The cost basis basics of mutual funds

Bankrate.com

Increased participation in mutual funds in recent years confirms their many conveniences. But one convenience in particular -- the automatic reinvestment of capital gains and dividends -- often creates tax obligations that aren't anticipated by some of these shareholders. This tax tip will help taxpayers who have sold shares in mutual funds calculate the cost basis.

As this tip demonstrates, the basis is necessary for determining your capital gain or loss. This tip also explains how to report undistributed gains on your taxes, as well as other factors that could affect the calculation of your basis.

Accounting for investors' mutual feeling
The popularity of mutual funds has skyrocketed in recent years. According to Arthur Keown, author of Personal Finance: Turning Money into Wealth, the number of funds available increased from 161 in 1960 to 6,000 in 1996. Assets of mutual funds were more than $3.5 trillion by the end of 1996. How can you profit by owning shares in a mutual fund? Investors in mutual funds make money one of three ways:

  • If the value of securities held by the fund increases, the value of your shares in that mutual fund will increase as well. So if the value of Microsoft stock rises, a mutual fund that holds Microsoft will probably enjoy an increase in the value of its shares.
  • Most investors in mutual funds receive dividends, which are payments that corporations make to their shareholders. So a mutual fund that holds General Electric when it pays dividends will transfer this income to its shareholders through dividends.
  • If the fund sells a stock that it holds for more than it paid for it, investors in the mutual fund receive this profit in the form of a capital gain. Likewise, investors can experience a capital loss if the stock is sold for less than its purchase price.

For whom the (tax) bell tolls
Mutual fund investors can choose to receive capital gains and dividends in the form of a check from the fund or have gains and dividends automatically reinvested in the fund. There is a disadvantage to the convenience of automatic reinvestment, though: Many investors assume that since they didn't actually receive the reinvested dividends directly, these dividends aren't currently taxable. They are wrong.

If you are in the category described above and are unaware of this, your mailbox will contain an unpleasant surprise at the end of the year. Your mutual fund company will send you a tax form that reports all of the dividends you reinvested during the year. You will have to report these dividends on Schedule B of your income tax return.

The good news is that since your reinvestments purchase additional shares, the number of shares you hold in the fund will increase whenever you reinvest. This is helpful if you have to pay taxes on capital gains from selling shares of the mutual fund. The first thing you need to know to determine your fund's capital gain or loss is the price at which you sold the shares, which is fairly straightforward. You also need to know the cost basis, which is the original price paid for shares in the mutual fund. This calculation becomes more complex if shares are purchased at different times and prices. Reinvested dividends increase your cost basis, which is the total of:

  • Your original cash investment
  • Any additional cash investments
  • Reinvested dividends.

Understanding how to compute cost basis is essential for accurately calculating taxes. As your cost basis increases, your taxable gain decreases, meaning you will owe less in taxes. Likewise, anything that causes your cost basis to decrease will increase the taxes you will have to pay.

How to compute your cost basis
Is this confusing? Don't despair. The example represented in the table below will help you compute your own mutual fund's cost basis.

TRANSACTION
Date

COST

NUMBER OF SHARES

AVERAGE COST PER SHARE
(Cost divided by
number of shares
)

1. Original purchase
1/11/98

$2,500

    100

        $25

2. Additional purchase 6/14/98

$675

        25

        $27

3. Additional purchase 12/2/98

$875

        25

        $35

4.Reinvested dividend 12/31/98

$350

        10

        $35

Totals as of 12/31/98

$4,400

         160

      $27.50

    1. An investor opens a mutual fund on Jan. 11, 1998, by spending $2,500 for 100 shares.
    2. On June 14, 1998, he spends $675 to purchase 25 additional shares.
    3. On Dec. 2, 1998, he pays $875 to purchase another twenty-five shares.
    4. At the end of 1998, the investment earns a dividend of $350. The investor chooses to reinvest this dividend.

