Commodity ETFs: Be aware of these tax pitfalls 

How (most) Commodities ETFs work

For this article, we will examine two of the most popular commodities ETFs: the Invesco DB Commodity Index Tracking Fund (DBC) and the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC).

DBC is structured as a commodity pool, tracking an index of 14 diversified commodities, including oil, corn, wheat, gold, silver, etc. The fund gains exposure through the use of futures contracts, selected to minimize the adverse effects of contango. It costs a relatively hefty expense ratio of 0.87%.

PDBC tracks the same commodities but is structured as an open-ended fund per the Investment Company Act of 1940. It also gains exposure through futures contracts, but the proportion held must be less than 25% due to the Act. The rest is held in the Treasury as collateral. It's also slightly cheaper, with an expense ratio of 0.68%. 

What are the Commodity ETF implications for taxes?

Unwary investors who buy DBC often get a nasty surprise in the form of a Schedule K-1 come tax time. This is because DBC's commodity pool structure is legally considered a limited partnership. Limited partnerships don't pay federal income tax at the fund level – they pass on annual income and gains/losses in the form of a return of capital. 

As the end investor, this means you must report your share of the profits/losses the fund incurred using a Schedule K-1. Schedule K-1s aren’t the end of the world, but they're annoying and tedious to fill out. They also tend to arrive later than other forms, which could delay your filings. 

DBC does have an advantage, though. Commodities pools are taxed slightly more favourably compared to standard open-ended funds. Typically, open-ended funds are taxed based on how long they're held – either the long-term rate after a year and one day, or the short-term rate if less than that. 

Tax rates for commodities pools are split using a "60/40" rule. 60% of gains will be taxed at the lower long-term rate, while 40% will be taxed at the higher short-term rate. This makes them slightly more favorable for active traders who frequently jump in and out of positions. 

For buy-and-hold investors, PDBC looks more advantageous – no K-1 form, and a lower expense ratio. The thing to watch out for with PDBC is asset allocation – the type of account you hold it in. This is because the fund spits out massive distributions in the form of return of capital. 

The current 12-month distribution rate for PDBC stands at a whopping 35.63%. Therefore, it is best suited for tax-advantaged accounts. In taxable accounts, investors will incur a significant drag. This is even worse for foreign investors due to the 15-30% withholding tax on U.S. distributions depending on their country of residence. 

The final word on Commodity ETFs

DBC and PDBC exhibit low correlations with equities and fixed income, and possess high volatility, making them great assets for diversification based on Modern Portfolio Theory principles. As interest rates continue to rise and inflation fails to abate, they may experience more tailwinds. 

However, their complex structure requires investors and traders to be aware of tax implications. Choosing one over the other depends on one's investment objectives and asset allocation strategy. Personally, if my goal is to trade short-term in a taxable account, I'd prefer DBC. If my objective is to buy and hold long-term in a tax-advantaged account, I'd pick PDBC. 

Either way, ensure you consult with a tax attorney or certified professional accountant before investing in either of these funds. I'm not a tax professional, and this article should be read for information purposes only, and not interpreted as advice or solicitations to buy a fund.