If you have invested in a mutual fund and decide to sell some or all of your shares, you may have to pay federal income taxes, and perhaps state and local income taxes, when you sell redeem or exchange your shares at a gain. By taking advantage of certain options, you may be able to lessen the income tax bite. Before you decide to sell your shares, you should review all of your investments, gain an understanding of the tax rules, and confer with your tax and/or investment advisor.

The amount of taxes you owe depends on your gain or loss on the sale and whether that gain or loss is short term or long term. To calculate the gain or loss, you must first determine the "amount realized", that is, the amount your receive from the sale, redemption or exchange. From the "amount realized" you then subtract the "adjusted tax basis" for the shares, which generally is their cost (the amount you paid for them) and any required adjustments. You cannot correctly figure the gain or loss on the sale, redemption or exchange without making the adjustments. Federal tax regulations outline how to calculate the tax basis.

The original tax basis for your mutual fund shares is their cost, unless you acquired the shares by gift or inheritance. In that instance different rules apply and you should consult your tax adviser for guidance.

Beginning with the original tax basis for your shares, you increase or reduce the basis by making two required adjustments:

You increase the original tax basis of your shares by the amount of any undistributed capital gains a mutual fund reports to you that you include in your income, and by the amount of income tax considered paid by you on that income.(1)

You reduce the original tax basis of your shares by the amount of any tax-free return of capital distributions you receive. If the return of capital distribution exceeds the basis for your shares, the excess is treated as a gain from the sale of those shares. (2)

If you’ve purchased shares in a fund at different times, it is likely that each lot of shares will have a different cost basis for tax purposes. If you sell all the shares in the fund at the same time, computing the gain or loss is relatively straightforward. However, should you sell, redeem or exchange some but not all of the shares you need to identify which are being sold and their cost basis, in order to figure the tax consequences of the transaction.

The tax law requires you to use either a cost-basis method or an average-basis method for figuring your taxes. There are two types of cost-basis methods, specific identification and first-in first out (FIFO). There are also two types of average-basis methods, single-category and double-category.

Each method has it’s own set of rules that have to be strictly followed. If you elect to use either the single or double-category method for a fund, you must continue to use the selected method for all sales, redemptions and exchanges of that fund’s shares, unless you get permission from the IRS to revoke the election. Make sure you understand how each method impacts your tax results before you proceed with your transaction.

Specific Identification-To use this method, you must notify the mutual fund of the particular shares you are selling at the time of sale or transfer and you must receive confirmation from the fund that the shares you identified were in fact sold or transferred. If you want to minimize your gains or maximize your losses, you should sell the shares with the highest tax basis

First-In First-Out (FIFO)-If you cannot identify which shares you sold, you will be deemed to have sold the oldest shares first. In a rising market, this method is likely to produce the greatest gain on any sale or transfer of shares.(3)

Single-Category-With this method, you figure the average cost of all shares owned at the time of each sale, regardless of how long you have actually owned the shares, and those you sell are considered to be those you acquired first. The average basis of the shares you continue to hold is the same as the average basis of those you sold. The next time you sell shares, your average basis will still be the same. (4) Investors tend to favor this method because of its simplicity, but it doesn’t give you the control to produce desired tax results that the Specific Identification method provides.

Double-Category-With this method, you divide your shares into two categories: long-term shares, held more than a year, and short-term shares, held one year or less. The basis of each share in a category is the average of the basis of all the shares in that category. When you sell, you specify the category from which the shares are being sold. You must receive confirmation of your designation for it to be effective.(5) This method involves several requirements, but it provides a greater measure of control over tax results than does the Single-Category Method.

 

1. A mutual fund that has undistributed capital gains is required to report them to you on IRS form 2439 for the year in which they occur.
2. A mutual fund is required to report any return of capital distributions to you on IRS form 1099-DIV
3. The IRS automatically applies FIFO if you don’t specify a method, or if you don’t meet the technical requirements of the method you chose.
4. Unless you acquired additional shares in the interim.
5. If you fail to specify, or if you do not receive confirmation, the IRS will assume the shares you sold came from the long-term category