The concept of capital gains or losses can be complicated enough when you're dealing with a single, concrete asset. It becomes even more complex when you sell from a mutual fund that you've invested in over an extended period of time. You'll have a different cost basis for your initial investment, for additional investments, and for any purchases made through reinvested dividends.
Each investment has its own cost basis and its own holding period. Some basic rules can help to determine each.
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 capital gain distributions.
Capital gains distributions are reported on Form 1099-DIV, which shows dividends and capital gains distributions paid throughout the year. They're taxed at long-term capital gains tax rates regardless of how long you own the shares within the fund.
Long-term rates are normally reserved for assets that you've owned for longer than a year. They're more favorable than short-term rates.
Capital Gains Come From Selling
You would calculate your capital gain or loss for each mutual fund share you sell when you sell shares. This is where it gets complicated, because you'll have a different cost basis and a different holding period for each share if you've invested in the fund over a period of time.
The Internal Revenue Service lets you choose one of four different accounting methods to calculate your gain. A word of warning, however—you must stick with that method on that mutual fund going forward when you use a particular accounting method to file your tax return. You're locked in, at last for that fund. You can choose different accounting methods for each mutual fund you own.
You might want to calculate all four methods in a trial run to determine which is the most advantageous for you.
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
- Average cost basis, double category method
Using Specific Identification
The specific identification method of accounting is the preferred method for savvy investors, but it requires ongoing attention to detail. You'll have to keep track of each lot of shares you buy and sell, and your broker must allow you to sell specific shares. This option is usually provided within a mutual fund company's cost basis tracking service.
Specific identification lets you choose which shares to sell for the greatest possible tax benefit. An investor might want to sell the most profitable shares to offset other losses, or they might want to sell the least profitable shares to minimize capital gains tax.
Using First-In, First-Out Identification
You can still use the actual cost basis method even if you can't specify particular shares to sell. You would keep track of your cost basis for every lot of shares you buy, and assume that the first shares sold were the first shares you bought.
Single Category Method
You can calculate your average cost basis according to the price you paid for each share by using this method, 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 you owned at the time. When you sell some shares, it's assumed that they're 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're selling a mixture of long-term and short-term shares.
Double Category Method
You would calculate your average cost basis on the price paid for each lot of shares you bought with this method, including any reinvested dividends and reinvested capital gains. But you have to separate your shares into long-term and short-term investments, then calculate the average cost basis for each category of shares.
The average cost basis is the total purchase price of all shares in the same category, divided by the number of shares owned in that category. It's assumed that the shares are sold on a first-in, first-out basis when you sell some shares.
As of April 1, 2011, the IRS no longer allows taxpayers to use the double-category method. If you were using that method for shares acquired before April 1, 2011, and you sell the stock after that date, you must use the single category method to calculate your basis.
Reinvested Dividends and Capital Gains Distributions
Many investors reinvest dividends and capital gains distributions received from their mutual funds. Each reinvestment counts as both a cash distribution and an additional fund purchase. The dividends and capital gains distributions are included in taxable income.
The additional shares purchased in the reinvestment have their own cost basis, which is 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. It can help to use Quicken or Microsoft Money to keep track of your capital gains.