Do ETFs Pay Capital Gains? How the Taxes Work
Learn the tax implications of owning ETFs. Understand how capital gains are generated when you sell or from the fund, and the mechanics of their tax efficiency.
An Exchange-Traded Fund (ETF) is an investment fund holding assets like stocks or bonds, traded on stock exchanges. Investors buy shares representing ownership in these assets. A capital gain occurs when an investor sells an asset for more than its original purchase price. This profit is considered taxable income by the Internal Revenue Service (IRS). ETFs can generate these taxable events for shareholders in two primary ways.
Capital Gains from Selling ETF Shares
An investor triggers a capital gains tax event by selling their ETF shares for a profit. The gain or loss is calculated starting with the cost basis, which is the original purchase price plus any commissions. When the shares are sold, the cost basis is subtracted from the sale proceeds. A positive result is a capital gain, while a negative result is a capital loss.
The tax treatment for these gains depends on the holding period, or the length of time the shares were owned. A short-term capital gain occurs from selling shares held for one year or less. These gains are taxed at the investor’s ordinary income tax rate, which for 2024 and 2025 ranges from 10% to 37%, depending on taxable income and filing status.
Long-term capital gains occur when an investor sells shares held for more than one year. These gains are taxed at preferential rates that are lower than ordinary income rates. For the 2024 and 2025 tax years, the long-term capital gains rates are 0%, 15%, or 20%, based on the investor’s taxable income.
As an example for 2024, single filers with taxable income up to $47,025 may qualify for the 0% rate, while those with income between $47,026 and $518,900 fall into the 15% bracket. High-income earners may also be subject to an additional 3.8% Net Investment Income Tax (NIIT) on their investment income.
Capital Gains Distributed by the ETF Fund
Investors can also face capital gains taxes from distributions made by the ETF, even without selling their shares. This happens when the fund manager sells underlying securities within the portfolio for a profit, often during rebalancing. The fund is required to distribute these realized gains to shareholders, who must then pay taxes on the distribution.
ETFs are known for tax efficiency due to “in-kind” creations and redemptions. To create new ETF shares, institutional investors called authorized participants (APs) deliver a basket of the actual securities to the fund manager. In exchange, they receive a block of new ETF shares. This in-kind transaction does not involve cash and does not generate a taxable event for the fund.
The redemption process provides a tax advantage. When an AP redeems ETF shares, it returns a block of them to the fund manager and receives a basket of the underlying securities in return. This allows the fund manager to offload appreciated securities without selling them for cash on the open market.
By transferring securities “in-kind,” the fund avoids realizing capital gains that would otherwise be distributed to all shareholders. This mechanism is why ETFs typically generate fewer capital gain distributions than traditional mutual funds, which must often sell securities for cash to meet investor redemptions.
Tax Reporting for ETF Capital Gains
For capital gains from selling ETF shares, your brokerage provides Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions.” This form summarizes each sale, including proceeds and cost basis. This information is used to complete Form 8949 and Schedule D of your tax return to report the final gain or loss.
For capital gains distributed by the fund, investors receive Form 1099-DIV, “Dividends and Distributions.” Box 2a of this form, “Total capital gain distributions,” shows the total gains the fund passed on to you. These distributions are generally treated as long-term capital gains, regardless of how long you have owned the ETF shares.
Tax Treatment of Specialized ETFs
The tax treatment for ETFs holding specialized assets can differ from standard stock-based funds, as the underlying holdings and fund structure dictate the tax consequences.
For bond ETFs, capital gains from selling shares are taxed based on the standard holding period rules. However, the interest payments distributed by the fund are taxed as ordinary income, not at the lower long-term capital gains rates.
ETFs holding physical commodities like gold or silver are subject to different rules, as the IRS classifies these metals as “collectibles.” Long-term capital gains from selling shares in these ETFs are taxed at a maximum rate of 28%. Short-term gains are taxed as ordinary income.
Currency ETFs also have unique tax rules. For many structured as grantor trusts, gains from selling shares are taxed as ordinary income, regardless of the holding period, meaning investors do not get the benefit of lower long-term rates. Because tax treatment can vary by fund structure, it is important to review the ETF’s prospectus.