Investing in Gold Can Be Taxing

Case Study

19 Oct Investing in Gold Can Be Taxing

Investment asset classes include precious metals, especially gold. Enthusiasts cite several reasons for including gold in a diversified portfolio. If governments print money to cover increasing obligations, gold may act as an inflation hedge. Moreover, gold can offer a safe haven in times of geopolitical upheaval: in mid-2016, for example, when Great Britain voted to leave the European Union (Brexit) and financial markets were unsettled, the price of gold reached a two-year high.

If you decide to allocate some investment dollars to gold, there are many options to choose. The tax treatment can vary, depending on how you invest, and you might be unpleasantly surprised.

Classed as a collectible

Gold investors may prefer to invest in ‘physical’ gold: mainly, coins and bars. If the price of gold increases over time, so will the value of these holdings. Investments in gold mining companies, on the other hand, do not have this direct relationship.

However, physical gold is considered a ‘collectible,’ under the tax code, similar to paintings or rare stamps. Any profits on the sale of collectibles is taxed as ordinary income, with a top rate of 28 percent if the item has been held for more than one year.

Example 1: Dave Adams bought gold coins several years ago. He sells them in 2016. This year, Dave’s taxable income is $250,000, which puts him in the 33 percent federal tax bracket. His profits on the sale of the gold coins is taxed at 28 percent, the top rate on collectibles.

Suppose that Dave had invested in a gold mining stock or in a fund holding shares of mining companies. In that situation, Dave’s profitable sale would have been taxed no higher than 15 percent, the typical tax rate on long-term capital gains. The highest tax rate on long-term capital gains, owed by investors with extremely high incomes, is 20 percent, which is still lower than the maximum 28 percent tax rate on long-term collectibles gains.

Funds can be collectibles

Increasingly, investors are choosing bullion-backed exchange-traded funds (ETFs) for gold investing. Essentially, these funds buy huge amounts of physical gold, store that gold, and issue shares to investors. The value of the shares is directly related to the price of gold.

Example 2: When gold trades at $1,250 an ounce, Jenny Brown invests $25,000 in a gold-backed ETF. If gold prices go up 20 percent, to $1,500 an ounce, Jenny’s shares will be worth approximately $30,000, for a 20 percent gain. If gold falls 20 percent, to $1,000 an ounce, Jenny’s shares will be worth around $20,000, for a 20 percent loss.

Gold-backed ETFs can be bought and sold like any stock or fund, so they can fit easily into the rest of your portfolio. As indicated, they offer a direct play on the price of gold. On the downside, gold-backed ETFs are taxed as collectibles, even though they seem to be similar to traditional traded securities. If you sell one of these ETFs at a profit after a holding period of more than a year, you will not get the benefit of low long-term capital gain tax rates. Instead, long-term gains will be taxed as ordinary income, with tax rates as high as 28 percent.

Mining stocks & funds

Another way to put gold into your portfolio is to buy shares of a gold mining company, or shares of a fund holding mining-company stocks. Generally, rising gold prices are good for these securities. In fact, if you are truly bullish on gold, such investments might be ideal because operating leverage can boost your gains.

Example 3: Wayne Douglas buys shares of ABC Gold Mining Corp. when gold is priced at $1,250 an ounce. ABC can mine and deliver gold to the market at $1,000 per ounce, with costs that are mainly fixed, for a profit of $250 an ounce, in this example.

Suppose that gold goes up to $1,500 an ounce, for a 20 percent gain. Here, ABC’s profit goes from $250 an ounce to around $500 an ounce, for a 100 percent gain. With a leap in profitability of that magnitude, it is possible that ABC shares will rise far more than the 20 percent rise in the price of gold. This is a simplified example, but a successful investment in mining shares might be more lucrative than an investment in physical gold or in bullion-backed ETFs, if gold rises in price.

In addition, gains on the sale of mining shares held more than one year will get long-term capital gain tax treatment, as mentioned. Depending on the investor’s income, such gains would be taxed at 20 percent, 15 percent, or even zero percent.

Nevertheless, operating leverage can work against investors, too. A drop in the gold price could reduce or eliminate profits and send ABC’s share price tumbling. Moreover, any investment in an operating business takes on business risk: exposure to poor management, labor problems, lagging production, and so on. Thus, buying mining shares is not a direct play on gold’s valuation.

There are still other ways to invest in gold, from closed-end funds to exchange-traded notes. Each may have pros and cons as well as varying tax treatment. If you are considering an investment in gold via an unfamiliar vehicle, our office can explain the tax consequences.