How many shares can the investor purchase? The shares are worth $35 each as of Dec. 2. You can find the price by taking the purchase price and dividing it by the number of shares, or $875/25=$35. That means that the $350 reinvestment buys 10 additional shares of the fund at this time. The number of shares equals the reinvestment amount divided by the price, or $350 divided by $35.

The investor's cost basis in the mutual fund at the end of 1998 is:

  • His original cash investment ($2,500)
  • Additional cash investments made on June 14 and Dec. 2 ($675 and $875)
  • Reinvested dividends. ($350)

Thus, the cost basis is $4,400 ($2,500+$675+$875+$350). The investor now owns 160 (100+25+25+10) shares. The reinvested dividends have increase his cost basis by $350, and will decrease any taxable gain he may have if he sells shares before the end of 1998.

Other factors may affect basis
Other factors may affect the cost basis of your mutual funds. Some of the more common are:

  • Front-end sales charges you pay with either the purchase or any additional purchases
  • Returns of capital or principal, such as non-dividend distributions.
  • Undistributed capital gains.

Sales commissions on shares you own, also known as load charges, are added to your cost basis. In computing your gain or loss, these charges are prorated over the number of shares bought in the transaction.

If a mutual fund company makes a tax-free return of your investment capital or principal, you must reduce your cost basis in the fund by the value of this return. If the fund returns your entire investment, your cost basis becomes zero. This means any additional amounts that are returned to you will be taxed as a capital gain.

Determining the capital gains tax
If a nonzero basis results in a capital gain from your fund, you will have to pay taxes. The rules for reporting capital gain distributions differ from those for ordinary capital gains. Box 2a of Form 1099-DIV reports all capital gain distributions, also known as capital gains dividends, from mutual fund companies and real estate investment trusts (REIT). According to Chapter 17 of IRS Publication 17, these are to be reported as long-term capital gains. For this type of distribution, the length of time you have held these shares is irrelevant.

Did you receive a distribution from mutual fund or REIT that you held for six months or less, and then sold at a loss? You may be subject to a different set of rules. The loss is treated as a long-term capital loss up to the total of any capital gain distributions you received and your share of any undistributed capital gains. Any remaining loss is short-term capital loss. You should consult Capital Gain Distributions under Dividends and Other Corporate Distributions in Chapter 1 of IRS Publication 17 for additional information.

Undistributed capital gains
As we've learned by now, some mutual funds keep their long-term capital gains. This means they go ahead and pay taxes on them. Even though you didn't receive your share of these gains, you must treat them as a distribution. However, they won't be included on Form 1099-DIV. Instead, your share of the fund's undistributed capital gains and tax paid will be reported to you on Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains.

Report undistributed capital gains as long-term capital gains on line 11 of Schedule D of Form 1040. This actually results in a tax credit, as opposed to a tax deduction, for your share of the amount of tax the mutual fund company paid on this gain. A tax credit isn't simply a tax deduction that reduces your taxable income. Rather, it offsets your taxes in a direct dollar-for-dollar manner. Your cost basis in the fund is increased by the amount of income recognized and decreased by the amount of the tax credit.

You take credit for the tax paid by the mutual fund or REIT by including it on line 63, Form 1040, and checking box a on that line. Attach Copy B of Form 2439 to your return, and keep Copy C for your records.

Additional information. For additional information regarding distributions from mutual funds, consult IRS Publication 564. If you have other questions about reporting gains or losses, you should consult Chapter 17 of IRS Publication 17: Your Federal Income Tax.

Conclusion
Investing in mutual funds is more popular than ever. These funds provide a number of advantages to the small investor. One advantage, the automatic reinvestment of dividends, often has unanticipated tax consequences. This is particularly true if any shares of the mutual fund have been sold in the current tax year. Knowing how to calculate a fund's cost basis is essential for computing a capital gain or loss. Understanding the rules associated with computing the cost basis will make the tax season a little less taxing.

By Cora M. Barnhart Bankrate.com
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