Simplicity. That's an excellent word to describe mutual funds. The simplicity of mutual funds has permitted millions of people to participate in the opportunities and profits derived from the ownership of American business. Investment selection, timing, diversification, and monitoring are fundamental aspects of modern-day mutual funds, and by simply checking off the appropriate box on an application, income and capital gains can be automatically reinvested to acquire more shares. An investor can even redeem mutual fund shares with checkwriting privileges that accompany any mutual funds today. It would seem to follow that paying income tax generated by fund ownership would be simple too--but that can be a trap. The ability to invest and redeem shares easily and in small amounts complicates the correct determination of capital gains incurred in the sale of mutual fund shares.
During the investment and reinvestment phases, the taxation of mutual funds is uncomplicated. Mutual funds send out a Form 1099 which summarizes the dividend income, interest income, and capital gains distributed to investors during the year. Things get a bit more complicated when shares are sold. An investor first needs to determine which mutual fund transactions constitute a sale, and, secondly, he must determine the cost basis of the sold shares.
What's a Sale?
Often, an investor is surprised to learn that certain types of transactions are considered sales by the IRS. For example, a transfer of assets from one mutual fund to another in the same fund family is not considered a transfer for tax purposes; rather, it represents the sale of one fund and the purchase of another. Redemptions by checks are also considered sales, as are redemptions derived from an investor's participation in a systematic withdrawal plan.
Sometimes the reverse is true--what an investor thinks is a sale may not be. Falling victim to the wash sale rule is the most probable cause of this kind of confusion. The wash sale rule prohibits an investor from selling an asset to realize a tax loss if the purchase and sale of the same asset occur within 30 days of each other. If this happens, that portion of the tax loss attributable to the repurchase can not be declared. In the case of mutual funds, the wash sale rule can be triggered accidentally--and therein lies the difficulty. Further elaboration about these rules and the ways to minimize problems are presented later in this article.
Cost Basis
The second mutual fund tax problem lies in how to determine the cost basis of the shares sold. Cost basis information is the key to determining taxable profit or loss. If 12 monthly systematic withdrawals are made, for example, 12 separate sales must be reported, requiring the determination of 12 separate cost bases so that the appropriate profit or loss for each sale may be deter- mined.
This is also true for mutual funds that purchase only tax-exempt municipal bonds. Although the interest from such bonds escapes income taxation, the sale of municipal bond fund shares, as with any other mutual fund, is still a reportable capital transaction. A cost basis determination must therefore be made for tax-exempt funds. The cost basis problem, however, does not exist for money market mutual funds because the share value remains constant.
The information necessary to report a sale on Schedule D, Form 1040
includes:
1) date(s) of purchase(s), 2) date of sale, 3) proceeds from the sale, and 4) the cost basis of shares sold.
The date of purchase in the case of mutual funds can, under certain circumstances, be satisfied by use of the word "various" because, in fact, the sold shares are likely to include those that were acquired in small share increments over long time periods through dividend and capital gain reinvestment. The date of sale and the proceeds from the sale are items easily plucked from recent confirmation statements. The difficult task is determining the cost basis of the sold shares.
The concept of cost basis is new to many mutual fund owners. Most of the time, the cost basis of an investment is represented by its original cost. Thus, if an investment of $4,000 is used to buy an asset that is later sold for $6,000, determining the profit is easy--the proceeds of the sale, $6,000, less the cost basis of the shares, $4,000, provide a taxable profit of $2,000.
There are, however, many circumstances and many financial transactions that can alter the cost basis of an investment. Depreciation, for example, will decrease the cost basis of an investment. Assume a piece of income producing real estate costs $400,000 and that over the years, the investor takes tax deductions for depreciation that total $100,000. If the property is sold for $600,000, the profit will not be $200,000--it will be $300,000, be-cause the tax law required that the $100,000 of depreciation be used to reduce the cost basis of the investment from $400,000 to $300,000.
An ironic example of a situation that can favorably impact cost basis is death. Assume that the investor who purchased the 100 shares of ABC for $4,000 dies at a time when the shares are worth $6,000. The inheritor of the shares holds them until they are worth $7,000 and then sells them. The profit will not be $3,000--it will be only $1,000, because estate tax law permits inherited property to have its cost basis "stepped-up" to the value of the property at the time of the owner's death, in this case, $6,000. These are but two examples; there are many other situations that affect the cost basis as well.
