Personal finance

Democratic plan would close tax break on exchange-traded funds

U.S. Senate Finance Committee Chairman Ron Wyden, D-Ore., questions IRS Commissioner Charles P. Rettig at a June 8, 2021 Senate Finance Committee hearing.
Tom Williams | Pool | Reuters

Senate Finance Committee Chairman Ron Wyden, D-Ore., has floated a new levy on exchange-traded funds to help pay for the Democrats’ $3.5 trillion budget package. 

Exchange-traded funds, or ETFs, are baskets of assets — such as stocks or bonds — and can be bought or sold throughout the day like stock. While everyday investors don’t directly own the shares, a fund manager may buy or sell the underlying assets to financial institutions.

Regular investors typically avoid taxes while owning the fund because financial institutions can swap the underlying assets for others, known as an “in-kind” trade, which doesn’t trigger capital gains.

Wyden has called for ending the tax break for these in-kind transactions, according to the proposal, which may affect all investors across the $6.8 trillion U.S. exchange-traded fund industry.

The plan aims to crack down on the financial institutions that bypass capital gains taxes.

“We’re only talking about the taxable accounts of the wealthiest investors,” said Wyden in a statement, as the plan exempts ETFs in tax-deferred retirement plans, such as 401(k) plans or individual retirement accounts.  

“This particular proposal simply applies the same rules already in place for corporations to regulated investment companies, so wealthy investors can no longer avoid all tax on their gains,” he said.

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Fund managers use the in-kind trading strategy to get rid of appreciated assets without creating a taxable transaction.

For example, a fund manager may tell a financial institution to deposit stocks, and the financial institution redeems the assets the fund manager wanted to sell two days later, known as a “heartbeat trade.”

“Everyone uses [heartbeat trades] when there’s going to be a rebalancing,” said Fordham University law professor Jeffrey Colon, who has researched the topic.

Wyden’s plan to tax in-kind trading has already received pushback from the ETF industry, saying the plan may hurt smaller investors as they could be liable for taxes as well.

Wyden’s proposal may raise $200 billion over the next decade, according to preliminary estimates from the nonpartisan Joint Committee on Taxation. However, lawmakers are still debating ways to fund the $3.5 trillion budget.

“As the Senate Democratic caucus continues to look at the menu of tax policy I’ve put forward, this package of loophole closers will be an important part of our conversation,” Wyden said.

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