Mutual Fund Redemptions

A guide to helping clients minimize the tax bite.
BY LEE G. KNIGHT AND RAY A. KNIGHT

EXECUTIVE SUMMARY
CLIENTS REDEEMED A RECORD AMOUNT OF MUTUAL FUND shares during the summer of 2002, apparently fed up with markets that continued to decline. CPAs can help these investors use the basis elections in Treasury regulations section 1.1012-1 and the capital loss provisions in IRC sections 1211 and 1212(b) to gain maximum tax advantage from these transactions.

DISPOSING OF MUTUAL FUND SHARES RESULTS IN A long-term capital gain or loss if the shares are held for more than one year and a short-term gain or loss if they are held for one year or less. Investors pay a maximum tax rate of 20% on long-term gains. Short-term gains are taxed as ordinary income at rates up to 38.6%.

FOUR METHODS ARE AVAILABLE TO MUTUAL FUND investors to compute the basis in their share holdings. These include the first in, first out (Fifo), specific identification, single-category average and double-category average methods. All four have advantages and disadvantages based on a particular client’s situation. The single-category method is the most popular because it is easy to understand and requires less recordkeeping.

WHEN A CLIENT DISPOSES OF SHARES AT A LOSS, he or she must be careful to avoid the wash sale rule. It disallows a capital loss to the extent the investor buys substantially identical securities within 30 days before or after the day on which he or she makes the sale that produces the loss. Automatic reinvestment programs sometimes can cause clients inadvertently to run afoul of this rule.

CONTRIBUTING MUTUAL FUND SHARES TO CHARITY is another way to minimize the tax consequences on disposal. Doing so lets the investor take a tax deduction for the fair market value and avoid including the gain on his or her tax return. If shares show a loss, CPAs should encourage clients to sell them first and donate the proceeds, preserving the loss.

LEE G. KNIGHT, PhD, is professor of accountancy and director of the accounting program at the Calloway School of Business and Accountancy, Wake Forest University, Winston-Salem, North Carolina. Her e-mail address is knightlg@wfu.edu . RAY A. KNIGHT, CPA/PFS, JD, is managing director of Capstone Planning Alliance, LLC, in Winston-Salem. His e-mail address is rayknight@capstoneplanning.net .

hhe downward spiral of the stock market over the last three years will go on record as one of the worst bear markets in U.S. history. Financial experts cite the sluggish economy, anemic corporate profits, the possibility of war with Iraq, the ongoing battle against terrorism and the accounting scandals as contributing factors. Nonprofessional mutual fund investors are more concerned about surviving the downturn than what caused it. Surprisingly, during most of the decline, mutual fund investors followed professional money managers’ advice to stay the course and avoid panic selling.

In July 2002 mutual fund investors apparently hit their psychological limit on losses and withdrew a record $49 billion from mutual funds—significantly higher than the $30 billion they had pulled out after September 11, 2001. The July withdrawals followed $18 billion in June 2002. In August 2002 withdrawals slowed to $9 billion, but most financial experts said this level still was too high to support a sustained recovery.

Whether mutual fund redemptions lock in profits earned during the 1990s or produce losses, CPAs can provide critical tax-planning guidance to their clients. While the best time to counsel clients is before a transaction closes, some planning opportunities remain open until a client files his or her tax return. This article shows how CPAs can help clients make the most of the current investment environment by using the basis elections in Treasury regulations section 1.1012-1 and the capital loss provisions in IRC sections 1211 and 1212(b). It also includes guidance on how to convert paper losses into realized capital losses without triggering the wash sale rule and how to use the charitable contribution provisions to mitigate the current market’s negative effects. CPAs will need to counsel clients carefully because of the detailed implementation and documentation requirements, as well as the IRS’s strict interpretation and enforcement of these rules.
An Upward Trend?

The combined assets in the nation’s mutual funds increased by $317.9 billion, or 5.19%, in November 2002. Stock funds saw a 6% increase, taxable bond funds a 2% increase. Stock funds experienced a net inflow of $6.46 billion in November, compared with a $7.50 billion outflow in October.

Source: Investment Company Institute, Washington D.C., www.ici.org .

USING BASIS TO SAVE TAXES
When an investor sells, exchanges or redeems a mutual fund share, the gain or loss generally equals the amount realized (sales price less expenses of sale) minus the share’s adjusted tax basis (IRC section 1001). The gain or loss is capital in nature—long-term if held for more than one year and short-term if held for one year or less. Under IRC section 1(h), investors pay a maximum rate of 20% on net long-term capital gains. Ordinary income tax rates (up to 38.6%) apply to net short-term capital gains, making it desirable to have gains characterized as long-term.