The Cost Basis of Mutual Funds
Unfortunately, determining the cost basis of mutual funds can be quite complex. Yet ironically, the two "simple" attributes of mutual funds--the ease of making small and frequent additional investments and the ability to reinvest dividends and capital gains--are at the root of the problem. Regardless of the amount or the frequency, each additional investment and each reinvestment of distributions constitutes a new purchase. When shares are subsequently sold, the question is: Which shares were sold? Under the appropriate circumstances, investors can select specific shares, first purchased, or the shares that carry an average price.
To select the best method for you requires your understanding of the benefits and problems associated with each method because once a cost basis method is selected for a given fund with a given registration, the method must be continued until the fund is eventually liquidated. Any subsequent change in method will require IRS approval and, unfortunately, the IRS tends to be stingy in giving such approval without very good cause.
The Specific Identification Method
The specific identification method gives an investor the most flexibility and therefore the best opportunity to achieve the lowest tax cost. The disadvantage is that the process requires accurate and thorough recordkeeping, and extra effort on your part to meet IRS requirements at the time of sale. The method, however, allows the investor to pick and choose which shares to sell, or for that matter, donate. An investor should sell only shares with the highest cost basis in order to minimize the personal tax burden, and donate only shares with the lowest cost basis to an authorized charity. Donations of appreciated shares to IRS-authorized charities allow an investor to avoid having to declare as taxable income the difference between the property's cost basis and the fair market value, while permitting the investor to deduct from taxes the fair market value of the.gift. Please note, however, that such gifts may precipitate an undesirable "alternate minimum tax" for some large-income taxpayers. Investors should therefore investigate this potential complication before making charitable gifts of any appreciated property.
Unfortunately, there are some disadvantages to the specific identification method. First, keeping records to separately identify each and every "purchase batch" of shares is very cumbersome--so awkward in fact, that one investor/engineer resorted to color-coding transactions in order to keep them straight. The problem is that there are likely to be a large number of buys with a small monetary value to match up with a single sell. When the IRS wrote the regulations for the specific identification method, they obviously did not have mutual funds in mind. They were thinking about common stock purchases and sales. The vast majority of mutual fund investors keep their securities on deposit with the sponsor and reinvest income and capital gains distributions. Every time shares are acquired through reinvestment, such shares represent another "batch," and short of asking for delivery, there is no way to physically isolate them from all the other batches. In addition, if delivery is taken, an investor still has a problem because delivery cannot be made for fractional shares. Such fractional shares are automatically sold and the sale produces a capital gain/loss tax problem.
To take advantage of specific identification to compute the cost basis of shares sold you must clearly identify the origin of the shares at the time of the sale. It is best to keep a copy of all letters sent to the fund specifying the purchase date and price of the sold shares, and to request written confirmations from the fund. When making telephone redemptions, you should follow up the call with a letter. A sample redemption is illustrated below:
"RE: ABC Mutual Fund, Account No. 12345, registered to (whomever)
Please redeem 57.728 shares and remit the cash proceeds to my address of record. I wish to designate that you sell the 12.345 shares acquired on August 12, 1979, at $28.47/share; the 23.896 shares acquired on December 18, 1979, at $31.12/share; and the 21.487 shares acquired on February 12, 1980, for $30.88/share."
The FIFO Method
The FIFO approach to the cost basis problem is the "default" method taken by the IRS in the event the investor fails to choose a method or reports a sale improperly. FIFO stands for first-in, first-out--in other words, the first shares purchased, or the oldest shares left in your inventory, are considered the first shares sold. Most of the time, this approach produces the largest profit and thus the largest tax because mutual fund prices tend to increase with the passing of time. Thus, the oldest shares will probably have the lowest cost basis. The accounting required to keep this system "straight" isn't easy either, but at least, if done consistently and accurately, it will always be found acceptable by the IRS. Most investors would be ill-advised to use the FIFO method however because it is likely to generate the highest tax burden.
The Average Cost Method
The Average Cost Method represents a compromise for mutual fund investors. As the name implies, a running average cost is maintained by dividing the current number of shares into the total dollars invested and reinvested. With this method, every share, regardless of when it was acquired, will carry the same cost basis. Although there is less planning flexibility than with the specific identification method, there is greater income tax saving than with the FIFO method. Accounting complexity, too, is reduced--especially if the worksheet presented here is used.
Factors that Change the Average Cost Basis
A number of different kinds of transactions can alter the average cost basis: the purchase of additional shares through cash contributions, the reinvestment of distributions, redemptions, share splits, share dividends, and perhaps the most difficult of all, distributions that have been reclassified as "return of capital" after the fact.
1) Cash Purchases increase the total cost and the total shares, and therefore influence the average cost per share.
2) Reinvestment should be treated exactly like purchases, i.e., they increase the total cost and the total shares, and therefore influence the average cost per share.
