If a mutual fund or ETF holds securities that have appreciated in value, and sells them for any reason, they will create a capital gain. However, due to the structural differences in the way the shares are created, an ETF fund can avoid recognizing capital gains on trading profits because they can avoid the outright selling of holdings triggering a capital gain that would have to be distributed.
Mutual funds and ETFs risk generating tax bills for investors whenever they sell stocks in a fund’s portfolio at a profit. Investors can be liable for taxes on those capital gains even though they themselves don’t sell their fund shares. Mutual funds are required to pass on capital gains taxes to investors through the life of the investment, but ETFs incur capital gains only upon sales of the ETF.
When an ETF experiences redemptions, it can hand over a basket of the fund’s underlying securities instead of cash. It can also pick which shares to hand over, picking the shares with the highest cost basis will reduce the greatest embedded capital gains. Because the trade is conducted in-kind, no capital gains are realized. Although, ETFs don’t shield dividend and interest income from current taxation.
From the perspective of the Internal Revenue Service, the tax treatment of ETFs and mutual funds are the same. Both are subject to capital gains tax and taxation of dividend income. However, ETFs are structured in such a manner that taxes are minimized for the holder of the ETF and the timing on the ultimate tax bill, after the ETF is sold and capital gains tax is incurred, is left up to the the investor.