Some Further Explanations About Using Those Tax-Calculation Methods
Last week, after we outlined the different ways investors who sold mutual fund shares in 1998 could account for taxable capital gains and deductible losses, we received a flurry of questions via e-mail.
Which isn’t surprising given how complicated it can be for fund investors--especially long-term shareholders who’ve reinvested dividends and capital gains distributions over several years--to determine the original cost of their shares.
In an ideal world, taxes would be voluntary, the IRS wouldn’t know where you live, and fund investors wouldn’t have to go through this accounting rigmarole.
But it isn’t, and they aren’t, and it does, and you do. And guess what? You now have only 32 days left to figure it all out.
If you didn’t see last week’s column, “4 Methods to Madness of Calculating Capital Gains, Losses,” you can check it out on The Times’ Web site at https://www.latimes.com/taxes.
The story discusses the four ways to determine the tax basis, or cost, of any fund shares you sold last year--or, for that matter, any fund shares you sell in the future.
To briefly recap, those four ways are: specific identification, where you indicate the specific fund shares when you sell; first in, first out, where you sell shares in the order they were purchased; average cost/single category, where you add up all the money you invested in the fund over time and divide by the total number of shares now held, to arrive at an average per-share cost; and average cost/double category, similar to the single-category method except that you separate fund shares into two buckets--one consisting of shares you’ve held for more than a year and the other of shares you’ve held for less than a year.
As we said last week, which method you choose can have a big impact in determining the size of the taxable capital gain (if any) on fund shares sold.
Also as noted last week, there are restrictions on use of these methods, including that specific identification must be indicated at the time you sell (not after the fact), and that once you choose an accounting method for a specific fund, you’re stuck with that method for as long as you own that fund.
The following are some of the reader questions we received on this subject, and the answers:
* If I automatically reinvest capital gains distributions paid by my fund, does that affect the tax basis of the fund shares I purchase with those distributions, or just the holding period?
On some level, both.
For starters, “you have to think of reinvesting distributions as a two-step process,” says Rande Spiegelman, manager of KPMG’s personal financial planning services in San Francisco.
In effect, the fund is cutting you a check in the amount of the distribution. If you own 1,000 shares of ABC Fund, for instance, and it distributes gains of $2 a share, the check will be for $2,000.
Step 2: You turn right around and send the check back to the fund company to purchase new shares.
The holding period and price of those new shares will be determined by the day of the distribution and the market price, or net asset value (NAV), of the fund after adjustment for the distribution.
For instance, let’s say you bought 500 shares of XYZ Fund at $19 a share 18 months ago. And nine months ago, the fund’s NAV per share had risen to $22. The fund then distributed capital gains of $2 a share to shareholders. Because that payout reduced the assets in the fund, the fund’s market price was reduced from $22 a share to $20 that day.
So you got a $1,000 distribution, which you reinvested at the new, adjusted price of $20 a share, for a total of 50 shares.
Now, if you went to sell those specific 50 shares at $21 a share, using specific identification, your gain would be $1 a share. And it would be recorded as a short-term gain (taxed at your ordinary income tax rate) because the specific shares were purchased less than a year ago.
Had they been purchased more than a year ago, the IRS would consider it a long-term gain, taxed at a maximum rate of 20%.
But if you’re using the average cost/single category accounting method, shares purchased with reinvested capital gains become part of the averaged cost of your total shares. In addition, as you sell fund shares, average cost/single category accounting assumes you’re selling on a first-in, first-out basis. In the XYZ Fund example, 50 shares sold would be from the initial shares bought, so the gain would be long-term in nature, thus qualifying for the 20% maximum tax rate.
* I understand that reinvested capital gains distributions will affect my tax basis. But what about reinvested dividends?
They work the same way. Shares purchased with reinvested dividends are priced at the fund’s NAV per share on the day of the payment.
* Does the IRS allow you to use a “weighted” average when calculating gains and losses? I didn’t see that mentioned in your article.
Both average-cost methods--single category and double--are by definition weighted.
For instance, if you bought 1,000 shares of XYZ Fund at $10 a share, and an additional 100 shares at $20, you wouldn’t simply take the $10 unit price and the $20 unit price, add them together and divide by 2. That would give you an average cost of $15. Which is wrong.
Rather, using average cost, you take the total amount of money you invested and divide that sum by the number of shares of the fund you hold.
So, in this example, you invested a total of $12,000 (1,000 shares at $10 a pop plus 100 shares at $20 apiece). Then you divide $12,000 by the total number of shares owned. With 1,100 shares, your average cost tax basis would be $10.91.
* I realize that to use the specific identification method I have to inform my broker or fund company of my intent at the time of the transaction. Is there some way for those of us who do our fund trading electronically to specifically identify which shares are to be sold?
Not yet, at least with the major online brokers.
At this time, “there’s no way to do that through the Web,” says Greg Gable, spokesman for brokerage Charles Schwab. “You would have to call and place the transaction over the phone.”
Unfortunately, at some online brokers, phone transactions are more expensive than Internet trades. At Schwab, for instance, there’s no charge for selling a fund via the firm’s popular OneSource program, whether you do it over the Internet or the phone.
However, if you sell one of Schwab’s non-OneSource funds by phone, you would have to pay a slightly higher fee than for Internet trades.
The same is true at E-Trade. However, Brian Murray, E-Trade’s vice president in charge of mutual funds, says E-Trade customers will soon be able to do specific identification over the Web--perhaps as early as this summer.
But remember: Whether you let your fund company know that you intend to use specific identification via the Web or by phone, back it up with a written note indicating your intent to use this method. And get a written receipt back from your fund company in case you get audited by the IRS.
* If I didn’t sell any of my mutual funds last year, why do I owe capital gains taxes at all?
Remember what a mutual fund is. It’s an investment company that buys and sells individual securities. Just as you trigger taxes every time you sell at a profit, your fund does too, whenever it sells stocks at a gain.
By law, a fund is required to distribute all net capital gains it realizes to shareholders every year. Whether you accept that distribution in the form of cash, or whether you reinvest that money and buy additional shares of the fund (which most investors do), you still owe the IRS.
* Average cost seems simpler than the other three methods, at least from a paperwork standpoint. Can I use this method to calculate the tax basis of individual stocks in my portfolio?
No. “Averaging is only allowable for the sale of mutual funds,” says Boni Callaway, education coordinator for Invesco Funds. For individual stocks, your choices are limited to first in, first out or specific identification.
*
Times staff writer Paul J. Lim can be reached by e-mail at paul.lim@latimes.com.
