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Strategies for buying and selling mutual funds.

Proper planning reduces confusion and minimizes taxes.

Following the phenomenal economic growth of the 1980s, investor interest in mutual funds has continued into the 1990s. Mutual funds have made it easier for small investors to have access to capital markets-- investors who otherwise lack the funds either to diversify their portfolios sufficiently or to justify hiring professionals to manage them. Because of the importance of mutual funds as an investment vehicle for both middle- and upper-income individuals, CPAs must be able to provide clients with tax strategies for buying and selling.

This article reviews the rules mutual fund investors must know to minimize taxation and maximize wealth accumulation.


Mutual fund shareholders may receive one or more of the following distributions:

* Ordinary dividends.

* Capital gains dividends.

* Exempt-interest dividends.

* Return-of-capital (nontaxable) distributions. A foreign tax credit will be passed through to shareholders if more than 50% of the fund's assets consists of stocks or securities in foreign corporations.

Distributions from short-term capital gains income are classified and taxed as an ordinary dividend. A capital gains dividend is classified and taxed as a long-term capital gain. Capital losses realized by the fund are not passed through to shareholders but are offset against capital gains. Unused losses are carried forward for up to eight years to be offset against subsequent gains.

All mutual funds charge annual management fees that, along with other annual investment expenses such as shareholder servicing costs, are deducted from dividend distributions. If investment expenses exceed net investment income, no distribution is required. If a fund chooses to retain capital gains (most do not), the fund may nevertheless elect to have the gains taxed as if they had been distributed and subsequently reinvested. The fund pays the taxes on the gains and passes them through to shareholders as refundable credits. Shareholders are entitled to increase their cost bases in the fund by the amounts of the deemed dividend distributions, less the credit.

Because fund distributions represent asset transfers from the fund to shareholders, the per share net asset value decreases by the exact amount of the per share distribution. A shareholder generally reports dividends in the taxable year they are received. An exception, however, is made for dividends declared in October, November or December and payable to shareholders of record during these months. If dividends actually are paid by February 1 of the following year, they are deemed to have been paid the previous year.

Mutual funds typically offer shareholders the opportunity to reinvest distributions to purchase additional shares instead of receiving them in cash. Regardless of whether additional shares are purchased or a cash payment is made, the distribution is taxable to the shareholder.


Mutual fund investors can use a number of planning strategies to minimize their income tax liabilities.

Avoid buying into tax liabilities. An investor who buys shares in a mutual fund also purchases part of the fund's accumulated untaxed dividends and capital gains. Consequently, when new shareholders receive distributions of previously accrued dividends and gains, they are in effect receiving a return of capital. Nevertheless, they are immediately taxed on the distribution. Rather than creating a permanent increase in taxable income the increase will be remedied if and when a shareholder redeems shares in the fund. They will have a smaller gain (or greater loss) equal to the amount of additional income from purchasing the fund before the distribution date instead of on the ex-distribution date---the date a purchasing shareholder is no longer entitled to the distribution.

Exhibit 1, page 39, illustrates that an investor should time purchases to occur on or soon after the ex-distribution date (unless he or she has another reason for making a purchase on a particular date). Capital gains distributions usually occur once a year, in December. Income distributions for stock funds also usually are made once a year but may be made more often. Fixed income funds normally make income distributions monthly.

Capital gains distributions are more volatile than income distributions and thus have the greatest potential to affect a shareholder's tax liability adversely. Large capital gains distributions are most likely when

* The fund is an aggressive growth fund.

* The fund has a high portfolio turnover rate.

* There is a run-up in stock or bond prices.

If a potential for a large capital gains distribution exists, it is even more important for a mutual fund purchase not to occur shortly before the distribution date. Information on distribution dates may be obtained from mutual fund investment guides such as Morningstar Mutual Funds (Chicago, updated annually), The Individual Investor's Guide to No-Load Mutual Funds (Chicago: International Publishing Corporation, updated annually) and Weisenberger Investment Companies Service (New York: Warren, Gorham & Lamont, updated annually), from a fund's annual report or by calling the fund.

Maximize the deferral advantage. Tax on a stock's unrealized gains is deferred until shares are actually sold; being able to defer tax on the appreciation results in a lower effective tax rate when the stock is sold because appreciation compounds on a pretax basis. The longer the deferral period, the lower the effective tax rate.

A stock mutual fund investor obtains the same deferral advantage to the extent the fund continues to hold appreciated securities instead of selling them. A fund's portfolio turnover rate measures the extent to which its portfolio is turned over in the course of a year. A portfolio turnover rate of 20% implies that, on average, the fund turns over 20% of its holdings annually and an individual security is held on average for five years. A fund with a relatively small turnover rate, therefore, generally offers investors a greater opportunity to achieve tax deferral.

