Question: As we approach the end of 2022, I am seriously considering selling my entire mutual fund portfolio for fear of a continued downward spiral in the markets. The funds were mostly purchased many years ago and all my dividends have been reinvested. How do I calculate my tax base and capital gains?
Answer: 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 vetted by experienced investment managers. Funds, like the individual stocks they buy, are subject to fluctuations in the price (value) of stocks. Therefore, buying shares of a mutual fund allows the investor to actually buy many shares while utilizing 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 your entire interest in the fund, your tax base is simply the combination of your cash purchases and any dividends reinvested in the funds. Dividends that you have reinvested are treated the same as if you had received a cash distribution from the fund and then decided to give the fund a check to buy 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 from shares held for one year will benefit from the more favorable tax treatment of long-term capital gains. Gains from shares held for less than one year will be treated as short-term capital gains subject to ordinary tax rates.
If you sold only a portion of the shares held in a mutual fund, you may have to choose between one of four methods to determine your repurchased share basis. A choice is only necessary if you bought units of 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 shares you bought are the first shares you sell.
2. Specific identification method: Using the specific identification method allows you to identify specific stocks being sold. This is only allowed if a mutual fund will redeem shares using this method. Also, you must submit written notice to the mutual fund company before redeeming the shares. This notice must provide the fund company with the specific shares to be redeemed and the purchase price per share. You are advised to keep a copy of this notice in case of an IRS audit. If you don’t follow these procedures, the IRS may force you to use the FIFO method.
3. Average Cost Method: Under this method, you can calculate your per share basis using the average cost per share. To arrive at your average cost per share, simply total your investment, including any dividends invested, and divide that number by the total number of shares held.
4. Average Double Cost Category Method: This method requires you to classify your mutual actions as short-term or long-term. An average is calculated for each category. You can then choose shares of either class to determine the basis for fund shares sold.
Before using the average cost method, be aware that if this method is used, it must be used for all 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 must indicate on your tax return or in a statement attached to your tax return that the average cost method was used.
Before spending time calculating 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 CPA and owner of a full-service accounting and tax firm in Monterey. He can be reached at 831-372-7200. Please direct questions to Barry at PO Box 710 Monterey, CA 93942 or email: [email protected].