Sections 1211 and 1212(b) say investors must use capital losses to first offset any capital gains realized during the year. They then can use the excess losses to offset up to $3,000 of ordinary income in the current year and carry forward any remaining loss to offset income in future years.

Original cost basis. The adjusted tax basis used to compute the gain or loss on a sale begins with the original cost basis unless the investor acquired the shares by gift or inheritance. IRC sections 1014 and 1015 delineate the rules for determining the basis of mutual fund shares in this situation. This article assumes the investor purchased the mutual fund shares, either directly or via a dividend-reinvestment program.

The original cost basis of a mutual fund share generally is its purchase price in cash or property, plus an allocable portion of load charges (sales or similar charges). IRC section 852(f) limits the amount of load charges added to a mutual fund share’s basis if all of the following conditions exist. The investor

Receives a reinvestment right because of the purchase of the shares or the payment of the fees or load charges.

Disposes of the shares within 90 days of purchase.

Subsequently acquires shares in the same mutual fund or another fund for which the mutual fund company waives the load charge because of the reinvestment right.

The investor adds the amount of any load charge excluded from the basis of the original shares to the basis of subsequently acquired shares (unless, of course, the three conditions are met).

Example. Mary Darby invests $100,000 in shares of Prime Fund, which deducts a 3% up-front load charge, or $3,000, from her initial purchase and invests the $97,000 balance in the fund she selects. When the value of Mary’s mutual fund investment drops to $95,000, she exchanges all the shares for another fund within the same “family.” If the exchange occurs within 90 days after the purchase, Mary has a $2,000 loss ($97,000 purchase price less $95,000 sales price) and adds the $3,000 load charge to the basis of the new shares. However, if she waits until after the 90th day, she can include the $3,000 load charge in the basis of the shares sold, making her loss $5,000 ($100,000 basis less $95,000 sales price) instead of $2,000.

If an investor acquires mutual fund shares through a dividend reinvestment program, the original tax basis is the amount of the distribution used to buy the shares. This treatment applies even if the distribution is an exempt-interest dividend not included in the investor’s income.

Example. On January 2, 2002, John Jacobs invested $5,000 in a fund, acquiring 500 shares at $10 per share. He participated in the fund’s dividend reinvestment program and elected to reinvest all dividends in additional shares of the same fund. At the end of 2002, the fund paid $600 of dividends when the value of the shares was $15 per share. John now owns two lots of shares: 500 with a purchase price of $10 per share and 40 with a purchase price of $15 per share.

Basis adjustments. The investor generally makes two required adjustments to the original cost basis to derive the adjusted tax basis. First, he or she increases the original basis by the difference between the undistributed capital gains included in income and the amount of income tax considered paid on these gains. Mutual funds report undistributed capital gains on form 2439 for the year they occur, and CPAs should advise clients to retain a copy of this each year to document basis increases.

Second, the investor decreases the original or adjusted tax basis for any distribution considered a tax-free return of capital under IRC section 301(c)(2). If the return of capital distribution exceeds the basis for the mutual fund shares, he or she treats the excess as a gain from the sale of the shares. If the investment is in a fund that pays exempt-interest dividends, however, the investor cannot decrease the basis of the mutual fund shares by the dividends. Mutual funds report return of capital distributions on form 1099-DIV. CPAs again should advise clients to keep a copy to document their basis.

Identifying shares sold. Shares with different tax bases held in a given mutual fund enable the investor to influence the taxable gain or loss on share dispositions by controlling the basis of the shares sold or transferred. Regulations section 1.1012-1 sanctions four methods for calculating the basis of shares sold or transferred:

First-in, first-out (Fifo) method.
Specific identification method.
Single-category average method.
Double-category average method.

Investors can use the Fifo and specific identification methods for sales of stock as well as mutual fund shares under regulations section 1.1012-1(c). Both methods use the actual cost or other basis of the particular shares deemed sold in determining the gain or loss reported on the investor’s tax return. By comparison the single-category and double-category average methods apply only to mutual funds and lump the actual cost or other basis of shares together to determine their average basis under regulations section 1.1012-1(e).

The single-category and double-category methods require the investor to make an election on the first tax return for which he or she wants the method to apply. The investor cannot make this election on an amended return unless he or she files that return no later than the due date for filing, including extensions. The election remains in place until the investor gets IRS permission to revoke it and applies to all of the investor’s shares in a particular fund. He or she may use other methods for shares in other funds.

