Although taxes can create a lot of headaches throughout the long and busy season, I always reflect and realize how much I learned. I hope others reflect on what went wrong, what went right, and how to adjust to make your tax filing season a bit easier next year.
One item that was new to me this year and I came across a few times, are what are known as Widely Held Fixed Investment Trusts (WHFIT). Some of my writing may get technical, but I will keep this as simple as I can but still point out how these investments are taxed.
The reason for me writing this is not to discourage these types of investments, but to be aware what headaches they may create in regards to taxes. I also write this because I foresee more of these popping up with digital currency expanding, which may create investments that take a similar structure. Let’s start with what these investments are:
What are WHFITs or investment trusts?
The purpose of these investments is to give individuals the ability to invest in certain assets without having to outright own the asset. A perfect example is certain metals: like gold. Many are interested in owning gold for its limited availability and widely known “hedge” from inflation. It is a physical asset that holds value.
So how do you go about owning gold? You could go purchase gold bars or coins; to do this you would have to find a seller, buy it from them, find safe storage (which costs ongoing fees) and eventually find a willing buyer in the future if you want to get the value back out of the investment. Sounds like a headache!
This was recognized and securities were created that allow investors easier access to metals like gold. Insert: WHFIT. This is traded on the stock market through an ETF-like investment. The idea behind it is that a trust is formed for the specific purpose of holding gold. When you become an investor in this trust, you own a proportionate amount of the trust and the gold that the trust owns. The trust has management expenses that are paid collectively by all trust holders in order to handle the headaches of purchasing, storing and selling the gold, so that burden no longer falls on you.
I used gold in this example but I saw a few cases of silver this year as well, and I am sure there are many others. There are also virtual currencies that have similar structures; instead of buying actual bitcoin and creating a digital wallet, you can own a trust like GBTC to handle this for you. I suspect that these virtual currency trusts will become more popular as virtual currencies become more popular, to give access to more investors.
Why are they bad?
They are not! I am not implying these are bad investments or that the extra work is not worth the investment. I am just saying that there is extra work, which I will explain below.
The trust is created for investment and pays no taxes, but instead all the trust’s taxable income gets passed on to the owners of the trust (aka investors in these securities).
This may seem like a non-issue because the trust shouldn’t really be selling any holdings, right? You own the investment so you can own pieces of gold so the trust should be holding onto gold. BUT, just like an individual would have to pay expenses to store the gold, the trust has to pay these expenses as well. The trust also has to pay management expenses to those that manage the trust. So, how does the trust pay that? It sells gold and uses the cash for these expenses.
Typically, the trust does this every month to pay their storage fees, and therefore as trust owner, every month there is a taxable event that will get passed on to you and will have to be reported on your tax return.
Here is the kicker: the way that these trusts operate, many of them fall under de minimis rules with the IRS which allows them limited reporting requirements on these distributions. What this ultimately means is that they just say how much gold was sold to create cash - the rest of the reporting requirement falls on the investor.
What do I have to report?
When you get your 1099 from your broker come tax time, the trust will report its internal sales as capital gains with “Unknown basis and undetermined holding period”. In other words, you have to figure that out or else you will be reporting the full amount as taxable income at your highest tax rate. Therefore, it is typically worthwhile to figure your basis and how long you owned the investment to be reporting it correctly.
I am not going to go into that full calculation here, but the trusts will typically publish a year-end report that outlines how many ounces of metal was sold throughout the year (and when). This will allow you to calculate your individual basis and holding period on all the assets sold, which will help you to correctly report your taxable income for the year. Most of these trusts will have a tax center at the end of the year that will give you the information you need and examples to follow.
The final piece of this process is adjusting the basis of your shares downward for the basis you report each year. Every time you “use up” some of your basis when reporting the taxable event, the basis in your remaining shares declines dollar for dollar. This is something that you have to track year over year until you sell the position (or your basis becomes $0).
So, even though you didn’t actually sell any of your shares, there will be a taxable event each year that you hold these trusts which results in a reporting requirement.
Final Thoughts
Again, this was not to discourage these investments, but to point out some of the tax complications that come with them. If it is still worth it to you or you have the means to hire a tax expert to get this done for you, then that is your choice! But if you are typically a DIY tax preparer and this sounds like too much, then maybe it is easier to avoid it altogether.
I think it also brings up the bigger issue of making sure you understand how investments are taxed before getting into them so that you are not surprised come tax time. Another example of this that I have come across are publicly traded partnerships, which may surprise people when they receive a K-1 in the mail.
In talking purely tax purposes, you may also consider holding these investments in a tax deferred account, like an IRA. This will shelter the tax consequences and none of these calculations will have to be done. Tax location is important in instances like this!