Gold has had a fantastic year so far in 2020, with its price climbing from around $1,500 per ounce at the end of 2019 to briefly above $2,000 per ounce recently. That's put the cherry on top of a nice five-year bull market that has seen the yellow metal almost double in price. Other precious metals have seen similarly impressive gains: Silver went from around $18 per ounce to $29 in 2020, and palladium soared to new record heights above $2,750 per ounce before falling back more recently.

There are plenty of gold investors who have ridden the wave higher and are looking to cash in. Unfortunately, the IRS will want its share come tax time -- and the cost could be higher than you expect.

Gold bullion next to a chart showing prices rising.

Image source: Getty Images.

Special tax rules for gold

Most investors are familiar with the capital gains tax rules that apply to most investments. The profits from most stocks, bonds, and funds get taxed at ordinary income rates if you hold them for a year or less. However, if you're a long-term investor and hold your investments for more than a year, then lower long-term capital gains tax rates apply. For high-income investors, that can cut tax rates of 22% to 35% down to just 15%, or a 37% ordinary tax rate to 20%. For lower-income investors, long-term capital gains often come tax-free.

The problem is that many gold investments get put in a different category. The IRS characterizes many of them as collectibles. Collectibles don't qualify for the lower capital gains rates above. Instead, they're subject to a maximum capital gains tax of 28%. That's quite a bit higher than the 0%, 15%, or 20% that apply to most long-term capital gains.

What precious metals investments are collectibles?

Here's where the tax laws get confusing. Section 408(m)(2) of the Internal Revenue Code includes "any metal" and "any stamp or coin" within the definition of collectible. However, Section 408(m)(3) claims to make "certain gold, silver, or platinum coins" exempt from the higher collectible tax.

That would seem to make popular gold bullion coins like the American Eagle series eligible for the lower tax rate. Unfortunately, elsewhere in the tax code, there's a provision that requires all bullion to be treated as collectibles for tax purposes. 

Many investors don't buy gold or other precious metals in actual bullion form. Gold and silver ETFs like SPDR Gold (NYSEMKT:GLD) and iShares Silver (NYSEMKT:SLV) do a good job of tracking the prices of underlying commodities. However, even though investors in those ETFs own shares rather than bullion directly, the funds themselves invest in those precious metals -- and that leaves them subject to the same higher tax rates on collectibles.

Some foreign gold investments have taken advantage of complex tax laws to get regular capital gains treatment. The Canadian ETF Sprott Physical Gold Trust (NYSEMKT:PHYS) and similar funds holding various combinations of metals are considered passive foreign investment companies. That gives taxpayers the right to elect to have gains treated as regular long-term capital gains.

How about gold mining stocks?

The rules governing collectibles apply to direct investments in gold and other bullion. If you buy shares of operating mining companies, though, you can get the same treatment as you would with any other business.

The challenge there is that gold mining stocks don't always move in tandem with the underlying metal. For instance, even if gold prices are on the rise, a facility accident or other company-specific issue can hit a mining stock hard. If you're fortunate enough to find a winner, however, you'll get preferential tax treatment if you hold shares longer than a year.

Keep your profits

Tax planning is never fun, but neither is paying more to the IRS than absolutely necessary. By knowing the rules governing gold investments, you'll know what to expect and be able to take steps to minimize how much you have to pay.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.