Fifo method. The investor uses the basis of the oldest shares (first) purchased as the basis of the shares sold. This method may be a good choice if the investor cannot identify the lots from which he or she sells or transfers shares. The problem with Fifo, however, is the investor has little control over the amount of gain or loss recognized from the disposition. In fact, he or she may wind up reporting a gain even though the share’s value dropped after the last purchase.

Example. Jane Altec invests $25,000 in ABC Mutual Fund, acquiring 500 shares at $50 per share. The fund’s net asset value steadily increases and she invests another $37,500, acquiring 500 shares at $75 per share. The price then falls to $60 per share and Jane sells 500 shares. Despite this drop in price, Jane reports a $5,000 gain under Fifo ($30,000 selling price less $25,000 adjusted tax basis). She assumes the 500 shares sold at $60 per share came from the first 500 purchased at $50 per share.

CPAs should counsel clients using Fifo to keep records of both purchases and sales until they dispose of shares acquired on a particular date.

Specific identification method. The investor specifies the shares he or she is selling and uses the actual holding period and adjusted tax basis to determine the amount and type of gain or loss on disposal. An investor must be able to adequately identify the shares sold. To satisfy the regulations section 1012-1(c)(3) identification requirements, CPAs should advise their clients to

Specify to their brokers or other agents, at the time of sale or transfer, the particular shares they want to sell or transfer.

Obtain written confirmations of these specifications from the brokers or other agents within a reasonable time.

If the broker or agent sells the wrong lot of shares, the written confirmation may be the only way a client can avoid using the basis for the shares actually sold. In other words, the investor has the burden of proving which shares the broker or agent sold.

Example. Assume Jane Altec, the investor in the previous example, uses the specific identification method. She directs her broker to sell the 500 shares purchased for $75 per share ($37,500 total cost) and receives a timely written confirmation. Jane reports a $7,500 loss ($30,000 selling price less $37,500 adjusted tax basis), compared to the $5,000 gain reported under Fifo. Moreover, even if the broker actually sells the shares from the lot purchased for only $50 per share, Jane can use the $75 per share basis she specified to calculate her loss.

Single-category average method. The adjusted basis of each share sold is the adjusted basis of all shares in the investor’s account at the time of disposal divided by the total number of shares in the account. For the holding period, however, the investor assumes a Fifo flow, and thus, considers all shares held for more than one year sold before any shares held for one year or less.

Example. Mike Manor made the following investments in Reynolds Fund during 1999 and 2000:

Dates Shares Total Cost
January 2, 1999 100 $10,000
July 1, 1999 90 $10,000
January 2, 2000 80 $10,000
March 1, 2000 80 $10,000
Total 350 $40,000

On March 15, 2000, Mike redeemed 150 shares for $19,500. Under the single-category method, the average cost of Mike Manor’s shares was approximately $114 ($40,000 divided by 350 shares.) Of the 150 shares redeemed, he treated 100—those acquired in January 1999—as held for more than one year. He treated the other 50 shares as held for one year or less. The gain on each share sold was $16 ($130 – $114). Thus, Mike had a long-term capital gain of $1,600 (100 shares @ $16 per share) and a short-term capital gain of $800 (50 shares @ $16 per share).

The basis of any shares remaining after a sale is the same as the basis of the shares sold. As soon as the investor acquires additional shares, however, he or she must recalculate the average share price. Many consider this recalculation burdensome, but the single-category method avoids a major shortcoming of using Fifo in bull markets: the oldest shares usually have the lowest basis and thus produce the largest gain. Of course, in bear markets, the older shares may have a larger basis, generating a smaller gain under Fifo.

Double-category average method. The investor divides all shares in an account into two categories: short-term and long-term. The former category includes shares held for one year or less; the latter, shares held for more than one year. The adjusted basis of each share in a category is the total adjusted basis of those shares divided by the total shares in the category.

The investor may specify to the custodian or agent handling his or her mutual fund account the category from which to sell or transfer shares. If the agent or custodian confirms this choice in writing, the investor can use the average basis of the shares in the specified category as the basis of the shares sold. In the absence of specification or confirmation, the IRS assumes the shares the investor sold are from the long-term category. If the number of shares sold or transferred exceeds the number in the long-term category, the IRS charges the excess against the short-term category.

The investor must transfer shares held for more than one year to the long-term category. If he or she has not sold any shares from the short-term category at the time of transfer, the basis of the transferred shares is their cost or adjusted basis—not the average basis. If the investor has sold some of the shares in the short-term category, the basis of the transferred shares is their average basis in the short-term category at the time of the most recent sale.

