price for that.
    - credit_guy 8y ago
      > change the ownership structure and there would be a transfer price for that The transfer price in gp’s example would be zero, wouldn’t it.
      - URSpider94 8y ago
        Probably not. If the transfer price is zero, then that now becomes my tax basis in the property. So assuming again that I put in $100k originally, and now take out one house worth $150k, then sell it, I’m going to pay capital gains on the full $150k, not just my $50k gain. What probably happens is that I sell you my share in the holding entity for $150k, and the entity sells me the house for $150k. There are cases where you could simply dissolve the entity and distribute the assets, which would avoid the sale and resulting taxes, in which case you’re just re-titling it and not selling it. Tl;dr: this gets complicated really quickly.
- vmarsy 8y ago
  > Except these institutions are not paying taxes on the gain?? Why should they? They are not people. When you buy an item for $50 at a store, as a consumer you would pay sales tax on it. But every transaction made from the buying of raw materials up to the time the store sold you the item is done tax free by the businesses, only at the time of sale to the final consumer, a tax is due. Here ETF is kind of similar, except that the consumer provides the raw materials: A consumer buys the ETF at a share price of $100, and sells it once the ETF reaches $150: $50 should be taxable to the consumer. Instead of it being categorized as "sales tax" it's "income tax" or "LTCG tax", but the principle is the same. If the institution made money off that transaction, by charging someone a $5 fee for instance, then tax should be paid on those $5 by the institution, but I don't see why amount the fund grew should have an impact. It goes both way obviously, if the consumer buys an ETF a $100 but sells it at $75, the institution should not be able to claim a loss on those $25, but that doesn't seem to be something claimed by the article.
URSpider94 8y ago
You could make the same argument about buying into a mutual fund, yet mutual funds have to distribute capital gains every year. Similarly, if I tried to re-create an index in my own account with individual stocks, I would end up incurring cap gains as I had to add and remove stocks when the index changes. For whatever reason, we seem to feel like ETF’s deserve different treatment.
- AnthonyMouse 8y ago
  The real question is why we don't treat other things the way we treat ETFs, which is more efficient. If you own Stock A and it has appreciated significantly over the years, but now you think Stock B is a better choice, the fact that trading one for the other is a tax realization event may cause you to not do it. This doesn't get the government any revenue this year, and it costs the government revenue in the future if you were right that Stock B is now the better choice, because you'll have less taxable appreciation when you finally do cash out during your retirement. It also makes the economy less efficient in general by locking up capital in whatever people invested in years ago.
  - cheerlessbog 8y ago
    If I sell my car and buy another for the same price, should I avoid sales tax? Making it possible to trade stocks without tax consequences may make it easier to better deploy capital, but it would also have a destabilizing effect, because it could make the markets more exposed to emotional reactions and poor information.
    - AnthonyMouse 8y ago
      > If I sell my car and buy another for the same price, should I avoid sales tax? Did the person you sold your old car to have to pay an equal amount of sales tax? Because in that case yes. > Making it possible to trade stocks without tax consequences may make it easier to better deploy capital, but it would also have a destabilizing effect, because it could make the markets more exposed to emotional reactions and poor information. This sounds like the argument a monopolist makes for why competition is bad.

patrickg_zill 8y ago

should be... "One of Wall Street's Dirty Little Secrets" note: title was changed from its original posting of "ETF Tax Dodge is Wall Street's Dirty Little Secret"

cheez 8y ago

That's brilliant. Love the visualization as well.

cletus 8y ago

I'm willing to join in the outrage at Wall Street (a|im)morality but this one doesn't particular bother me. Let me explain why. So imagine an S&P 500 ETF went from a $10B valuation to $15B in 5 years. Lots of transactions took place as the index gets rebalanced. Companies leave the index. Others take their place. No tax is paid by the fund. You're tempted to be outraged. Let's say that the offset tax amounts to $1B for simplicity. But consider: someone invested $10k in that fund and held for 5 years. They sell and owe taxes on $5k. If the ETF had been paying taxes that $15B would be $14B and the seller would owe taxes on $4k instead of $5k. In Australia, when you hold a company and it, say, pays dividends. It typically pays corporate taxes on that. As a stockholder you not only receive that dividend but you receive a credit for taxes paid (called "franking credits"). If the dividend is fully franked (meaning the full corporate tax rate was paid) then you might receive a $700 dividend and $300 (30% of the gross $1000 dividend) in franking credits. When you do your taxes, if your tax rate is higher than 30% you pay the difference. If it's less you'll get a refund. This is to avoid double taxation, basically. In the US, you don't have this. Earn income through a company, it pays taxes, it pays a dividend and you pay taxes again. This was the whole reason for the (misguided) passthrough entity tax break with the Trump tax cuts. It would be a lot easier if US dividends were just taxed at source and they came with a tax credit that could be applied to, say, US tax liabilities. So, you can view heartbeat trades as simply a way of avoiding double taxation. It's at least debatable. After all, if you invest in a company you only pay taxes when you sell on the gain (dividends notwithstanding) so this is really just treating ETFs the same way.

