Mutual Fund Redemptions

Managing gains and losses.
BY NICHOLAS FIORE

utual funds are extremely popular investment vehicles. They enable taxpayers to purchase shares in a variety of funds rather than invest in individual stocks, thereby providing risk diversification, professional investment management and more ready liquidity.

Because mutual funds are capital assets, redemptions (which are simply sales of the fund shares) will result in gains or losses. When taxpayers compute and report these gains or losses, the IRS allows a choice of four alternative methods for determining the basis of the shares sold, each of which may affect the amount and character of the gain or loss recognized.

BASIS VALUATION METHODS

Of the four allowable methods, the first two are based on the mutual fund shares’ actual costs; the other two are based on averages.

  1. Under the specific-identification method, a taxpayer specifies the shares he or she wants sold; the costs involved in acquiring those shares determine their basis. The taxpayer must indicate to the broker the exact shares to be sold at the time of sale or transfer and must receive confirmation from the broker within a reasonable time. The taxpayer then uses the cost basis of the shares sold to compute both the amount and nature (that is, short-term or long-term) of the gain or loss.
  2. Under the Fifo method, the earliest shares acquired are deemed to be the first sold. If a taxpayer does not select one of the other methods, the IRS will use this method to calculate his or her gain or loss.
  3. Under the single-category method, all the shares a taxpayer holds at the time of disposition are considered part of one group. To determine the adjusted basis per share, the total cost of the shares in the group at the time of disposition is divided by the total number of shares in the group. This figure is then multiplied by the number of shares sold.
  4. Under the double-category method, all the shares in a taxpayer’s account at the time of disposition are divided into two categories—long-term (shares owned for more than one year) and short-term (those held for less than a year).

To determine the adjusted basis of each share in a category, the total adjusted basis of all the shares in the category is divided by the total shares in the category at that time.

The taxpayer must separately maintain each category’s adjusted basis. A taxpayer may identify the category from which the shares to be sold or transferred originate; the fund’s share agent or custodian must confirm this determination in writing.

Reinvested shares. Taxpayers who hold mutual funds often instruct that fund dividends be reinvested. Shares acquired due to reinvestment are added to the short-term category at actual cost. If the taxpayer holds those shares for more than a year and does not dispose of them, they are transferred to the long-term category and take the average cost of the disposed-of shares as their adjusted basis. After such a transfer, the taxpayer must compute a new weighted-average cost per share for the long-term category.

NEED FOR GOOD RECORDKEEPING

The issues involved when a taxpayer disposes of either a portion of his or her mutual fund holdings or his or her entire interest underscore the importance of maintaining good records. In particular, when reinvestments are made in a fund, the taxpayer must maintain the cost records of the shares acquired, in order to determine gain or loss accurately. This is a burden for taxpayers; they must retain detailed records to support the complex and various computations that may be involved.

For a detailed discussion of this topic, see “Managing Portfolio Gains and Losses in Mutual Fund Redemptions,” by Gerald Weinstein and Robert Bloom, in the April 2000 issue of The Tax Adviser.

—Nicholas Fiore, editor
The Tax Adviser

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