Which method is best? CPAs will find that all four options provided in regulations section 1.1012-1 have attractive features and all have shortcomings. The single-category method is the most popular because it is easy to understand, requires less recordkeeping than the specific identification and double-category methods and produces lower capital gains than Fifo if the oldest shares have the lowest costs. The specific identification and double-category methods are more complicated and impose more onerous recordkeeping requirements. However, they offer investors more flexibility and control over the amount of the gain or loss.

Most CPA/financial planners favor the specific identification method, but it may not be the best choice (or even a choice) for some investors. The IRS will not allow a taxpayer to switch to specific identification or Fifo if he or she previously had used either of the average methods for sales or transfers from a fund. The rules on this are so stringent that even if the investor holds shares in the same fund in two separate accounts, using average cost to dispose of shares in one account precludes the use of specific identification in the other.

Investors also may find it difficult to meet the specification and written confirmation requirements. Many online brokers do not have the recordkeeping systems that will allow investors to specify which shares they are selling or to automatically provide written confirmation of these instructions. Major mutual fund companies, on the other hand, say they can provide investors with the needed information; yet, these same companies indirectly push investors toward the single-category average method by using it to calculate gains and losses on quarterly and annual statements. Fidelity Investments recently introduced a new recordkeeping system that gives its clients Web access to lot-specific transactions dating back to 1987. Vanguard says it is considering a similar system, and other mutual fund companies may follow suit once investors realize the added flexibility and control they have over the amount and characterization of gains and losses from sales and transfers.

The double-category method usually offers less control and flexibility than specific identification, but imposes less stringent recordkeeping requirements and offers more control than the Fifo and single-category methods. For example, if the average basis of an investor’s long-term shares is substantially lower than the basis of his or her short-term shares, the double-category method lets the investor choose between realizing a relatively large long-term capital gain (by specifying the shares sold came from the long-term category) or a relatively small short-term capital gain (by specifying the shares sold came from the short-term category). CPAs will find the decision that produces the greatest tax savings depends on many factors, including the taxpayer’s marginal income tax rate and other capital gains and losses realized during the tax year.

USING MUTUAL FUND LOSSES
CPAs know and appreciate the benefits of converting paper losses into realized capital losses. Clients, however, often need a refresher course on these benefits and help developing a plan to realize them. The first step is to have the client sell shares in funds with built-up losses. The basis election may help the client control the amount of losses the disposal produces. If the client follows a “buy-and-hold” strategy—which is consistent with the professional money manager’s belief in not selling during market downturns—the goal is to sell these shares without triggering the IRC section 1091 wash sale rule.

After completing the disposal transaction, the client must make sure he or she has the right type and amount of income against which to offset the capital losses. Some clients won’t have to take specific actions to ensure the availability of this income; others will need to create capital gain income. The basis election may help the client create the needed gains. Clients also can minimize the impact of both gains and losses by using the charitable contribution provisions of IRC section 170.

Avoiding the wash sale rule. The wash sale rule disallows a capital loss on the sale of shares to the extent the investor buys—or enters into a contract or option to acquire—substantially identical stock or securities within 30 days before or after the day the investor makes the sale or transfer that produces the loss. This reason alone keeps some investors from selling shares that produce losses. They often fear the shares will increase in value during the 30-day waiting period, leaving them on the sidelines. If the investor decides to repurchase the shares anyway, he or she will incur unnecessary brokerage or other transaction fees on both the sale and repurchase transactions.

Fears about the wash sale rule tend to have more validity when investors sell individual stocks to unlock capital losses than when they sell mutual fund shares. Mutual funds usually allow investors to switch from one fund to another for a nominal fee. Additionally, many funds offer such a large number of investment vehicles to choose from, it’s relatively easy to find a mutual fund that will react to prevailing market forces in a similar fashion to the fund in which the investor has paper losses. Reacting similarly to market forces does not make the securities substantially identical, and thus, will not trigger the wash sale rule. An investor should be able to convert paper losses to deductible capital losses by temporarily switching from one mutual fund to another without losing the opportunity to take advantage of a sudden surge in the overall market while waiting for the 30-day waiting period to expire.

Beware of automatic reinvestment programs. One problem CPAs should warn clients about is the inadvertent application of the wash sale rule through a mutual fund’s automatic reinvestment program. The IRS considers the acquisition of additional shares via the automatic reinvestment of dividends or capital gains as a purchase of additional shares within the 61-day period (30 days before and after the disposal) and, thus, may disallow a loss on the sale of shares from the same fund.

