Mutual Funds and Capital Gains

Calculating Cost Basis and Capital Gains on Mutual Fund Shares

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Mutual Funds and Capital Gains

You will need to calculate capital gains on each share of the fund you are selling. If you have invested in a fund over a period of time, then you will have different cost basis for your initial investment, additional investments, and any purchases made through reinvested dividends. Each investment has its own cost basis and its own holding period.

Capital Gains Distributions

Mutual funds often sell profitable investments at certain times throughout the year.

The funds then distribute the profits to shareholders in the form of a capital gain distribution. Capital gains distributions are reported on Form 1099-DIV, which shows dividends and capital gains distributions paid throughout the year. Capital gains distributions are taxed at long-term capital gains tax rates, no matter how long you have personally owned shares in the mutual fund.

Capital gain distributions can be reported directly on Form 1040 if you have no other capital gains to report. Otherwise, capital gain distributions are reported on Schedule D along with your other gains and losses.

Capital Gains When Selling Mutual Fund Shares

You will calculate your capital gain or loss for every mutual fund share you are selling. If you have invested in a fund over a period of time, you will have a different cost basis and different holding period for each share you own.

The IRS allows you to use four different accounting methods for calculating your gain.

You can use the method which is most advantageous to you. However, once you choose your accounting method for a particular mutual fund, you must stick with that method. You can choose different accounting methods for each mutual fund you own. The four allowable accounting methods are:

  • Actual cost basis using specific identification,
  • Actual cost basis using first-in, first-out identification,
  • Average cost basis, single-category method, and
  • Average cost basis, double-category method

Specific Identification of Mutual Fund Cost Basis

The specific identification method of accounting is the preferred method for savvy investors. You will need to keep track of each lot of shares you buy and sell. Moreover, your broker must allow you to sell specific shares. This option is usually provided with a mutual fund company's cost basis tracking service.

Specific identification enables the investor to choose which shares to sell for the greatest possible tax benefit. An investor may want to sell the most profitable shares to offset other losses, or may want to sell the least profitable shares to minimize the capital gains tax.

First-In, First-Out Method of Identification

Even if the shareholder cannot specific particular shares to sell, the actual cost basis method can still be used. You keep track of your cost basis for every lot of shares you buy. When calculating your gain, you assume that the first shares sold are the first shares you bought.

Average Cost Basis, Single Category Method

You calculate your average cost basis based on the price paid for each share you bought, including any reinvested dividends and reinvested capital gains.

The average cost basis is the total purchase price of all shares divided by the number of shares owned. When you sale some shares, it is assumed the shares are sold on a first-in, first-out basis. Your capital gain is calculated using the holding period of the oldest shares being sold, even if you are selling a mixture of long-term and short-term shares.

Average Cost Basis, Double Category Method

You calculate your average cost basis based on the price paid for each lot of shares you bought, including any reinvested dividends and reinvested capital gains. However, you must separate your shares into long-term and short-term investments, and then calculate average cost basis for each category of shares. The average cost basis is the total purchase price of all shares of the same category divided by the number of shares owned in that category.

When you sale some shares, it is assumed the shares are sold on a first-in, first-out basis.

Reinvested Dividends and Capital Gains Distributions

Many investors re-invest dividends and capital gains distributions received from their mutual funds. Each reinvestment is both a cash distribution and an additional fund purchase. The dividends and capital gains distributions are included taxable income. The additional shares purchased in the reinvestment have their own cost basis (the purchase price of the shares) and their own holding period.

Tracking Mutual Fund Cost Basis

Tracking your cost basis can be a time-consuming task. I recommend using Quicken or Microsoft Money to keep track of your capital gains.

IRS Information

IRS Publication 564, Mutual Fund Distributions, contains in-depth information about the tax aspects of investing in mutual funds.