Are you an investor in mutual funds or have you recently been thinking of putting some money into them? You’re not alone. The Investment Company Institute estimates that 56.2 million households owned mutual funds in mid-2017. The current number of individual investors is estimated at around 100.0 million. Despite their rising popularity, the tax rules involved in selling mutual fund shares can be quite complex.
First, the Basics
Let’s start with the basics of selling mutual fund shares. When you sell appreciated mutual fund shares, you are taxed at the capital gain tax rates. Fund shares that you owned for more than a year have a “long term” holding period; shares that are held for a year or less is classified as a “short term”. Different tax rates apply to long-term and short-term capital gains, so it is important to keep track of your stock purchase and sale dates. Mutual funds also make “capital gain distributions” during the year (proceeds are generally automatically reinvested into additional mutual fund shares). No matter the length of time you held shares in the mutual fund, these “capital gain distributions” are taxed as long-term capital gains. The long term federal capital gains tax rate will be 15% or 20% and you may also owe the 3.8% net investment income tax. Your actual capital gains tax rate is dependent on your total income from all sources.
Second, sale considerations
When a mutual fund investor is selling or redeeming mutual fund shares, gain or loss is measured by the difference between the amount realized from the sale and the investor’s basis in the shares. One difficulty is that certain mutual fund transactions are treated as sales even though they might not traditionally be thought of as such.
A sale occurrence is recognizable when an investor redeems all shares in a mutual fund and receives the proceeds. Similarly, a sale occurs if an investor directs the fund to redeem the number of shares necessary for a specific dollar payout.
It’s less recognizable that a sale occurs if you’re swapping funds within a fund family. For example, you surrender shares of an Income Fund for an equal value of shares of the same company’s Growth Fund. No money changes hands but this is considered a sale of the Income Fund shares. Another example: Many mutual funds provide check-writing privileges to their investors. However, each time you write a check on your fund account, you’re actually triggering a sale of fund shares.
Finally, calculating basis for shares redeemed/sold
Another difficulty that may arise is determining your tax basis for the mutual fund shares sold.
If an investor sells all shares in a mutual fund in a single transaction, determining basis is relatively straight-forward. Simply add the basis of all the shares (the amount of actual cash investments) including commissions or sales charges. Then add distributions by the fund that were reinvested to acquire additional shares and subtract any distributions that represent a return of capital.
The calculation is more complicated if you dispose of only part of your interest in the fund and the shares were acquired at different times for different prices. You can use one of several methods to identify the shares sold and determine your basis.
- Specific identification. At the time of sale, you identify the specific shares to sell. For example, “sell 100 of the 200 shares I purchased on June 1, 2019.” You must receive written confirmation of your request from the fund. This method may be used to lower the resulting tax bill by directing the sale of the shares with the highest basis. Caution: Not all mutual fund companies can fulfill the request for the specific identification method and that is when you can move to FIFO.
- First-in first-out (FIFO). The first shares bought are presumed to be the first shares sold. That is – the basis of the earliest acquired shares is used as the basis for the shares sold. If the share price has been increasing over your ownership period, the older shares are likely to have a lower basis and result in more capital gain (although this gain will be subject to the favorable capital gain tax rates).
- Average basis. Since the tracking of basis can be difficult for shares purchased at different times and for different prices, the IRS permits you to use the average cost basis for shares that were acquired at various times and that were left on deposit with the fund or a custodian agent.
The method you use to determine the basis of shares has tax ramifications. If you elect the “average basis” method, you may not change methods without the consent of the IRS. The cost to obtain IRS consent is about $10,900 so make sure the “average basis” is what is best for you. Note: you are allowed to switch between the specific identification and FIFO methods without the permission of the IRS.
As you can see, mutual fund investing can result in complex tax situations. Contact your Wegner CPAs tax professional if you have questions. We can explain in greater detail how the rules apply to you.