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Tax Ramifications


Before You Adjust Your Portfolio; Think Taxes.

As the stock market continues its volatile ride, investors have become increasingly active in the management of their portfolio. A growing number of investors are diversifying their portfolios with alternative investments, like Managed Futures, in an attempt to smooth portfolio returns. On the other hand, some traditional investors have been forced to adjust their investment time horizons, moving away from a long-term “buy and hold” strategy to one that is more short-term in nature, in an attempt to capture short-lived profits in individual stocks. As investors are adjusting their investment approaches, it is important to understand the tax ramifications that result from these changes.

A review of the different tax consequences associated with these alternate approaches to investing in the markets would be beneficial. Investors in the higher tax brackets might be surprised to find that an investment in Managed Futures may provide a tax savings when compared with a short-term equity investment strategy. Before making any adjustments to an existing investment strategy, it is important for each investor to consult his or her professional tax advisor in order to fully understand the merits of each approach to investing in the markets.

The Basics

In order to qualify for the Long Term Capital Gains Tax Rate of 20%, you must hold the investment for more than one year. If you liquidate your position within one year of the purchase date, you will be taxed at the Short Term Capital Gains Tax Rate, which is the same as your ordinary income tax level. For many individuals this rate can be as high 38.6% percent, which is substantially more than the 20% Long Term Rate.

By comparing the Short Term Capital Gains Tax Rate associated with trading stocks to the Standard Tax Rate associated with investing in Managed Futures, we can gain a better understanding of how Managed Futures investments can be attractive from a tax standpoint.

The Managed Futures Tax Advantage

Most people new to Managed Futures assume that all profits in the futures markets are taxed at the Short Term Rate. However, the IRS concedes that the inherent trading style associated with these types of investments should be structured differently than that of a tradition stock investment (transaction). From a tax perspective, capital gains or losses in Managed Futures are treated with a 60/40 (Long Term/Short Term) split for all profits or losses on domestic exchanges, regardless of how long the position was held. In other words, 60% of these profits are taxed at the 20% long-term rate and 40% of these profits are taxed at the investor’s ordinary income tax rate. Unlike stock trades, this tax rate will remain fixed no matter how long the investment is held. All profits based on foreign markets will be taxed at the Short Term tax rate.

The Managed Futures Tax Advantage Most people new to Managed Futures assume that all profits in the futures markets are taxed at the Short Term Rate. However, the IRS concedes that the inherent trading style associated with these types of investments should be structured differently than that of a tradition stock investment (transaction).

From a tax perspective, capital gains or losses in Managed Futures are treated with a 60/40 (Long Term/Short Term) split for all profits or losses on domestic exchanges, regardless of how long the position was held. In other words, 60% of these profits are taxed at the 20% long-term rate and 40% of these profits are taxed at the investor’s ordinary income tax rate. Unlike stock trades, this tax rate will remain fixed no matter how long the investment is held. All profits based on foreign markets will be taxed at the Short Term tax rate.

Shortened Time Horizon

Many stock investors who have been disillusioned with their buy and hold strategy are choosing to alter their investment approach. Rather than holding onto their stocks positions for more than a year, many investors are now trading from an intermediate three to six month time horizon. This shortened time perspective will increase their tax rate on profits from the Long Term 20% tax rate to the Short Term rate, which is equivalent to the ordinary income tax rate (e.g. 27%, 35% or 38.6% for 2002/03).

Conclusion

With all things equal, Table 1 compares the tax liability for profits generated from Managed Futures versus trading stocks. For a high net worth investor in the 38.6% tax bracket, it is clear to see the tax savings advantage that a Managed Futures (60/40) breakdown offers over the short-term tax rate applied to stock trading. Before making any dramatic adjustments to your portfolio, it is always prudent to consider the tax ramifications first. After all, it could save you a great deal of money at tax time.

Table 1: Tax Liability Comparison

COMMODITY TRADING INVOLVES SUBSTANTIAL RISKS DUE IN PART TO THE HIGHLY SPECULATIVE NATURE OF SUCH TRADING. AS A RESULT, AN INVESTMENT IN A COMMODITY TRADING ACCOUNT IS ONLY SUITABLE FOR YOU IF YOU HAVE ADEQUATE MEANS TO PROVIDE FOR YOUR CURRENT NEEDS AND PERSONAL CONTINGENCIES AND YOU CAN BEAR THE ECONOMIC RISK OF LOSING YOUR ENTIRE INVESTMENT.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.