loeg 8y ago
Heatbeats don't avoid double taxation. They just defer capital gains incurred by fund turnover in an ETF.
cheerlessbog 8y ago
It's only double taxation if you arbitrarily consider the transfer of the dividend from the company to yourself to be a non taxable event. Until that point the money isn't "yours" in the full normal sense. If I buy 1% of Exxon I don't have the legal right to extract 1% of its income. Another argument for "double" taxation : corporations are artificial entities created by law with significant privileges, such as shielding owners from direct liability in most cases. That's a privilege society extends and it is arguable reasonable that it is subject to a different tax regime than capital which is owned directly by the individual.

supercanuck 8y ago

>Imagine that a grocer got a tax deduction every time someone returned a box of cornflakes to his store. Heartbeats are when the grocer asks a friend to buy all the boxes and return them, just to pocket more deductions. >Fund managers and bankers say the trades are perfectly legal... How is this legal, this seems to me to be fraud?? If this was small town grocer and John Doe, how would this not be rolled up into a defrauding the government? https://www.justice.gov/jm/criminal-resource-manual-923-18-usc-371-conspiracy-defraud-us https://www.justice.gov/jm/criminal-resource-manual-923-18-u...

loeg 8y ago
It's a poor metaphor.

OscarCunningham 8y ago

But don't investors eventually pay the tax when they sell the ETF?

lixtra 8y ago
Yes, but meanwhile the deferred taxes compound. The question is wether rebalancing an ETF should trigger taxes or not.

doctorpangloss 8y ago

Taxes have an outsize impact on markets. People shouldn’t really care about the difference between 15 versus 25 percentage point taxes if they feel they’re timing the market right. But if you look at a chart of redemptions and CG taxes (check Wikipedia), it turns out a 5-9 percentage point decrease occurs around 9-40x increases in redemptions during the low tax period. This is basically why you observe Republican (i.e. low tax) administrations experience traditionally low stock market prices—everyone is selling and turning their imaginary paper into cash! Capital gains taxes are essentially the free shipping of equities. They totally distort people’s behavior disproportionate to their impact on returns, most of all by discouraging normal (retail) investors from selling when their gut tells them to, and then they bear most of the losses. Obviously a more equitable scheme would make capital gains taxes progressive instead of time based. Just to make it clear about the article, if you made ETFs pay the taxes we’d get even more correlation and asset inflation. The best example of that is the cryptocurrency market.

ISL 8y ago
To address the timing problem, one could make capital-gains taxes time-independent, or smoothly-varying with time. Making capital-gains taxes progressive would address an entirely different set of concerns, and applies a different set of forces onto the market.
- loeg 8y ago
  Cap gains are taxed in progressive brackets on an annual basis.

stochastician 8y ago

Matt Levine has an excellent explanation of why this isn't as big of a deal as it seems (read down to Heartbeats) [1] > On the other hand I am not convinced that one should look at the transaction in isolation here. My view of the situation is not only that “an ETF is a mutual fund that doesn’t pay taxes,” but also that everyone accepts that. There just seems to be broad agreement among investors and regulators and policymakers that an ETF is supposed to be tax-efficient, that ETF investors get to defer capital gains until they sell their shares. (Again: This is a very widely advertised benefit of ETFs. 7 ) Some ETFs ran into a bit of a technical problem that might have required them to pay taxes, and so they developed a very technical solution that fixed it. The fact that the solution is a little shammy-looking would be a problem if everyone expected them to pay the taxes, but since people don’t expect that, any old solution will do. [1] https://www.bloomberg.com/opinion/articles/2019-03-29/deals-on-the-train-are-everyone-s-business https://www.bloomberg.com/opinion/articles/2019-03-29/deals-...

lconstable613 8y ago
With respect to Matt Levine, the exact opposite is true. ETFs were a tax dodge that became embedded in the system. To get technical, Congress enacted §311(b) exemptions in 1986, exempting gain recognition for in-kind distributions for Subchapter M companies as §852(b)(6). At the time, mutual funds rarely distributed property in kind. The first ETF appeared in 1993, and the spectacular tax advantage is a big reason for its success. Given their popularity, ETFs are also given regulatory exemptive relief from parts of the '33 and '40 Acts. I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free. Credential - I'm a lawyer and value investor @ https://lembascapital.com/ https://lembascapital.com/ and I spend a great deal of time looking at fund structures. PS Other smart mutual funds began distributing in kind once they realized this tax structure was sufficiently embedded. See e.g. Sequoia Fund, the famous value investing mutual fund (at least pre Valeant) - https://www.wsj.com/articles/SB921028092685519084 https://www.wsj.com/articles/SB921028092685519084
- benj111 8y ago
  I didn't read the Levine article as stating where ETFs games from, rather where they are today. "I'd argue this is like frequent flyer miles -- the IRS basically gave up on collecting them as taxable income because everyone thought of them as free." Isn't that what Levine is also arguing? Realpolitik as tax law.

