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Managing Portfolio Gains and Losses in Mutual Fund Redemptions There are four ways to compute basis when selling mutual fund shares. The choice of method can affect the tax ultimately paid. This article explains the methods and their use when fund share prices are rising or falling, and examines special rules that may also affect gain or loss. Gerald
P. Weinstein, Ph.D., CPA Robert
Bloom, Ph.D. For more information about this article, contact Mr. Weinstein at (216) 397-4609 or weinstein@jcu.edu. Executive Summary
This article discusses the tax planning aspects encountered when selling a mutual fund investment. The IRS permits taxpayers to choose among alternative basis determination methods to reflect the sale. To ensure that the tax paid by the taxpayer will be minimized, judicious, purposeful planning is essential.
Overview Mutual funds, referred to by Sec. 851 as regulated investment companies, have become an extremely popular investment vehicle in the last two decades. Instead of investing in individual securities, many taxpayers are purchasing shares in a variety of mutual funds, which offer risk diversification, professional investment management and ready liquidity. Because mutual funds are capital assets, redemptions (i.e., sales) of shares create capital gains or losses. The IRS permits taxpayers to choose among four alternative basis determination methods in computing the gain or loss on disposition. When a partial disposition occurs, the method selected can affect the gain or loss recognized. While the total net gain or loss remains the same, the nature and character may differ, depending on the tax method used. This article generally discusses the four methods, then applies three of them to examples. The first two examples involve partial and total fund liquidations when share prices are generally rising; the latter two examples address such liquidations when share prices are generally falling.
Basis Valuation Methods Mutual funds are vehicles in which to invest in capital assets. Taxpayers generally are aware of the importance of maintaining records on capital asset (e.g., stock and debt) purchases until the underlying security is sold; they may not realize that similar records must be maintained for mutual fund investments. In particular, if reinvestments (e.g., dividends and capital gain distributions) are made in the fund, cost records of the shares acquired must be maintained to determine gain or loss accurately. As tax advisers know, this issue often creates a burden for taxpayers, because they must retain detailed records to support computations. The problem is aggravated if a taxpayer unknowingly treats a mutual fund as a money market fund and makes frequent withdrawals. Because reinvestments lead to purchases at different times and in different amounts, sales of shares from a mutual fund investment can create complex computations. By carefully selecting the method to use, a taxpayer can effectively specify the category from which particular shares are deemed removed at the time of sale. Advance planning can reduce the immediate tax burden significantly. The IRS permits any of four methods to be used in determining the basis of a mutual fund investment. Two are cost measures; the other two are average measures. Each is described below.
Cost Methods The two cost basis methods—specific identification and first-in, first-out (FIFO)—have rules similar to generally accepted accounting principles (GAAP). A key difference between the IRS methods and their accounting counterparts is that the former require the cost flow to be compatible with the physical flow; that is not a requirement in financial accounting. An advantage of using the two tax cost methods is that switching between them is allowed. Specific identification: This method is similar to the specific identification method under GAAP for inventory. Specific shares are identified as sold; the specific cost of acquiring these shares determines the cost basis. To apply this method, the shares sold have to be specified to the broker at the time of sale or transfer. The taxpayer must receive a broker's confirmation in writing within a reasonable time, according to Regs. Sec. 1.1012-1(c)(3). The taxpayer then uses the actual cost basis of the specific shares to compute gain or loss. (In view of its simplicity and similarity to its financial accounting counterpart, this method is not illustrated in this article.) FIFO: This method deems the earliest acquired shares to be the first sold. According to Regs. Sec. 1.1012-1(c)(1), the IRS uses this method if the taxpayer does not select one of the allowed alternatives. If shares were purchased at different times or prices and the taxpayer cannot establish the specific shares sold, the actual cost basis of the shares first acquired becomes the basis of the shares sold. For tax planning purposes, in periods of rising (mutual fund share) prices, FIFO will generate a larger profit (i.e., recognized gain) than any other method.
