Chapter 32
Tax Rules for Investors in Mutual Funds

As a mutual fund shareholder, you may receive several types of distributions, such as ordinary dividends, capital gain distributions, exempt-interest dividends, and return of capital distributions. The rules for reporting the different types of distributions are discussed in this chapter.

The tax law provides different methods of identifying the particular shares being sold when you sell a portion of your mutual fund holdings and of determining the cost basis of those shares. You may be able to use these methods to obtain a preferred tax result on the sale.

32.1 Timing of Your Investment Can Affect Your Taxes

You may buy a tax liability if you invest in a mutual fund that has already realized significant capital gains during the year. For example, if a fund is about to make a year-end capital gain distribution and you invest shortly before that, you will in effect have to pay tax on the return of your recently invested money.

You will be eligible to receive a forthcoming dividend or capital gain distribution if you are a shareholder of record on the “record date” set by the fund. On the “ex-dividend date,” the net asset value per share will be reduced by the distribution amount per share. If you buy before the record date, the higher cost for your shares will be offset by the distributions you receive, but you will have to pay tax on the distributions. On the other hand, because you paid the higher pre-distribution price, your higher basis will reduce any capital gain on a later sale, or increase any capital loss.

If you want to limit your current tax and forego the basis increase, postpone your investment until after the record date for distributions. By that time, the value per share that determines the price will have been reduced by the distribution. Before investing, you may be able to find out from the fund when distributions for the year are expected; call the fund or check the fund’s website for an estimate of projected distributions.

32.2 Reinvestment Plans

A mutual fund will allow you to reinvest dividends and capital gain distributions from the fund in new fund shares instead of receiving cash. You report reinvested distributions as if you received them in cash. Form 1099-DIV sent to you by a fund reports the gross amount of taxable distributions that you must report on your return (32.3).

Keep track of reinvested distributions. If you reinvest your mutual fund distributions instead of taking them in cash, you will need a record of the distributions and of the shares purchased with the reinvestment; your fund can likely provide you with a history of your reinvestments. The reinvested distributions are considered your cost basis for the acquired shares. You need a record of reinvestments to figure your cost when you sell your shares; see below (32.8) for calculating gain on the sale of mutual fund shares.

Reinvested distribution can trigger wash sale. If you redeem fund shares at a loss within 30 days before or after a dividend distribution is reinvested into your account, a “wash sale” results, and the portion of the loss allocable to the reinvestment is not deductible (30.6). The allocable loss is disallowed even though the wash sale was inadvertently caused by the reinvestment. The disallowed loss is actually deferred, as it is added to the cost basis of the replacement shares and will affect the computation of gain or loss on a later sale.

32.3 Mutual Fund Distributions Reported on Form 1099-DIV

Mutual fund distributions are reported to you and the IRS by the fund on Form 1099-DIV or substitute statement. Distributions that you reinvested to acquire additional shares are reported and taxed in the same way as distributions that are actually paid out to you.

Types of distributions. The Form 1099-DIV (or substitute statement) from your fund for 2017 may show several kinds of distributions. Distributions that you reinvested (32.2) instead of receiving in cash are included on the Form 1099-DIV.

• Ordinary dividends—are the most common type of dividend, payable out of the fund’s earnings and profits. They are shown in Box 1a of Form 1099-DIV. Short-term capital gain distributions are reported as ordinary dividends.
• Qualified dividends—shown in Box 1b, are your share of the ordinary dividends (Box 1a) that are qualified dividends (4.2) from the fund’s investments in U.S. corporations and qualified foreign corporations. This amount is eligible for the zero, 15%, or 20% capital gain rate (5.3), but only if you held your fund shares for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date (4.2).
• Capital gain distributions—shown in Box 2a of Form 1099-DIV, are your share of the net long-term capital gains realized by the fund on sales of securities in its portfolio. These are taxable to you as long-term capital gain (5.3) regardless of how long you have owned your fund shares.

  If the fund retained long-term capital gains and paid tax on them, your share will be reported to you on Form 2439, rather than Form 1099-DIV (32.6).

• Return of capital (nontaxable) distributions—shown in Box 3 of Form 1099-DIV, are a return of your investment that reduce your basis in your shares and are not taxed until basis has been reduced to zero. If basis has been reduced to zero, you report the excess amount on Form 8949 as either short-term or long-term gain (depending on your holding period for the shares) by reporting the excess as the sales price in column (d), and reporting a zero basis in column (f). See the Form 8949 instructions for further details.

See Table 32-1 for details on how to report these and other distributions on your tax return.

Year-end dividends. Mutual funds sometimes declare dividends at the end of a calendar year but do not pay them until January of the following year. If the dividend is declared in October, November, or December, and paid in the following January, the fund will report the distribution as taxable in the year it is declared.