mruts 8y ago

Every cent that is not taken by the government and instead retained by investors is a win in my book. Better that the money is only taxed once instead of twice. Even better if it's not taxed at all! No one wants to pay taxes, and everyone tries to use every loophole they can find to get out of them. The only reason your average Joe finds this upsetting is because he doesn't have as many loopholes to exploit. And when he loses a loophole, like the state income tax deduction, he gets pissed!

colejohnson66 8y ago
So how do you propose the government pay for anything without taxes?
- walshemj 8y ago
  The USA pays quite a lot of taxes.
dang 8y ago
We've already asked you not to post ideological flamebait to HN. If you want to have generic ideological arguments, please do that on another site. Because such discussions are predictable, they do not count as interesting and therefore are off topic here. https://news.ycombinator.com/newsguidelines.html https://news.ycombinator.com/newsguidelines.html

gok 8y ago

How would ETFs (and passive investment systems in general) work without this trick? If there were no tax free way to do rebalancing, how could you really track the exchange?

loeg 8y ago
Mutual funds do this by distributing capital gains to investors annually. Yes, that would be one reason they might lag the index.

URSpider94 8y ago

People are missing the point. This is not a tax dodge in the sense that you never pay the taxes. It’s a tax dodge in the sense that you postpone paying taxes in the year when they are due (which is the most common kind of tax dodge). It’s absolutely correct that the ETF shareholders will pay the tax one way or another, either now on an annual cap gains distribution, or when they sell the shares later. It is NOT double taxation, because you either pay now or later, not both. The issue is that the government cares deeply that you pay taxes in the year that you incur them. The US government, as you may know, has massive debt, and so getting the tax later costs it money in interest payments. They care about this so much that if you owe a lot in taxes, you actually have to pay them in quarterly installments, so the Feds don’t have to wait a whole year to get your money. Since ETF’s are buy-and-hold investments, it could literally be decades before you actually send in a check for taxes that would ordinarily be due today.

AnthonyMouse 8y ago
> The issue is that the government cares deeply that you pay taxes in the year that you incur them. The US government, as you may know, has massive debt, and so getting the tax later costs it money in interest payments. They care about this so much that if you owe a lot in taxes, you actually have to pay them in quarterly installments, so the Feds don’t have to wait a whole year to get your money. Which is very silly, because the government pays a lower interest rate on its debt than the average returns from the stock market. So the government would actually come out ahead to carry more debt now and allow you to accrue more taxable appreciation, because the tax paid on the market gains from the money not paid in tax until later are more than the interest the government has to pay on its debt in the meantime.
- cheerlessbog 8y ago
  I may equally lose that money. There's a reason that government debt pays less. The sooner they get their money, the less time it is exposed to that risk.
  - AnthonyMouse 8y ago

intopieces 8y ago

If ETFs are able to dodge taxes that mutual funds cannot, why do people still invest in mutual funds? Different risks?

greenyoda 8y ago
One disadvantage of an ETF is that you have to pay a brokerage commission each time you trade it. Many mutual funds have no fees for buying/selling shares. If you have a savings strategy like automatically investing a percentage of every paycheck, the commissions on ETF trades could add up quickly.
- loeg 8y ago
  Brokerage commissions are $0 for Vanguard ETFs in a Vanguard brokerage or Fidelity ETFs in a Fidelity brokerage, etc. This isn't a real downside unless you want to trade ETFs in a brokerage account unaffiliated with the ETF.
loeg 8y ago
ETFs only trade interday; mutual funds only trade end of day. It can be more convenient to automatically invest some portion of your pay in a mutual fund than an ETF. (Also, Vanguard mutual funds are shares classes of their ETFs, so they have the same tax benefit ETFs do here.)
twiceaday 8y ago
You can buy fractional shares of mutual funds. Vanguard only lets you auto-invest on a schedule into mutual funds. Mutual funds trade once a day, at the end of the day, for the intra-day-valume-based average cost so you are not timing the hour.

jannotti 8y ago

When all is said and done, this ends up seeming like pretty much the exact same treatment that "like-kind exchange" gives to Real Estate. In both cases you're allowed to swap an asset without capital gains at the swap time (but your basis stays at the low old price, so you eventually will). I'm not sure how much I like these rules, but either they're both "dodges" or neither is.