Average Methods Under the single- and double-category methods, a little of each individual acquisition is deemed sold, because the costs are averaged over all shares held. Average costing methods mitigate the effects of various costs, producing a smoothing effect. In times of rising share prices, use of one of these two methods may lessen the tax burden. The single- and double-category average methods were created to allow taxpayers to use an IRS-approved average method. Neither of these methods is identical to GAAP's weighted-average inventory method. Regs. Sec. 1.1012-1(e)(2) provides that, once an average method is adopted, it cannot be revoked without IRS consent. The gain or loss on future redemptions may be affected by the particular method selected; the average methods can produce different results when partial dispositions occur. Accordingly, one should calculate the tax effects under each method before choosing one of them. If either of the two average methods is applied, special care should be taken in the computations. When the disposition is reported on the return, the taxpayer must specify, under Regs. Sec. 1.1012-1(e)(6), whether he used the single- or double-category method. Single-category method: Under this method, a single group includes all shares held at the time of disposition. To find the adjusted basis per share, under Regs. Sec. 1.1012-1(e)(4)(i), 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 (analogous to the GAAP weighted-average method). The shares deemed sold are those first acquired, according to Regs. Sec. 1.1012-1(e)(4)(ii). If the IRS establishes that the single-category method has been used to convert a long-term capital gain or loss to a short-term one, or a short-term capital gain or loss to a long-term one, use of the method will be disallowed by Regs. Sec. 1.1012-1(e)(4)(iii). Double-category method: Under this method, all shares in the account at the time of each disposition are divided into short-term and long-term categories. Shares owned for more than one year are classified as long-term; those held for less time are short-term. According to Regs. Sec. 1.1012-1(e)(3)(i), to find the adjusted basis of each share in a category, the total adjusted basis of all shares in the category at the time of disposition is divided by the total shares in the category at that time. Each category's adjusted basis is separately maintained. A taxpayer may identify the category from which the shares to be sold or transferred originate; the determination must be confirmed in writing by the share agent or custodian. A taxpayer who does not identify the specific shares sold is required to use FIFO in charging the shares sold to a category, according to Regs. Sec. 1.1012-1(e)(3)(ii). Regs. Sec. 1.1012-1(e)(3)(iii)(a) provides that newly acquired shares (e.g., from reinvestment) are added to the short-term category at actual cost. If dispositions are made from the short-term category, the adjusted basis of the disposed of shares is found using the computational rule described above. Undisposed of shares transferred to the long-term category after the one-year holding period is met take the average cost of the disposed of shares as their adjusted basis. Regs. Sec. 1.1012-1(e)(3)(iii)(b) provides that, after the transfer, a new weighted-average cost per share for the long-term category must be computed; there are no multiple layers. While the IRS does not allow last-in, first-out (LIFO) to be used for securities transactions, the effects of LIFO can be approximated by use of the double-category method. Contrary to LIFO, however, there are only two layers in the double-category method. The adjusted basis (as well as the adjusted basis per share of the long-term category) changes each time a transfer of this nature occurs. Each calculation results in the creation of both a long-term and a short-term pool.
Rising Prices Partial Redemption Using the data shown in Exhibit 1 assume a $3,000 liquidation on Feb. 4, 2000, at $34 per share, a liquidation of 88.235 shares ($3,000/$34). The following discussion illustrates how basis and gain change depending on the basis computation method used.
FIFO: Under FIFO, the adjusted basis is determined by measuring the actual cost of the first 88.235 shares acquired; the earliest shares acquired are deemed sold. Through June 28, 1996, the taxpayer had acquired 85.253 shares. The dividend reinvested on Dec. 28, 1996 put the total number of shares owned above the 88.235 sold; only 2.982 shares of that reinvestment (88.235 x 85.253) are thus considered sold. The adjusted basis of the 88.235 shares redeemed is determined as follows:
The capital gain is computed as follows:
Because the first 88.235 shares were acquired more than one year before the sale, the entire capital gain is long-term. Single-category method: In the single-category method, all shares held at the date of disposition are included in a single group. The adjusted basis per share is $27.33 ($3,678.08/134.574 shares).
The single-category method forces a taxpayer to determine holding period on a FIFO basis. Accordingly, the entire gain is long-term, but less than the gain reported under FIFO. Double-category method: Because all shares in the account at the time of disposition are divided into short-term and long-term holding periods under this method, the shares acquired Feb. 4, 1999 and thereafter must be assigned a short-term adjusted basis per share. This basis per share is $33.29 ($452.91/13.606 shares). The adjusted basis per share for shares held more than one year is $26.66 ($3,225.17/120.968 shares). Under this method, there are two bases, one for each category. The taxpayer may elect to treat the disposition as coming first from the short-term category or the long-term category. If the taxpayer does not specify, the shares redeemed are assumed to be from the long-term category, under Regs. Sec. 1.1012-1(e)(3)(ii). Assume the taxpayer elects to treat the sale of the 88.235 shares as originating from the most recent purchases, a LIFO physical flow. Thus, to a limited extent, the double-category method can be used to approximate the LIFO method. All the shares acquired in the most recent 12 months are deemed sold.
