Mutual Fund Tax Issues

It is important to plan ahead and maintain good records on mutual fund buy and sell transactions if you want to save yourself a lot of hassle when calculating your taxes, not to mention money!  

The rules governing taxes on mutual funds are similar to stocks; you compare your original cost (or basis) in the shares sold to the sales proceeds (net of any transaction costs). Like stocks, it is best to maximize the basis in the shares being sold to minimize the gain, or conversely to maximize the loss.  Which method you use to calculate your basis when you sell your shares is thus very important; they are detailed to the right. 

You may also be selling losing fund investments with the objective of offsetting gains from earlier transactions. In fact, you can sell enough losers to completely offset those gains and generate a $3,000 net capital loss for the year ($1,500 for married taxpayers filing separately). You can then deduct that loss against your other income from all sources (wages, interest, etc.).

If you sell your entire holding in a particular fund, it's easy to determine your tax basis. It is the sum total of the cost of all your share acquisitions, including any that you bought via the fund's automatic dividend reinvestment program.

However, it takes more thought to calculate your strategy when you sell a portion of your shares and you have purchased shares at several different times and at different prices.  In this case you have several blocks of shares, each with a different per-share cost.  Some blocks may have been held over 12 months and some less.  So when you sell some shares, you need a method to determine which block those shares came from. You can then calculate your gain or loss and determine whether it's classified as long-term or short-term.

Watch Out for 'Wash Sales'
As with individual stocks, if you intend to sell some mutual fund losers for the tax deduction, watch out for the dreaded "wash sale" rule.  Your tax loss gets disallowed if you buy back the same fund shares within 30 days. This is not a total disaster, because the disallowed loss gets added to the tax basis of the shares you buy back.  So you'll eventually make up the difference with a smaller gain or bigger loss when you sell those shares. Still, you lose the current deduction.

You can avoid the problem by repurchasing shares in a different fund with the same investment characteristics. For instance, sell one small-cap fund, then buy a different small-cap fund run by a different manager. You might get in trouble, however, if you sell one S&P 500 index fund, then buy another one within 30 days.

Also, be sure to "turn off" your automatic dividend reinvestment program if it would cause a buyback within 30 days after your loss sale. The buyback would rule out some or all of your tax savings under the wash sale rule.

Methods of Valuing Gains
There area four basic methods of valuing basis:

1. First-in, first-out (FIFO) method;
2. Specific identification (specific ID) 
3. Single-category or average basis
4. Double-category average basis method

In detailing the methods, we will use a common example where you bought three blocks of 100 shares in a given fund at $20, $25, and $24, and later sold 150 shares for $26 ($3,900). 

Benefits:  FIFO increases the odds that your gains will be long-term and qualify for the 20% maximum rate on long-term capital gains. 
Cons:  In a rising market, FIFO tends to generate the biggest tax bill because the oldest, cheapest shares are considered sold first.

The IRS uses FIFO is the "default" method.  In other words, you must use FIFO to calculate mutual fund gains and losses, unless you take the action required to use one of the alternative methods explained below.  

Specific ID Method
Here you specify exactly which block or blocks of shares you intend to sell.  This allows you to minimize gains or maximize losses by selling your highest-cost shares first.  Thus using specific ID, you can sell 100 shares from Block 2 (basis of $2,500) and 50 from Block 3 (basis of $1,200). So your gain is only $200 ($3,900 proceeds less basis of $3,700), vs. $650 if you used FIFO.

To use specific ID, you must take action at the time you make the transaction by telling your broker or the fund to sell specific shares by reference to their acquisition date and per-share cost.  Also, the broker or fund must send you a written confirmation of your instructions (keep this in your tax file for proof).  Unfortunately, some fund companies don't allow this method because of the paperwork involved.

Timing:  selling the most expensive shares could mean your gains will be short-term and taxed at your regular income tax rate rather than the long-term capital gains rate of 20%. On the other hand, if you are selling losers it's generally better to sell short-term shares. Your short-term losses offset short-term gains that would otherwise be taxed at your income tax rate.

Single-Category Average Basis Method
Each time you make a sale, you simply figure your average share basis.  This method is available when you leave your mutual fund shares on deposit in an account with an agent or custodian, but do not actually have possession of your share certificates.

In our example, your average basis on the 150 shares was $23 per share.  So your tax gain is $450 ($3,900 proceeds less basis of $3,450).

Almost all funds now report single-category average basis numbers on transaction statements. They may also automatically calculate your gains and losses under this method. This is very convenient, but as Example 2 illustrates, it doesn't necessarily minimize your taxes.

If you want to use the single-category average basis method, you must indicate so by making a notation on the line of Schedule D, where the gain or loss from the transaction shows up. Just write "single-category average basis method." Beware. Once you use this method for a particular fund, you must continue to do so for all future sales of shares in that fund. (Other funds are unaffected.)

Double-Category Average Basis Method
Here you separate shares into two pools - one holding all long-term shares (held over 12 months), and the other consisting of all short-term shares.  Then each time you sell, you calculate the average per-share basis for each pool. You can then sell strictly out of one pool or the other, or mix and match as you see fit.  

Benefits:  You have more flexibility to control the basis of the shares being sold and whether the resulting gains will be taxed at 20% or your regular rate.
Cons:  Tougher to account for and calculate.  And once you use the double-category method for a fund, you are locked into it for all future sales of its shares.

Example:  Assume the 100 shares bought at $20 are in the long-term pool and the remaining 200 shares are in the short-term pool (average basis of $24.50).  You have two choices:  
1.) You sell all 150 shares out of the short-term pool. This results in a short-term capital gain of $225 ($3,900 proceeds less basis of $3,675).  
2.) You decide to sell all 100 shares in the long-term pool and 50 shares out of the short-term pool. This would result in a long-term gain of $600 ($2,600 proceeds less basis of $2,000) and a short-term gain of $75 ($1,300 proceeds less basis of $1,225).

For many people it makes more sense to use the specific ID method instead, because you can tailor the tax results with greater precision for the same amount of trouble.  And unlike this method, using specific ID has no impact on how you handle future transactions.

If you do use the double-category method, you must specify to your broker or fund how many shares you want to sell out of each pool, and your instructions must be confirmed in writing (just like for specific ID). If your fund won't give you a confirmation, you are considered to sell shares from the long-term pool first. Finally, you must write "double-category average basis method" on the line of Schedule D.