Question: Due to all the uncertainties in Washington, I am seriously considering selling my entire mutual fund portfolio for fear of a major downward adjustment in the stock market. The funds were bought decades ago and all of my dividends have been reinvested over the years. How do I calculate my tax base and my capital gains?
Reply: Mutual funds have become one of the most popular vehicles for stock market investments. Mutual funds typically buy an inventory of different stocks and are overseen by experienced investment managers. Funds, like the individual stocks they buy, are subject to changes in the price (value) of stocks. Therefore, buying shares of a mutual fund allows the investor to buy many stocks while using the expertise of the fund’s investment manager.
As with the sale of an individual stock, to calculate the gain on the proposed sale of your funds, you must first calculate your tax base or the cost of the fund units.
If you have sold all of your interest in the fund, your tax base is simply the combination of your cash purchases and all dividends reinvested in the funds. Dividends that you reinvested are treated the same as if you had received a cash distribution from the fund and then decided to give a check to the fund to purchase additional shares of the fund. Finally, you will need to compare your selling price to your calculated tax base to arrive at your capital gain.
Please note that capital gains on shares held for more than one year will benefit from the more favorable tax treatment of long-term capital gains. Capital gains on shares held for less than one year will be assimilated to short-term capital gains, subject to the rate of ordinary income tax.
If you have only sold a portion of the shares held in a mutual fund, you may need to choose one of four methods to determine your repurchased share base. A choice is only necessary if you have bought shares in the fund at different times. The following four methods are available to you:
1. First in, first out (FIFO) method: With the FIFO method, the assumption is that the first stocks you buy are the stocks you sell first.
2. Specific identification method: Using the specific identification method allows you to identify the specific shares sold. This is only permitted if a mutual fund repurchases shares using this method. In addition, you must submit a written notice to the mutual fund company before redeeming shares. This notice must provide the fund company with the specific shares to be repurchased and the purchase price per share. You are advised to keep a copy of this notice in the event of an IRS audit. If you do not follow these procedures, the IRS may force you to use the FIFO method.
3. Average cost method: Under this method, you can calculate your base per action using the average cost per action. To get your average cost per share, simply add up your entire investment, including dividends invested, and divide that number by the total number of shares held.
4. Medium-cost-double category method: This method requires you to rank your mutual stocks short or long term. An average is calculated for each category. You can then choose stocks from either class to determine the basis of fund units sold.
Before using the average cost method, be aware that if this method is used, it must be used for all the accounts of the mutual fund on which it is used. However, any method can be used for other mutual fund accounts that you sell. In addition, you are required to indicate on your income tax return, or in a return attached to your income tax return, that the average cost method was used.
Before you spend time figuring out your cost base, I recommend that you first contact your broker or mutual fund company to determine if they have the information you need.
Barry Dolowich is a Certified Public Accountant and owner of a full service accounting and tax firm with offices in Monterey. He can be reached at 831-372-7200. Please direct questions to Barry at PO Box 710 Monterey, CA 93942-0710 or email: [email protected]