Fund turnover rates vary widely. Very aggressive growth funds that are actively managed may have annual turnover rates as high as 200% to 300%. A high turnover rate means tax deferral is nonexistent. Other stock funds, particularly passively managed index funds, may have turnover rates of under 10%. A low turnover rate means considerable tax deferral is achieved. Information on a fund's turnover rate may be obtained from the same sources that provide information about a fund's distribution dates, described above.

Avoid conversion of short-term capital gains to ordinary income. Investors also may use a fund's turnover rate to assess the likelihood realized gains will be short-term instead of long-term. Short-term capital gains are fully taxable as ordinary income. A fund with a turnover rate in excess of 100%, for example, undoubtedly will have significant short-term gains. But, a fund with a turnover rate of 10% or less will have virtually all long-term gains.

A fund's realization of short-term capital gains presents potential disadvantages to investors. Because distributions from short-term gains are taxed as ordinary income, an investor is likely to carry forward capital losses because of the $3,000 ordinary income offset limitation against capital losses. Moreover, as a result of the Revenue Reconciliation Act of 1990, the maximum statutory tax rate on net long-term capital gains is 28%. A high portfolio turnover rate, therefore, in addition to significantly reducing or even eliminating the tax deferral advantage, presents an additional disadvantage to a taxpayer with significant capital losses or a 31% tax rate.

Take advantage of mutual fund capital loss carryovers. As noted earlier, a fund's capital losses are not passed through to shareholders but are offset against the fund's capital gains. A fund with recent net realizable (capital) losses could use the carryover losses to reduce subsequent capital gains. This means under certain circumstances a prospective investor might want to acquire a fund with recent net portfolio losses. However, this should be done only if these losses are not expected to be a reliable indicator of future substandard performance. For example, if the losses were incurred in a down market or if the management team subsequently was replaced, the investor might feel these losses are not important in predicting future performance. Information on whether a fund has recently experienced net realized losses is obtainable from the fund's prospectus, annual report or the fund itself.


Each time dividends or capital gains distributions are reinvested in additional shares, a separate cost basis must be calculated for the full or fractional shares purchased. Even when shares are purchased at different times, computing gain or loss is not difficult if all shares in the fund subsequently are redeemed at one time. The shareholder simply adds all dividends used to purchase additional shares and any subsequent purchases to the original purchase price and subtracts this amount from the redemption proceeds.

When a shareholder makes a partial redemption, computing gain or loss becomes considerably more complicated. Planning opportunities arise because the Internal Revenue Service allows investors to compute basis using four different methods.

Average cost method. If mutual fund shares are held by a custodian, which normally is the case, the investor can elect to use an average cost method to compute basis. In making this election, the investor must decide between the single-category or double-category methods.

The per share cost basis using the single-category method is calculated by dividing the aggregate cost of all shares by the number of shares the investor owns. Shares are considered to be sold on a first-in first-out (Fifo) basis.

With the double-category method, all shares held in a mutual fund account are divided between those held for one year or less and those held for more than one year. An average per share cost is computed for each category. The taxpayer specifies whether shares sold are from the shortterm or long-term category. The double-category method, when compared with the single-category method, can result in differences in classifications of gains (longterm versus short-term) as well as in the amount of taxable gain. The double-category method also gives taxpayers greater control over the amount of gain or loss recognized, as illustrated in exhibit 2, page 40.

Once a method is elected for shares in an account, the taxpayer must continue to use the same method for that mutual fund. The election must be made on the first tax return for the first taxable year the taxpayer desires the method to apply. When the election is made, the taxpayer reports on the return for each year the election applies that an average basis is used and which method has been selected.

When the double-category method is used, the taxpayer also needs to specify to the mutual fund custodian whether the shares are short-term or long-term. The taxpayer should receive written confirmation from the custodian verifying these instructions. If such confirmation is not received, the shares will be deemed sold from the long-term category, with any excess charged against the short-term category.

Specific identification method. This method gives investors more flexibility than the average cost method. When a partial redemption is made, the taxpayer is allowed to choose the specific blocks of shares sold. However, the/RS requires an adequate identification to be made of the shares sold. If the shareholder actually holds share certificates, adequate identification is made by delivering to the custodian the certificates corresponding to the particular blocks of shares.

Normally, however, shareholders do not have certificates for their shares. Share ownership is evidenced by noncertificate shares or a book entry in the fund's records. When selling noncertificate shares, the investor makes an adequate identification using a two-step process.

* Inform the transfer agent, in writing, which shares are to be sold. This is done by advising the agent of the sequence in which the shares are to be sold and the purchase dates, or cost, of the shares, or both.

* Ask for and receive written confirmation of the shares sold from the transfer agent.

