Understanding the taxes on covered call ETFs (e.g., QYLD, RYLD and XYLD) whose dividend payments count as ROC: short-term or long-term capital gain?

Question

As a US taxpayer, I am trying to understand the taxes on covered call ETFs (e.g., QYLD, RYLD and XYLD).

From projecttheta, with QYLD as the example:

Almost all of QYLD’s dividend payments have counted towards ROC (return-of-capital) payments, which hold special meaning for investors. Lets say you purchased shares of QYLD at $25. After 1 month you receive $0.25 per share in dividends. Instead of having that $0.25 taxed instantly, instead, your cost basis of your shares drops to $24.75, lowering by $0.25, your dividend payment. What this allows is for no taxes needing to be [paid] until the sale of QYLD, with the cost basis eventually running all the way down to $0.

Let's say I hold 1 share of QYLD for x months, during which I received 5 USD of dividends. Once I sell QYLD, does that 5 USD count as short-term or long-term capital gains? E.g., is it viewed long-term capital gains iff x≥12? Or is it always viewed short-term capital gains?

Answer 1

There are a number of kinds of ETFs. The large majority of them are open end grantor trusts which are pass-through entities and their distributions are non-qualified and are taxed as ordinary income. Qualified dividends are taxed at the long-term capital gains rate. The short answer is that it depends on the nature of the distribution.

As for you example of receiving $5 of dividends, if received in a non-sheltered account, that dividend is taxable upon receipt, not when you sell the fund. However, if that $5 dividend is reinvested, any capital gain from that reinvestment will be taxable when such shares are sold.