Futures in RICs are kind of a bummer... for now.
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Educational content. Not tax advice. Work with a tax professional.
When an investor holds a regulated futures contract directly, or another Section 1256 contract, the gains are split 60% long-term / 40% short-term no matter the holding period. Both pieces are capital gains on Schedule D and are fully offsettable by tax losses harvested elsewhere.
But… when a mutual fund or ETF holds those same regulated futures and distributes the gains, the 40% short-term piece becomes ordinary:
Ordinary rates (most people know this)
Ordinary character (most people do not know this)
People love to argue with me about this, so let’s start with this from IRS.
A net short-term capital gain loses its separate character as a short-term capital gain upon inclusion in investment company taxable income… Short-term capital gains become ordinary income when short-term capital gains exceed short-term capital losses for the taxable year..
This applies to any short-term capital gain distributed by a mutual fund or ETF, but the 60/40 nuance in regulated futures is front of mind, so I figured I'd explore it further.
Ordinary character matters because external tax-loss harvesting won’t help that much with the tax bill if a regulated investment company (RIC) shovels out short-term capital gains (but Internal losses, the kind a fund’s portfolio managers do, within the fund, will help).
In other words, losses from a robo-advisor, direct indexing, tax-aware long/short, etc., cannot meaningfully offset short-term capital gains distributions by a RIC, including from managed futures and derivative income ETFs and other sources of short-term capital gains.
Since the short-term gains are technically ordinary, harvested losses may offset $3,000 per Section 1211(b), as a tiny silver lining.
Below, I provide a numerical explanation via an infographic for how this plays out.