32.4 Tax-Exempt Bond Funds

Dividends from a bond fund that represent tax-exempt interest earned by the fund are not subject to regular income tax, but capital gain distributions are taxable. The exempt-interest dividends are shown by the fund in Box 10 of Form 1099-DIV. You report exempt-interest dividends along with your other tax-exempt interest on Line 8b of Form 1040 or of Form 1040A. The amount on Line 8b is not taxable, but if you receive Social Security benefits, it could increase the amount of taxable benefits (34.3). If part of the exempt-interest dividends are attributable to private activity bonds, that amount may be a preference item subject to alternative minimum tax (AMT) (23.3). The amount subject to AMT is shown in Box 11 of Form 1099-DIV.

Capital gain distributions are shown on Form 1099-DIV and must be reported on your return; see Table 32-1.

When you redeem your shares in a tax-exempt bond fund or exchange the fund shares for other shares in a different fund, you realize taxable capital gain or deductible loss.

If you received exempt-interest dividends on mutual fund shares held for six months or less and sold those shares at a loss, the amount of your loss is reduced by the exempt-interest dividend. To reflect this adjustment, on Part I(short-term gains and losses) of Form 8949, you increase the sales price in column(d) by the exempt-interest dividend.

32.5 Fund Expenses

If you own shares in a publicly offered mutual fund, you do not pay tax on your share of the fund expenses. There should be no entry in Box 5 of your Form 1099-DIV. However, expenses of a non–publicly offered fund are included in Box 5 of Form 1099-DIV and must be reported as a taxable dividend, even though the amount has not actually been distributed to you. This amount is included as a fully taxable ordinary dividend in Box 1 of Form 1099-DIV. An offsetting deduction may be claimed on Schedule A but only as a miscellaneous itemized deduction, subject to the 2% of adjusted gross income floor (19.1).

32.6 Tax Credits From Mutual Funds

Undistributed capital gains. Some mutual funds retain their long-term capital gains and pay capital gains tax on those amounts. Even though not actually received by you, you include as a capital gain distribution on your return the amount of the undistributed capital gain allocated to you by the fund. If the mutual fund paid a tax on the undistributed capital gain, you are entitled to a tax credit.

To claim the credit, check the Form 2439 sent to you by your fund, which lists your share of undistributed capital gain and the amount of tax paid on it by the fund. Enter your share of the tax the fund paid on this gain as a tax payment on Line 73 of Form 1040, and check box “a” for Form 2439. Attach Copy B of Form 2439 to your return to support your tax credit. Increase the basis of your shares by the excess of the undistributed capital gain over the amount of tax paid by the mutual fund, as reported on Form 2439.

Foreign tax credit or deduction. You may be able to claim a foreign tax credit (on Form 1116) or a deduction on Schedule A for your share of the fund’s foreign taxes. In Box 6 of Form 1099-DIV, the fund will report your share of the foreign taxes paid by the fund. The fund should give you instructions for claiming the foreign tax credit or deduction (36.13).

32.7 How To Report Mutual Fund Distributions

You cannot report mutual fund distributions on Form 1040EZ. Further, you must file Form 1040 and cannot use Form 1040A if you must report an undistributed capital gain on Schedule D or you must report a return of capital distribution on Form 8949 and Schedule D because your basis in your fund shares has been reduced to zero.

Check Table 32-1 above for details on reporting distributions on your return.

32.8 Redemptions and Exchanges of Fund Shares

When you ask the fund to redeem all or part of your shares, you have transacted a sale subject to capital gain or loss rules explained in Chapter 5. Exchanges of shares of one fund for shares of another fund within the same fund “family” are treated as sales. If you owned the shares for more than one year, your gain or loss is long term; if you held them for a year or less, your gain or loss is short term. However, if you received a capital gain distribution before selling shares held six months or less at a loss, your loss must be reported as a long-term capital loss to the extent of the capital gain distribution attributable to the sold shares. Any excess loss is reported as a short-term capital loss. This restriction does not apply to dispositions under periodic redemption plans.

Identifying the shares you sell. Determining which mutual funds shares are being sold is necessary to figure your gain or loss and whether the gain or loss is short term or long term (32.9).

Holding period of fund shares. You determine your holding period by using the trade dates. The trade date is the date on which you buy or redeem the mutual fund shares. Do not confuse the trade date with the settlement date, which is the date by which the mutual fund shares must be delivered and payment must be made. Most mutual funds will show the trade date on your purchase and redemption confirmation statements.