Using the same facts as exhibit 2, exhibit 3 (page 41) illustrates the specific identification method.

Fifo method. If an investor does not elect to use the average cost method or to identify the shares sold specifically, the Fifo method must be used. When a sale is made, the shares considered sold are those purchased earliest. If the price per share has risen since the shares were acquired, this method will result in the greatest overall capital gains. For example, in exhibit 2, which illustrates a scenario of rising prices, a sale of 50 shares under the Fifo method would result in a gain of $250 [redemption proceeds of $750 (50 shares x $15 per share) - basis of $500 (50 shares x $10 per share)]. (See the sidebar on page 42 for a Tax Court case illustrating the possible adverse tax consequences when a taxpayer does not specify shares sold and is forced to use the Fifo method.)

Should highest basis shares always be selected? In general, investors should charge the highest basis shares held against shares sold to minimize gain or maximize loss. There may be circumstances, however, when selecting lower basis shares might be preferable. For example, if the investor has both capital losses from other sources in excess of the $3,000 ordinary income offset limitation and his or her investment interest expense deduction is limited because of insufficient investment income, recognizing more capital gains could actually result in a reduction in taxable income. Selling lower basis shares also might be advisable if the investor plans an orderly redemption of the shares in a fund over a series of years, including years in which a higher tax bracket is anticipated.


Mutual funds have proven to be an efficient financial intermediary, providing investors immediate diversification and professional asset management. As the population continues to age, mutual funds are likely to play an increasingly important role in retirement planning and in meeting other financial needs. In spite of mutual funds' importance, their taxation is generally a source of confusion to the individual shareholder. CPAs have an important role to play in helping mutual fund investors. Beyond merely assisting clients to report fund distributions correctly and to maintain good records, however, the CPA should be able to suggest tax-saving strategies when funds are either bought or sold.

RICHARD B. TOOLSON, CPA, PhD, is assistant professor of accounting and business law at Washington State University in Pullman, Washington. A member of the American Institute of CPAs and the American Accounting Association, he serves on Washington State University's insurance, annuities and retirement committee.


* AS INVESTOR INTEREST in mutual funds continues to grow, CPAs must be able to advise clients on the tax consequences of buying and selling mutual fund shares and help develop strategies to minimize the tax.

* MUTUAL FUND shareholders receive distributions in the form of ordinary dividends, capital gains dividends, exempt-interest dividends and nontaxable return of capital. Distributions reinvested in additional shares are taxable income.

* INVESTORS CAN MINIMIZE their tax liabilities by timing their purchases according to fund distributions, choosing funds with low portfolio turnover--thus avoiding conversion of short-term gains to ordinary income--and taking advantage of a fund's capital loss carryovers.

* WHEN A SHAREHOLDER redeems a portion of his or her shares, computing the gain or loss can be complicated. A proper understanding of the rules can minimize the resulting income tax liability.

* THE COST BASIS OF mutual fund shares can be calculated using the average cost method (single- or double-category), the specific identification method or the first-in first-out (Fifo) method. The specific identification method offers the most flexibility; the Fifo method often results in the largest capital gains.


Benefit of purchasing mutual funds on or soon after the ex-distribution date

Purchase immediately before ex-distribution date. On December 15, John Jones pays $4,000 for 400 shares of Growth Mutual Fund, a no-load fund. He chooses to have all capital gains and dividends reinvested in additional shares. On December 16, the ex-distribution date, the fund declares a taxable distribution equal to 10% of its net asset value. Jones receives a taxable distribution of $400 As a result of the distribution, net asset value declines to $9 [$10 - ($10 x 10%)].

Jones uses the $400 distribut on to purchase 44.44 additional shares at $9 per share [$400 + $9 per share = 44.44 shares]. As a result, after the distribution, his basis increases to $4,400 [(400 shares x $10 per share) + (44.44 shares x $9 per share) = $4,400] and he reports $400 of taxable income While Jones's basis has increased by $400 to compensate for the $400 taxable distribution, his equity in the fund remains the same, $4,000 [$9 x 444.44 shares]. If, before another distribution, Jones redeems his shares when the net asset value is $12 for a total redemption value of $5,333 [$12 x 444.44 shares], he recognizes a $933 capital gain [$5,333 - $4,400].

Purchase on ex-distribution date. Assume instead that Jones acquired 444.44 shares of Growth Mutual Fund on December 16, the ex-distribution date, for $4,000 ($9 per share). Since the purchase occurred on the distribution date, there is no taxable income to repod. Upon redeeming his shares when net asset value is $12 for $5,333, he recognizes a capital gain of $1,333 [$5,333 - $4,000], $400 more than in the previous scenario to compensate for not recognizing $400 from the December 16 distribution. The advantage to Jones in this case is he shifted income recognition to a later period.