3) Partial or complete redemptions reduce the total cost and the total shares, but do not impact on the average cost per share.
4) Stock Splits or Stock Dividends do not change the total cost, but they do increase the total shares and decrease the average cost per share.
5) Return of Capital is the most difficult category to handle, principally because the investor generally does not know that this has occurred until the Form 1099 has arrived. The amount determined to be return of capital needs to be backed out of the cost data. Thus, a return of capital reduces the total cost, does not change the total shares, but decreases the average cost per share.
Don't Be Too Creative
Unfortunately, some mutual fund shareholders become "creative" by inventing their own methods for determining the taxable profit of mutual funds sales. Or worse, they neglect to report such sales or fail to realize that what they interpreted as a transfer is, instead, a "sale" as defined by the IRS. It typically takes several years for the IRS to catch up with such an "oversight." When they do, this creativity or neglect can cause an investor problems such as additional taxes, with interest and penalties calculated retroactively from the year in question. But that's not all: Under some circumstances, failure to report sales can constitute criminal neglect--and that can open up entirely new cans of most unpleasant worms.
Maintaining Good Records Is Not an Elective
Thus determining and maintaining accurate cost basis information on mutual funds is not an elective; it is a requirement of the law. In fact, it is essential that every investor maintain a complete chronology of all mutual fund transactions. This chronology should be maintained not only during the period of ownership but for as long as six years after the last shares of a given mutual fund are sold--under some circumstances, the IRS has that much time to pull an audit.
Investors tend to go to extremes when it comes to retaining mutual fund confirmation statements. They either toss them all out-- retaining only the last statement--or they maintain every statement they've ever received. Although it's a lot easier to handle the latter situation than the former, keeping only the minimum required statements makes a lot more sense. If the average cost basis method will be used, retaining just the last confirmation statement each year is enough--the one that shows the cumulative summary of all transactions for that year. Moreover, the summary statement should be retained as a permanent record for at least six years following the sale of the last of the shares in the account.
Good Records Result in Lower Taxes
Fortunately, there is a benefit for the investor from all this recordkeeping. Most investors overstate profits from their mutual fund sales because of poor records. These overstatements inevitably are the result of failing to take into consideration the fact that tax has already been paid on reinvested distributions that have therefore increased the cost basis. Ironically, it is the investor who fails to keep good records that falls victim to this tax trap. Thus, good records not only confirm the proper payment of taxes, but they help you avoid possible overstatements of profits as well.
Using the Worksheet
The data entry rules are presented below:
1) The dollar value of a purchase or reinvestment should be entered in column E as a positive number with the price per share entered in column F also as a positive number.
2) The dollar value of a partial or complete redemption should be entered in column E as a negative number, with the price per share entered in column F as a positive number.
3) The number of shares received as a result of a stock split or stock dividend should be entered in column G as a positive number, with zeros entered in columns E & F.
4) The dollar value of amounts determined to be a return of capital should be entered in column E as a negative number, and zero entered in column F.
The Wash Sale Rule
As previously stated, the wash sale rule prohibits an investor from selling an asset to realize a tax loss if the purchase and sale of the same asset should occur within 30 days of each other. If this happens, that portion of the tax loss attributable to the repurchase cannot be declared. In the case of mutual funds, the wash sale rule can be triggered accidentally.
Here's an example of the problem: A capital gains distribution is reinvested a few days after the investor requests a partial liquidation. Because the cost basis of the redeemed shares exceeds the selling price, the investor anticipates declaring a tax loss. What a surprise to learn the capital gains distribution took place within 30 days of the redemption. The wash sale rule would not have been a factor had the redemption resulted in a profit.
Three actions can be taken to avoid the problem--and again, remember, if the redemption will produce a profit, the wash rule won't be applicable. First, prior to initiating the redemption, contact the fund to determine the date for their next capital gains distribution, so that the conflict, if it does occur, won't be an accident. Secondly, notify the fund not to reinvest that particular capital gains distribution; instead, have it distributed as cash. Lastly, if all else fails, adjust the cost basis of the remaining shares to reflect the fact that a portion of the loss was disallowed.
Conclusion
The moral of the story is indeed simple--it is absolutely vital for mutual fund investors to keep complete records of purchases, redemptions, splits, and even gifts, whether to family members or to charities. In the case of charitable gifts, records should also be maintained of the fair market value at the close of business on the day the gift is officially accepted.
But, retaining fund confirmation statements isn't enough. Such statements are not adequate to establish the cost basis of an investor's holdings. An investor should establish and maintain cost basis worksheets as well. By doing so, tax problems and income taxes can both be minimized.