Your holding period starts on the day after the day you bought the shares (the trade date). This same date of each succeeding month is the start of a new month regardless of the number of days in the month before. The day you dispose of the shares (trade date) is also part of your holding period.

32.9 Basis of Redeemed Shares

To figure gain or loss, you need to know the basis per share. Generally, your basis is the purchase price of the shares, including shares acquired by reinvesting distributions back into the fund, plus commission or load charges.

Load charges. Basis does not include load charges (acquisition fees) on the purchase of mutual fund shares if you held the shares for 90 days or less and then exchanged them for shares in a different fund in the same family of funds for which the load charge is reduced or waived.

Cost basis of sold shares. If you are selling your entire mutual fund account, you need to know your total basis for all the shares. If your shares in the fund were acquired at different times, and you are selling only some of the shares in your account, you need to know which shares are being sold and the basis of those shares to determine gain or loss. In general, you can choose between at least three basis methods: the average cost method, the specific identification method, and the first- in, first-out method. These methods are discussed below. When you sell shares that you acquired after 2011, your cost basis for those shares will be reported to both you and the IRS; see below.

Basis will be reported to the IRS when you sell shares acquired after 2011. Mutual fund shares acquired after 2011 are considered “covered shares.” When you sell covered shares, the fund will report your cost basis for the shares in Box 1e of Form 1099-B sent to both you and the IRS.

When you sell shares acquired before 2012, or “noncovered shares,” your mutual fund will not report cost basis on the Form 1099-B it sends to the IRS. On the Form 1099-B it sends to you, the fund will probably report basis using the average cost method, but this does not require you to use the average cost method on your tax return and the basis information will not be reported to the IRS.

If you acquired shares both before 2012 and after 2011, a sale may involve noncovered shares, covered shares, or both, depending on the basis method you select and the number of shares sold. For example, if you use the average cost method, noncovered shares will be considered redeemed first in the order you acquired them, before covered shares are considered sold. The fund will separately figure the average cost for your noncovered and covered shares.

Whether the sold shares are covered or noncovered, you are responsible for reporting your cost basis and calculating your gain or loss on Form 8949 and Schedule D (Form 1040). For covered shares, the IRS can match the basis reported by the fund on Form 1099-B with the basis you report on your return.

Basis methods you can select. To identify the shares you are selling, you can choose between the average cost method, the specific identification method, the first in, first out method, or some other variation of the specification method. Check with the fund for its rules on selecting a preferred basis method for covered shares and its rules for changing the basis method.

If you sell covered shares without having designated a cost basis method, the fund will likely use average cost as its “default” method for reporting basis on the Forms 1099-B (Box 3) it sends to you and the IRS. If average cost is the fund’s default method, and you want to use another basis method for your first sale of covered shares, such as the specific identification method, you must select that method online or on a paper form you mail to the fund before the fund will complete your transaction. Once specific identification is selected, you can identify the specific shares you want to sell by phone (if allowed by the fund), online, or in writing. If you initially use the average cost method, either as the default or because you selected it, and you want to change to another method, or you initially choose another method and want to change to average cost, you must make the change from or to average cost online or in writing, not by phone. If you sell covered shares using the average cost method and then elect another basis method, the new method will apply only to shares purchased after the date that the change request is processed.

If you plan to sell noncovered shares and want to use the specific identification method when you report basis on Form 8949 and Schedule D, you must select that method prior to the sale (online or in writing) and must keep for your records a confirmation from the fund showing that you selected specific shares to be sold. You will need purchase records to substantiate the basis you report on your return for the specifically identified shares.

Here is a summary of the basis methods.

• Average Cost Method—averages your cost for all shares in the fund regardless of when they were acquired. You do not have to identify the exact shares being sold. The average cost for each share is the total cost for all shares, including those acquired by reinvesting dividends and capital gain distributions, divided by the number of shares. For holding period purposes when you file your return (long- or short-term treatment on Form 8949/Schedule D), shares sold under the average cost method are considered sold in the order you acquired them (FIFO). Your fund will calculate average cost separately for your covered and noncovered shares.
• Specific Identification Method—allows you to select exactly which shares are being sold, enabling you to determine your gain or loss and achieve a desired tax result. Check with your fund for its procedures in selecting the specific identification method and for identifying the shares to be sold using the method.
• First-in, first-out (FIFO) Method—treats shares as sold in the order that they were acquired.

Your fund may also offer variations of the above methods, such as highest in, first out (HIFO), which treats the highest cost shares as sold first, or last in, first out (LIFO), which treats the most recently acquired shares as sold first. Check with your fund for the available methods and selection procedures.

32.10 Comparison of Basis Methods

Your choice of basis method can have a significant effect on the computation of capital gains and losses when you sell a portion of your shares in a mutual fund (32.9). The following example compares the average cost method to the specific identification and FIFO methods.

