Mutual Funds Tax Considerations – IRS

So what exactly is a capital gain?

There can be two sources of capital gains for a mutual fund shareholder: 1) Gains from Sales: If you sell or exchange your mutual fund shares, you must pay tax on any gains arising from the sale, just as you would from a sale of individual securities. Shares that are held one year or less are considered short-term and are taxable at the shareholder’s income tax rate. Shares held for more than 12 months are considered long-term and taxable at a reduced rate.
Tax Reporting: Redemptions of mutual fund shares are reported to you on Form 1099-B. Remember that redemptions from municipal bond funds are taxable transactions.
Gains from Distributions – Capital gains realized by the fund on sales of its portfolio securities are “passed through” to shareholders as distributions. These amounts are reported to you by the fund on Form 1099-DIV. Short-term capital gains are included in Box 1a of Form 1099-DIV. Long-term capital gains are identified on Form 1099-DIV, Box 2a.

Now for some Q&A.

Q: Why would I have to pay tax on a capital gain distribution when my fund’s share price has decreased?
A: Capital gain distributions occur independently of price fluctuations in a fund. A mutual fund is required to distribute annual income and/or capital gains to its shareholders. At the same time, changes in financial markets can cause the price of fund shares to go up or down.

Q: Do I pay taxes on reinvested dividends like a DRIP program?
A: Yes, DRIP’s are taxed the same as cash distributions.

Q: How do I report international fund tax information on my tax return?
A: You may be entitled to take either a foreign tax credit or an itemized deduction for the amount of the foreign taxes paid, as reported in IRS Form 1099-DIV, box 6. It is usually more advantageous for you to take the foreign tax credit. To file for the allowable credit, you may be required to complete IRS Form 1116 and attach it to your IRS Form 1040. (Please refer to IRS Form 1040 instructions for exceptions from filing IRS Form 1116 to claim a tax credit.) If you are required to file Form 1116, please refer to the Source of Foreign Gross Income and Taxes Paid table

Use the Foreign Gross Income and Taxes Paid table only if you are required to complete IRS Form 1116 to claim a credit for foreign taxes paid. To compute the per-country gross income for Form 1116, apply the gross income percentage from the table to the amount in box 1a of your IRS Form 1099-DIV. To compute the per-country tax paid for Form 1116, apply the foreign taxes paid percentage to the amount shown in box 6 of your IRS Form 1099-DIV.

Q: I’ve redeemed shares from my account. What do I need to know about calculating my cost basis?
A: First, chose one of the four methods, keep these key points in mind:

You must state on your tax return the cost basis method you have selected.
When no method is stated, the IRS presumes you are using the First-In, First-Out (FIFO) method.
No matter which cost basis method you choose, you may not change to another method without permission from the IRS.
Reinvested dividends or capital gain distributions add to the cost basis of your shares. These dividends purchase shares. Your confirmation statements show you the number of shares purchased and the price of those shares.
Return of capital gain distributions reduces the cost basis of your shares. If the fund distributes a return of capital, it will report this amount to you in Box 3 of Form 1099-DIV at the end of the year.
The average cost methods are available only for mutual funds. They are not acceptable for sales of other investments, such as individual stocks and bonds. Different methods may be used for different funds. However, you must use the same method for the life of the fund.
Transfers of shares due to gifts or inheritance may require different basis calculations. In these situations, please consult your tax advisor before using this cost basis statement.
If you sell shares at a loss and purchased shares in the same fund within 30 days before or after the sale, the IRS considers it a “wash sale” transaction and the loss must be deferred for tax purposes. The rules for wash sales can be very complex. It is recommended that you consult a tax advisor if you suspect you are in this situation.

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Mutual Funds and Cost Basis Reporting

With each sale or exchange of mutual fund shares, you may realize a capital gain or loss that must be reported to the IRS.  To calculate gains and losses, you need to determine which shares were sold and the cost basis of those shares.

The sales proceeds minus the cost basis of the shares is your gain or loss.

The IRS permits the following methods of accounting for mutual fund cost basis:

1. First-In, First-Out (FIFO) Method

The FIFO method is the most common way of computing a basis. If you do not specify that another method is being used, the IRS will presume you are using the FIFO method.  As the name implies, the oldest shares available (first-in) are those considered sold first (first-out).

2. Specific Identification Method

The specific identification method allows you to choose which shares you are selling, thereby giving you more control over whether you will generate a gain or loss by the transaction. To use this method, you must specify to the mutual fund at the time of sale the particular shares to be sold. Your gain or loss will vary, depending on which shares you choose.

3. Average Cost – Single and Double Category

You may elect to calculate the cost basis of your mutual fund shares using an average price. There are some special requirements if you wish to do so. The IRS requires you to elect this method by stating so on your tax return and by using the method consistently for all your accounts in the same fund. The choice is effective until you get permission from the IRS to revoke it. These methods may be appealing for shareholders who redeem shares infrequently.

The single category method averages all shares owned at the time of sale.

In determining the holding period, the IRS considers the shares sold to be those shares acquired first (i.e., first-in, first-out).

The double category method requires you to divide all shares owned at the time of sale into two categories (long- and short-term) and calculate an average cost for each category. Shares held one year or less are short-term. Shares held longer than one year are long-term.

Similar to the specific identification method, you may specify to the fund at the time of sale from which category you wish to sell shares. If no specification is made, you must first charge the shares sold against the long-term category and then any remaining shares sold against the short-term category.