The balance of the sale, 74.629 shares (88.235– 13.606), is treated as long-term:
Under the double-category method, electing to sell the short-term shares first, the taxpayer creates a $9.66 short-term capital gain and a $547.78 long-term capital gain. If the taxpayer elects to have the disposition treated as though it originated from the long-term category, all the redeemed shares would come from this category. The recognized long-term capital gain is:
Summary: A striking feature of the foregoing results is that while each of the methods produces a capital gain, the amount and nature of the gain differ completely from method to method. In this example, using the double-category method and electing to sell from the short-term category first produced the lowest income (and presumably, the least tax). The $557.44 combined overall net gain is the least of any of the three methods. Exhibit 2 below summarizes these results.
Total Redemption Now assume all 134.574 shares are redeemed for $4,575.52; the adjusted basis of the investment is the same in all cases, $3,678.08. Hence, the overall recognized gain is approximately $898. However, as shown below, depending on the method used, the character of the gain differs. FIFO: Under the above discussion of the double-category method, during the preceding 12 months, 13.606 shares were acquired for $452.91. Redemption of these shares generates a short-term gain; sale of the remaining shares produces a long-term gain.
The disposition of the remaining 120.968 shares is treated as long-term:
Single-category method: As was previously discussed, the adjusted basis per share under the single-category method is $27.33; thus, the short-term shares sold produce the following capital gain:
The long-term shares yield the following results:
Double-category method: The results under this method are identical to FIFO. As was discussed, the adjusted basis per share of shares held one year or less is $33.29; shares held more than one year have an adjusted basis of $26.66 each. Accordingly, the gain computations are as follows:
Summary: Exhibit 3 below summarizes the results of using the various basis determination methods in a complete liquidation. Even in a complete liquidation, different results can be obtained depending on the method employed. While differences among the methods appear modest, this is in part due to the data, which does not use large numbers. However, the selection of methods affects the nature of the gain, which can have real tax effects, because long-term gains are generally taxed more favorably than short-term gains.
Falling Prices Partial Redemption Using the data in Exhibit 4 below, assume a $3,000 liquidation on Feb. 4, 2000, at $27.50 per share; this is a liquidation of 109.091 shares ($3,000/$27.50). This discussion reveals the effects of falling prices on the gain/loss computations and addresses several important rules.
FIFO: The adjusted basis is determined by measuring the actual cost of the first 109.091 shares acquired. The capital gain distribution reinvested on Dec. 27, 1998 put the total number of shares owned over the 109.091 sold; thus, only 5.87 shares of that reinvestment (109.091 – 103.221) need to be considered. The adjusted basis of the 109.091 shares redeemed is determined as follows:
The capital loss is computed as follows:
Because the 109.091 shares were all acquired more than one year before the sale, the entire capital loss is long-term. Single-category method: Under this method, each share is assigned an adjusted basis of $30.72 ($3,658.08/119.076 shares). The capital loss is computed as follows:
Because the shares sold must be determined on a FIFO basis under this method, and the number of shares sold does not exceed the number acquired more than one year before the sale, the entire loss is long-term. The loss reported under the single-category method is less than the loss under the FIFO method. Double-category method: Those shares in the older category (i.e., acquired more than one year before the redemption) are assigned an adjusted basis of $30.957 per share ($3,401.18/109.868 shares). The short-term shares each carry an adjusted basis of $27.90 ($256.90/9.208 shares). Under the double-category method, the taxpayer must select a category from which the redemption stems. The effect of each selection is examined below.
Because the redemption of 109.091 shares did not use up all of the 109.868 shares in the long-term category, the entire loss is long-term.
The remaining 99.883 (109.091 – 9.208) shares redeemed produce the following result:
The deductibility and character of the loss are affected by the items discussed below.
Special Rules Capital Gain Distributions on Short-Term Shares A special rule applies under Sec. 852(b)(4) when a taxpayer receives an undistributed capital gain or a capital gain distribution on shares held six months or less and sold at a loss. Only the part of the loss greater than the capital gain distribution is a short-term capital loss; the amount of the loss up to the amount received as a capital gain distribution is treated as long-term. Thus, the amount of the loss that can be used to offset ordinary income is limited. Because capital gain distributions from a fund are treated as long-term under Sec. 852(b)(3)(B), the limit effectively converts such long-term gains to short-term ones, by requiring them to absorb the converted short-term capital loss (thus reducing the short-term loss). Because the taxpayer generated a loss on his short-term holdings of $3.68, but received a capital gain distribution of $20.81 on Dec. 27, 1999, all of his $3.68 capital loss is treated as long-term. Thus, the taxpayer has a recognized $348.98 long-term capital loss ($345.30 + $3.68).