Transaction history. Assume that on February 7, 1997, you made an initial investment of $4,500 for 375 shares in ABC Mutual Fund at $12 per share. Under the dividend reinvestment plan, you received a $400 dividend on December 19, 1997, that you reinvested for an additional 40 shares at $10 per share. On June 12, 1998, you bought 350 shares at $15 per share. On December 22, 1998, you reinvested your dividend, this time for 25 shares at $12 per share. On September 9, 1999, you bought 200 shares at $16 per share. On August 17, 2010, you bought 200 shares at $25 per share. You did not reinvest your dividends received after 1998 and did not buy any more shares after August 17, 2010 or sell any of the shares.

Now assume that you are planning to redeem some of your shares in 2018 and are trying to decide whether to use the average cost, specific identification, or FIFO method for figuring basis. Since all of your shares have been held long term, capital gain or loss will be long term regardless of which basis method is used.

You decide to redeem 200 shares on October 13, 2018, when shares are selling at $20 per share. The table below shows your transaction history and following that is a comparison of how the three basis methods would work given these facts.

Specific identification method. If you identify the particular shares you are selling, you can use the basis of those shares to figure your gain or loss. You must specifically tell the funds the particular shares you want to be redeemed prior to the time of the sale, and must receive a written confirmation of your specification within a reasonable time. Depending on your situation, you may want to either maximize or minimize your gain or loss on the sale.

Assume that under the transaction facts above, you want to realize a loss on the redemption that can be used to offset other gains. You would specify the 200 shares purchased at $25 per share on August 17, 2010, as the shares sold. Since the sales price on October 13, 2018, was $20 per share, the loss would be $5 per share, for an overall long-term capital loss of $1,000 ($4,000 – $5,000).

On the other hand, if you realized a gain, you could offset some capital losses that you realized earlier in the year, but you want to minimize the gain. You would specify the 200 shares bought at $16 per share on September 9, 1999, as the shares sold. Since the shares were sold for $20 per share, the gain would be $4 per share, for an overall $800 long-term capital gain ($4,000 – $3,200).

FIFO (first-in, first-out). Under the FIFO method, the oldest shares, the February 7, 1997 shares, are considered sold first. Thus, the basis of the 200 shares sold would be $12 per share. Your long-term capital gain is $1,600 ($4,000 – $2,400).

Average cost. Assume that the ABC Mutual Fund has calculated your average basis and provides it on your account statements. Your average cost is $15.67. This is your total investment of $18,650 divided by the 1,190 total shares. At $15.67 per share, the total cost is $3,134 for the 200 redeemed shares. Your long-term capital gain is $866 ($4,000 – $3,134). The shares sold are considered to be from the earliest lot in 1997.

Conclusion.Given this transaction history and preferred gain or loss objective, the specific identification method is advantageous. It allows you to realize a loss if that is your preferred tax result, or to realize the lowest capital gain if that is your preferred tax result.

32.11 Mutual Funds Compared to Exchange-Traded Funds

From an investment perspective, mutual funds are similar to exchange traded funds (ETFs); both offer a bundle of underlying investments providing diversity that reduces the risk of loss. If there are any dividends from these investments, both permit dividend reinvestment in most cases. However, there are significant differences in tax treatment.

Tax efficiency. Mutual funds may generate tax consequences for investors because fund managers trade and re-balance the funds’ holdings to satisfy shareholder redemptions. In effect, there may be capital gains for shareholders even though such shareholders have unrealized losses on their holdings (i.e., the value of their investment may have declined even though they are required to report gains). In contrast, ETFs generally do not generate gains from underlying investments while shareholders hold their positions; shareholders only realize gain or loss when they sell their ETF shares. However, certain ETFs offer less tax efficiency (check with a financial/tax advisor for guidance on the tax ramifications of a particular ETF).

Dividends. Dividends paid from ETFs may be treated as qualified dividends, which are subject to favorable tax treatment (4.2). These dividends cannot offset capital losses. Capital gain distributions from mutual funds are considered long-term capital gains; they are taxed at favorable capital gain rates (32.3). They can also be used to offset capital losses and a limited amount of ordinary income (5.4).

Identifying shares sold. If you acquire shares at different times and sell less than your entire holdings, you may take action to minimize gain or maximize loss (depending on your overall tax position for the year). If no action is taken, you are treated as selling the first shares acquired (first-in, first-out). For ETFs, which are treated like stock, you can choose to use the specific identification method (32.10) to select those shares that produce the desired tax results. For mutual fund shares, you can use the specific identification method or an averaging method (32.10). You cannot use the averaging method for shares in ETFs.