New ETFs May Harbor Surprise Capital Gains

The rapid growth in the exchange-traded fund arena is increasing the complexity of capital gains taxes, writes the Wall Street Journal.

Last year, 18% of the ETFs tracked by Morningstar Inc. passed along capital gains to investors, or 95 ETFs in total. In 2006, that number was 6% and in 2005 it was 3%.

“ETFs are not immune” from capital gain, said Christine Hudacko, a spokeswoman for Barclays PLC. “We’ve got so many slices of the market,” it is difficult to compensate for mergers and other corporate actions, she said.

Holders of ETFs and mutual funds pay taxes on their gains when they sell fund shares, but they also pay taxes on trading profits the funds earn. The tax rate for long-term capital gains tops out at 15% and at 35% for short-term gains.

ETF fund managers can eliminate some capital gains before distributing to investors because of the unique way ETFs create and redeem fund shares.

Funds launched in 2006 or 2007 were three times more likely to pass along capital gains than older funds, according to Morningstar.