Example. Jason James owned 10,000 shares in the Polar Fund and participated in its automatic dividend reinvestment program. Because Polar Fund shares declined in value, Jason decided to redeem 50 shares on December 15, 2002 so he would have a capital loss to offset the capital gains he had realized during the year. On December 31, Polar Fund paid dividends and Jason received 45 additional shares. Because the reinvestment occurred less than 30 days after the redemption, the IRS would have disallowed the loss on 45 of the 50 shares Jason redeemed in 2002.

To avoid being blindsided by the accidental application of the wash sale rule, CPAs should advise clients to find out if a reinvestment is scheduled to occur during the waiting period, and if so, opt out of the automatic reinvestment plan or change the scheduled disposal date. Some mutual funds regularly schedule reinvestments of dividends and capital gains on certain dates each year—for example, the 15th day in the first month of each calendar quarter. Other funds leave the timing to management, forcing investors to ask when it plans a reinvestment.

Avoid the wash sale rule with bond funds. Investors using bond funds to generate capital losses may find it easier to avoid the wash sale rule than those who use stock funds because of how the courts interpret the substantially identical requirement with regard to bonds. In Hanlin v. Commissioner (108 F2d 429 (3d Cir. 1939), aff’g 38 BTA 811 (1938), nonacq ., 1939-1 CB (part 1) 55), the leading case in this area, the Board of Tax Appeals held that bonds issued by different federal land banks were not substantially identical because a default by one bank did not give the holder a claim against another in all circumstances. In affirming this decision, the Third Circuit Court of Appeals said wash sale treatment did not hinge on perfect correspondence but, instead, focused on whether the transaction changed the taxpayer’s economic position. Thus, factors that may keep investments in bond mutual funds from being substantially identical (avoiding the wash sale rule) are different issuers and interest rates and sufficiently different maturity dates to give them a different yield. This should be easier with bond funds than with individual bond issues.

Example. Jack Roberts purchases shares in a bond mutual fund when interest rates are at record lows. When rates rise and the value of the mutual fund shares declines, Jack decides to recognize the loss and switches to a mutual fund that invests in bonds issued by different state agencies at different interest rates. As long as the bonds in this new fund are subject to similar risks (they are backed by the full faith and credit of the state government and their value fluctuates similarly with prevailing interest rates), he can accomplish his objective of claiming the tax loss without a further loss in value. The wash sale rule will not apply because the bonds have different obligors and interest rates. If Jack prefers the original fund, he can always switch back after the 30-day wash sale period expires.

CHARITABLE CONTRIBUTIONS OF FUND SHARES
CPAs historically have shown clients the benefits of donating appreciated securities to qualified charities. This strategy allows taxpayers to deduct the fair market value of the securities as a charitable contribution without paying capital gains on the appreciation. Even in a depressed market, some buy-and-hold investors still have appreciated stock or mutual funds to donate.

Example. Michael Damon bought 1,000 Potential Fund shares in 1993 at $20 per share. The share price increased rapidly, but then started to decline in mid-1999. On July 15, 2002, when the share value was $35, Michael decided to stem the decline by donating the shares to his alma mater, Excalibur University, a qualified charitable organization. Michael paid no taxes on the $15,000 share appreciation (($35 – $20) x (1,000 shares)) and got a tax benefit of $13,510 ($35,000—fair value of the shares at the donation date—times 38.6% tax bracket).

Clients with built-up losses also can benefit from this strategy and get the capital loss from the sale as well as the charitable contribution. CPAs should advise the client to first sell the shares and then use the capital losses to offset capital gains realized during the year and $3,000 of current year ordinary income. Any remaining loss can offset income in future years. The client then donates the proceeds to a qualified charitable organization.

Example. In July 2002 Susan Prince sells Tank Fund shares with a basis of $30,000 for $18,000—a $12,000 loss—and donates the proceeds to Tabor University, a qualified charitable organization. Susan, who is in the 38.6% tax bracket, also sells shares in Zenith Bond Fund at a $2,000 gain. Susan can

Offset the $2,000 gain from selling the Zenith Bond Fund shares.
Offset $3,000 of ordinary income for 2002.
Carry forward the remaining $7,000 in capital losses to future years.
Save $6,948 (38.6% times $18,000) from the charitable contribution to Tabor University.

CPA GUIDANCE CAN MAKE A DIFFERENCE
CPAs will have clients who react to the continued stock market decline in a variety of ways. Some will panic and sell impulsively—certainly without consulting their accountants for advice. Others will stay on the sidelines, thinking their situations will improve over time. Knowledge of the various tax law provisions related to mutual fund investments should enable CPAs to help both types of clients minimize the income tax impact of their mutual fund transactions. Moreover, once market conditions improve, clients are not likely to forget the CPA who helped them navigate and survive the worst bear market ever.

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