Special Edition: Tax Rules for Exchange-Traded Index Securities

Can't get enough of exchange-traded index securities? Whether you're talking about Standard & Poor's Depositary Receipts(SPY Quote), the Nasdaq 100 tracking stock (QQQ Quote) or Merrill Lynch Internet HOLDRs(HHH Quote), these things are starting to catch on. See a recent Dear Dagen for more on their rising popularity.

Ask your tax questions on the TSC Tax Forum board.

This week's Tax Forum is devoted entirely to the tax implications of these securities. If you trade them, or would like to, you're probably wondering how the wash sale rule, distributions and options trades come into play. Read on to find out.

We'll return to the usual Q&A format next week. So send your tax questions to [e-mail]. And please include your full name.

The Basics

In general, exchange-traded index securities are taxed just like mutual funds.

Where capital gains are concerned, the difference between the original purchase price and selling price of your shares will be the amount on which you'll owe capital gains tax. And the normal holding periods for distinguishing between long-term and short-term gains and losses also apply -- a key consideration for investors who use these securities for market-timing.

One of the many advantages of these securities is that they don't make distributions very often. Here's why: To come up with cash to meet shareholder redemptions, a mutual fund may have to sell some of its underlying portfolio. That could generate a taxable capital gain that would eventually be distributed to shareholders. But when shares of an exchange-traded index security are redeemed, the security's specialist (the broker or firm that buys and sells a security in order to maintain an orderly market) will just find another buyer. No need to liquidate the underlying portfolio, and no resulting capital gain distribution.

If an exchange-traded index security does make a distribution, treat it just like a mutual fund distribution. Dividends and short-term capital gains are taxable as ordinary income and long-term capital gain distributions get the preferential rate (20% for most people). Remember, a long-term distribution is taxable as a long-term capital gain regardless of how long an investor owned the shares.

Tricky Wash Sale Rule

Selling one exchange-traded index security at a loss and buying another within 30 days will not trigger the wash sale rule. But what if you own an S&P 500 index fund, sell it at a loss and buy the Spiders which also track the S&P 500, within 30 days?

Unfortunately, there is no cut-and-dried rule here. "It's in the eye of the beholder. The question is: Did your economic position change?" says Jim Calvin, an investment management tax partner at Deloitte & Touche in Boston and editor-in-chief of the Journal of Taxation of Investments.

Many experts would argue that it has not. "I'd be reluctant to argue that it's not a wash sale, says Richard Shapiro, an Ernst & Young securities tax partner in New York.

If the fund you are selling mirrors the same index as the security you're buying, there's a strong argument to be made that the holdings are substantially identical.

And on the Options Front

You can trade options on most exchange-traded indices. For options on broad-based indices, such as Mid-Cap Spiders(MDY Quote), you must use the 60/40 rule to figure out your taxable gain or loss. The rule says that 60% of the gain or loss is long-term and 40% is short-term, regardless of the actual time it's held.

That's pretty clear. But, as we reported in May, there has been no ruling on how gains and losses from options on the QQQ should be reported.

The question is whether or not the Nasdaq 100 that the QQQ tracks is "broad-based." While there is still no definitive answer, "you can make an argument that it's based on a broad-based index," so use the 60/40 method, Shapiro suggests.

For securities that track a narrow index, such as the Select Sector Spiders and Internet HOLDRs, gains or losses from the corresponding options are taxed like those resulting from regular equity options trading.

In other words, gains from an option on Internet HOLDRs would be taxed like gains on a Microsoft(MSFT Quote) option. Check out the Internal Revenue Service's Publication 550: Investment Income and Expenses for more equity option details.

Finally, a Word on Shorting

In addition to the ability to trade Spiders, QQQs and the like on a real-time basis, you can short them, too. "I'm actually seeing people shorting them as a hedge against the market," says Gail Winawer, tax securities partner at American Express Tax & Business Services in New York.

For tax purposes, the short position follows the rules of the underlying long position. The same goes for options. If you short an option on a broad-based index, your gains and losses on the short position will be subject to the 60/40 rule. If you short a narrow-based index, report the gain or loss like you would any other short sale.