 Average cost method
 Single-category method. Jacqueline Gordon
acquired 100 shares of Diversified Stock
Fund on May 1, 19X1, at $10 per share for a
total purchase price of $1,000. She subsequently
received distributions that were reinvested to
purchase additional shares as follows: 20
shares at $12 per share on December 1, 19X1,
for $240 and 20 shares at $14 per share on
December 1, 19X2, for $280. Gordon, electing
the single-category method, subsequently
sells 50 shares for S15 per share on
January 1, 19X3. The per share cost basis is computed as:
[($1,000 + $240 + $280) / (100 + 20 + 20)] =
$10.86 per share. The gain would roe computed as follows:
Redemption proceeds $750 (50 shares at $15 per share)
Basis 543 (50 shares at $10.86 per share)
Total gain $207
 Since under the single-category method the
shares are considered sold on a first-in first-out
(Fifo) basis, the shares would be deemed sold
from the 100 shares acquired on May 1, 19X1,
resulting in a long-term capital gain.
 Double-category method. Assume the same facts
as above except Gordon elects the dou
-ble-category method. The 20 shares from the
short-term category would have a basis of $14.
The 140 shares from the long-term category
would have a basis of $10.33 [($1,000 + $240)
+ (100 + 20) = $10.33]. If Gordon specifies
the 50 shares sold come from the long-term
category, the gain is calculated as follows:
Redemption proceeds $750.00 (50 shares at $15 per share)
Basis 516.50 (50shares at $10.33pershare)
Long-term capital gain $233.50
Total gain = $233.50
 Alternatively, Gordon could specify that 20 of the
50 shares sold are from the short-term
category and the remaining 30 shares are from the
long-term category. The gain is calculated as follows:
Redemption proceeds from
short-term category $300 (20 shares at $15 per share)
Basis 280 (20 shares at $14 per share)
short-term capital gain $20
Redemption proceeds
from long-term category $450.00 (30 shares at $15 per share)
Basis 309.90 (30 shares at $10.33 per share)
Long-term capital gain 140.10
Total gain = $160.10 ($20 + $140.10)


A 1989 Tax Court case, Hall v. Commissioner [92 TC 1027 (1989)], demonstrates the adverse tax consequences that may result when the Internal Revenue Service applies the first-in first-out (Fifo) method because the taxpayer failed to properly identify the mutual fund lots sold under the specific identification method.

In Hall, the taxpayer partially liquidated both certificate and noncertificate shares in the Kemper Technology and Kemper Summit Mutual Funds. In initiating the sales of the noncertificate shares, the taxpayer failed to specify to the broker the particular shares or lots of shares to be sold. Moreover, the broker's written confirmation made no reference to the shares being sold.

To compute the gain or loss on the sale of the noncertificate shares, the taxpayer charged the shares of stock sold against the last lots of shares acquired (the last-in first-out method). This resulted in a short-term capital loss of $5,663 and a long-term capital loss of $2,000 for the Technology fund and a short-term capital gain of $9,984 and a long-term capital loss of $4,708 for the Summit fund.

The Tax Court concluded that since the taxpayer did not adequately identify which shares were to be sold, under Treasury regulations section 1.1012-1(c)(1), the shares were to be charged against the earliest acquired shares (the Fifo method). Accordingly, the Tax Court determined a short-term capital loss of $4,508 and a long-term capital gain of $12,064 for the Summit fund and, most important, no short-term gain or loss but a $156,032 longterm capital gain for the Technology fund. The result was a $33,149 increase in Hall's tax liability.

This drastic upward revision of taxable gain and tax liability dramatizes the negative outcome that may result when the basis rules are either not understood or are improperly applied. In all likelihood, if the taxpayer had identified adequately the noncertificate shares to be sold, the gain and loss computations made by the taxpayer would never have been challenged by the IRS.


Specific identification method

Assume the same facts as in exhibit 2 except Gordon chooses to use the specific identification method. She specifies the shares to be sold be charged against the last lots of shares acquired, which are the highest cost shares. The gain is computed as follows:
Redemption proceeds
from short-term lot $300 (20 shares at $15 per share)
Basis 280 (20 shares at $14 per share)
Short-term capital gain $ 20
Redemption proceeds
from long-term lot $450 (30 shares at $15 per share)
Basis 340 [(20 shares at $20 per share)+
 (10 shares at $10 per share)]
Long-term capital gain $110
Total gain = $130 ($20 + $110)
COPYRIGHT 1992 American Institute of CPA's
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Article Details
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Author:Toolson, Richard B.
Publication:Journal of Accountancy
Date:Oct 1, 1992
Previous Article:Offers in compromise.
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