Wash Sale Rule

If you sell shares at a loss and purchase shares in the same fund within 30 days before or after the sale, the IRS considers the purchase to have “washed” all or a portion of your loss. The IRS designed this rule to discourage investors from selling securities solely for the purpose of generating a tax loss. A wash sale is indicated on your statement.

In the case of a wash sale, two important adjustments must be made. All or a portion of the loss must be deferred and added back to the basis, and the holding period of the purchased shares must be changed to account for the deferral. Your statement already reflects the adjusted cost basis and allowable loss. You need not make any further adjustments.

Wash Sale explained

In the previous post about cost basis reporting, the mention of a wash sale came up as being exempted.

So what is a wash sale?

I looked it up and here is what I found;

Wash Sales rule.  If you buy replacement stock shortly after the sale — or shortly before the sale — you can’t deduct your loss.

Why might this rule be in place?  Look at this example below…

When the value of your stock goes down you know you have lost money.  US tax law does not allow that loss until you sell the stock.  The problem is, you may have a conflict. You want to deduct the loss, but you also want to keep the stock because you think it’s going to bounce back.  You might think that you can sell the stock to take the loss and buy it right back to keep it in your portfolio, but that is where the wash sale rule comes in.  This rule is in place for 30 days. 

So you have a wash sale if you sell stock at a loss, and buy substantially identical securities within 30 days before or after the sale.

Example: On March 31 you sell 100 shares of BCE at a loss. On April 11 you buy 100 shares of BCE. The sale on March 31 is a wash sale.

The wash sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale and the 30 days after the sale.  If you want to claim your loss as a deduction, you need to avoid purchasing the same stock during the wash sale period. For a sale on March 31, the wash sale period includes all of March and April.

Wash sale rules also apply if you enter into a contract or option to acquire stock.  Or, if within that wash sale period, you sell a put option on the same stock that is “deep in the money”.  You also have a wash sale if you sell options at a loss too.

The wash sale rule actually has three consequences:

  • You are not allowed to claim the loss on your sale.
  • Your disallowed loss is added to the basis of the replacement stock.
  • Your holding period for the replacement stock includes the holding period of the stock you sold.

The basis adjustment is important: it preserves the benefit of the disallowed loss. You’ll receive that benefit on a future sale of the replacement stock.

Example: Some time ago you bought 80 shares of BCE at $50. The stock has declined to $30, and you sell it to take the loss deduction. But then you see some good news on BCE and buy it back for $32, less than 31 days after the sale.

You can’t deduct your loss of $20 per share. But you add $20 per share to the basis of your replacement shares. Those shares have a basis of $52 per share: the $32 you paid, plus the $20 wash sale adjustment. In other words, you’re treated as if you bought the shares for $52. If you end up selling them for $55, you’ll only report $3 per share of gain. And if you sell them for $32 (the same price you paid to buy them), you’ll report a loss of $20 per share.

Because of this basis adjustment, a wash sale usually isn’t a disaster. In most cases, it simply means you’ll get the same tax benefit at a later time. If you receive the benefit later in the same year, the wash sale may have no effect at all on your taxes.

The wash sale rule can also have truly painful consequences.

  • If you don’t sell the replacement stock in the same year, your loss will be postponed, possibly to a year when the deduction is of far less value.
  • If you die before selling the replacement stock, neither you nor your heirs will benefit from the basis adjustment.
  • You can also lose the benefit of the deduction permanently if you sell stock and arrange to have a related person — or your IRA — buy replacement stock.
  • A wash sale involving shares of stock acquired through an incentive stock option can be a planning disaster.

 

Some additional information on wash sales:

  • You don’t have a wash sale unless you acquire (or enter into a contract or option to acquire) subsequently identical securities.
  • You don’t have a wash sale, even though you bought identical shares within the previous 30 days, if the shares you bought aren’t replacement shares
  • There are mechanical rules to handle the situation where you don’t buy exactly the same number of shares you sold, or where you bought and sold multiple lots of shares.
  • If a person who’s related to you — or an entity related to you, such as your IRA — buys replacement property, your loss may be disallowed under a different rule: you may be treated as if you made an indirect sale to a related person.
  • You don’t actually have to purchase stock within the wash sale period to have a wash sale. It’s enough if you merely enter into a contract or option to acquire replacement stock.

The wash sale rule only applies to losses. You can’t wipe out a gain from a sale by buying the same stock back within 30 days.

Plan around the wash sale:

While no technique is entirely safe and risk-free, here are some ideas to consider.

  • Most obviously, you can sell the stock and wait 31 days before buying it again. The risk here is that the stock may rise in price before you can repurchase it.
  • If you’re truly convinced the stock is at rock bottom, you might consider buying the replacement stock 31 days before the sale. If the stock happens to go up during that period your gain is doubled, and if it stays even you can sell the older stock and claim your loss deduction. But if you’re wrong about the stock, a further decline in value could be painful.
  • If your stock has a strong tendency to move in tandem with some other stock, you may be able to reduce your risk of missing a big gain by purchasing stock in a different company as “replacement” stock. This is not a wash sale because the stocks are not substantially identical. Thirty-one days later you can switch back to your original stock if that is your wish. But there’s no guarantee that any two stocks will move in the same direction, or with the same magnitude.