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Exchange-traded funds are touted for their tax efficiency. It’s one reason their popularity continues.Index-based ETFs carry a big tax advantage for investors because there is very little turnover of the securities within the fund since the managers are simply matching investments to the actual index. Consequently, lower capital gains are passed onto the investor. By contrast, actively managed mutual funds can involve large turnover of the underlying assets and result in large capital gains realized by the investor. This is because the gains at the fund level must be passed on and taxed to the investor, explains Mike D’Avolio, Intuit’s senior tax analyst. When an investor sells an ETF, a short or long term gain or loss is recognized and taxable just as it would be with the sale of an actual stock or bond. Investors in tax-deferred accounts such as IRAs don’t need to worry about these tax advantages because they won’t start paying taxes on those investments until they hit retirement age.

Such is the way of the world for plain vanilla ETFs. However, it’s a bit more complex when it comes to exotic ETFs, those that trade in foreign currencies, highly leveraged securities, precious metals, commodities or clean technology, for example.

For starters, Uncle Sam looks at the underlying investment held by the exotic ETF to determine the tax consequences of the income earned. Although this may sound basic, it’s often the simplest information that gets overlooked. The way ETFs are taxed is dependent upon the underlying assets within the ETF, says Roni Deutch, CEO and founder of the Roni Deutch Tax Center.

For example, if ETF A holds stocks, bonds or mutual funds, any gain realized on the sale of ETF A would be taxed using the rates for capital gains (maximum of 15% for long-term gains). If ETF B holds precious metals, any gain realized on the sale of ETF B would be taxed using the rates for the sale of collectibles. Sales of collectibles are taxed as ordinary income for short-term gains (assets held less than a year) and 28% for long-term gains. That means that the income from the sale of ETF A is going to be taxed less than the income from the sale of ETF B. This higher tax rate may come as a shock to inventors in funds that buy and sell bullion, such as the IShares Silver Trust (SLV) and SPDR Gold (GLD). Gains from most currency funds, are also taxed at ordinary income-tax rates.

Some Strategies Generate Fast Gains — That You’re Taxed on at Short-Term Rates

Then too, Uncle Sam is no fan of foreign futures, says Deutch. The IRS favors U.S.-regulated foreign futures, and allows them, no matter how long they are held, to be taxed under the 60/40 rubric. U.S.-regulated futures contracts are considered as IRC 1256 contracts; 60% of gains are long-term capital gains taxed up to 15%, and the other 40% are short-term capital gains and can be taxed up to 35%, dependent on your ordinary income rate. The maximum blended 60/40 tax rate is 23%. A net loss on 1256 contracts for 2009, for example, can be carried back three years instead of being carried over to the next year. The loss carried back to any year under this election cannot be more than the net section 1256 contracts gain in that year. In addition, the amount of loss carried back to an earlier tax year cannot increase or produce a net operating loss for that year.

Because certain exotic ETFs are set up legally as grantor trusts, the investor becomes the direct owner of a pro-rata share of the underlying security. A Schedule K-1 with the gains and losses is issued to the investor at the end of the year. By contrast, investors in plain vanilla ETFs are simply shareholders of a corporation and receive Form 1099s at year’s end, explains D’Avolio.

Know too, warns Deutch, that highly leveraged ETFs have a handful of nasty tax consequences associated with them. These ETFs aim to beat the Dow Jones Industrial Average on a daily basis. As a result, the underlying assets are being constantly traded. Because the underlying assets are being acquired and discarded day after day, the IRS treats the gain on the sale of ETF — notwithstanding the investor’s ownership of the ETF for over a year — as a short-term gain, which is taxed at higher rates. In addition, leveraged ETFs often use investment strategies that include swaps and futures in order to generate the sought-after returns, she says. These strategies disqualify the ETF from the traditional in-kind redemption process which has given ETFs their reputation for tax-efficiency compared with mutual funds, adds Deutch.

However, in 2009, most leveraged ETFs did end up being tax efficient, says Andy O’Rourke, senior vice president of Direxion, a provider of leveraged ETFs. Both ProShares and Rydex paid zero capital gains on all of the leveraged ETFs. Direxion Shares ETFs also paid capital gains on only 11 of their funds, and no amount greater than 15% of assets. This was achieved through the use of some tax efficient strategies such as carrying over capital losses to offset gains, and ‘high cost’ tax lot accounting where stocks that are sold are taken from the highest cost lots, O’Rourke explains.

Do your research. You really do need to read the fine print in an ETF’s prospectus. Ary Rosenbaum, an associate attorney with the law firm of Meyer, Suozzi, English & Klein says there are three questions to ask yourself: What is the capital gains treatment of the ETF? What is the tax implication of the ETF that may influence end of or beginning of the year tax strategy? And if the ETF is not plain vanilla, what are the tax rules for the underlying assets within the ETF?

You can generally find out something about the tax implications of the investment from the prospectus. However, because everyone’s tax situation is different, make sure you have a competent tax professional on your side. Says Jerry Lynch, a certified financial planner with JFL Consulting, When you start going with sophisticated ETFs, you are taking on a lot of potential tax liability. So you are taking on more risk, and generally, paying more taxes. Unless you know what you are doing, I would advise most average investors not to do this. It is not what you make, but what you make after taxes that counts.