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Reader Ken pointed to an article titled “Tax Traps for IRA investors in Short ETFs.” While it was written the beginning of this year, when the markets tanked, the issue, however, is still important.

Here are some highlights:

With the market down about 9% year-to-date, everyone is looking at making money shorting the market. It’s not easy: the downside potential is unlimited. Stocks sold short can be called away by the brokerage firm while a position is at a loss, thus, realizing the loss.

In particular, people are piling into short ETFs. However, qualified-account holders such as IRA investors who are buying short ETFs can run into the headache of unrelated business taxable income (UBTI).

Shorting stocks can only be done in taxable accounts and not qualified accounts like IRAs. However, IRA investors can buy ETFs like the ProShares UltraShort Financials (SKF), the Rydex Inverse Russell 2x Leverage (RRZ) or the Federated Prudent Bear Fund A (BEARX).

However, activities inside of these funds can cause the shareholder to file taxes even if they are bought inside an IRA. This occurs when a tax-exempt entity participates in business that is not deemed tax exempt by the Internal Revenue Service as part of the Employee Retirement Income Security Act of 1974 (ERISA).

[Emphasis added]

Over the years, I have talked with many investors and clients who had holdings in these types of short funds, especially BEARX, since it has been around a long time. However, I have never heard anyone bringing up the potential tax liability in an IRA account.

If you are an accountant, or have had tax issues as described above, please add your input as to how frequently this applies or if this will only occur as a random event depending on the fund’s activity.

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