Wash Sales Sec. 1091 applies to any exchange of securities, including mutual funds. A wash sale is defined as the sale of securities at a loss within 30 days before or after the purchase of substantially identical securities. The wash sale rule prevents a taxpayer from reaping the benefit of a deductible loss and altering the basis and holding period of his investment, while not really changing his portfolio. Sec. 1091 disallows a loss if, within the period beginning 30 days before the disposition of the shares and ending 30 days thereafter, the taxpayer acquires shares in a substantially identical mutual fund. Any disallowed loss is added to the basis of the newly acquired shares. The Code does not define "substantially identical" securities. In all probability, only a repurchase of the same mutual fund would be considered substantially identical. The wash sale rule must be considered when mutual fund dividends are reinvested and a portion of the fund is thereafter redeemed. Reinvested dividends create an acquisition of a substantially identical security. If the portion of the fund sold generates a loss, any loss attributable to shares acquired 30 days before or after the sale will be disallowed.1 The above example has avoided the wash sale issue by making the redemption more than 30 days after the most recent reinvestment. Tax professionals must inquire of clients whether subsequent purchases (or reinvestments) were made within 30 days of the sale. Exhibit 5 below summarizes the results of the partial redemption when prices are falling. Each of the four allowable methods results in a different long-term capital loss. Assuming that the newest shares were sold first, the double-category method was also affected by the fact that there was a capital gain distribution within the preceding six months. Had it not occurred, part of the loss would have been treated as short-term. None of the other available methods would have produced any short-term amounts. While the differences reported here are small, tax planning should involve "running the numbers" to see which method offers the optimal result.
Total Redemption Again using the data in Exhibit 4, assume all 119.076 shares are redeemed for $3,274.59. The adjusted basis of the redeemed shares is $3,658.08; the loss is $383.49. However, depending on the method used, the character of the loss differs. FIFO: The 9.208 shares acquired in 1999 produce a short-term result; the remainder produce a long-term result. The short-term portion is determined as follows:
Sec. 852(b)(4) applies; the loss is less than the capital gain distribution received within the last six months, and thus, is long-term. The remaining loss, derived from the 109.868 shares (119.076 x 9.208) held more than one year, is calculated as follows:
After converting the $3.68 short-term loss to long-term, the recognized long-term capital loss is $383.49 ($3.68 + $379.81). Single-category method: As was discussed, the average cost per share under this method is $30.72. For reporting purposes, the 9.208 shares acquired in the previous 12 months produce a short-term result, subject to the Sec. 852(b)(4) exception.
This capital loss exceeds the $20.81 capital gain distribution received on Dec. 27, 1999. Accordingly, the excess, $8.84, is treated as a short-term capital loss; the remainder, $20.81, is long-term. The other shares sold produce a long-term capital loss, as follows.
The result is an $8.84 short-term capital loss and a $374.58 long-term capital loss; the total loss is $383.42. Double-category method: Under this method, the results are identical to those when the FIFO method is used. As was discussed, shares in the older category are assigned an adjusted basis per share of $30.957; the short-term category shares have a basis of $27.90 each. Because all shares are sold, the taxpayer does not have the option of selecting one of the two categories from which to make the redemption. Nonetheless, the two categories must be maintained to distinguish between short- and long-term holdings. There were 9.208 shares acquired in the last 12 months; the capital loss related to this category is computed as follows:
Sec. 852(b)(4) mandates that this loss be treated as long-term. The remaining 109.868 shares held more than one year produce the following result:
The total loss is $383.49. Exhibit 6 below summarizes the results. While the total loss is approximately the same in each case, using the single-category method allows the taxpayer to generate a short-term capital loss that can be used to offset income that could otherwise be taxed at the maximum marginal rate.
Conclusion This article has discussed the allowable methods for determining the adjusted basis of an investment in a mutual fund and illustrated the effects of selecting one method over another. When a partial disposition occurs, different amounts and characterizations (short- or long-term) result, depending on the method selected. When a complete disposition occurs, the overall gain or loss is the same under all three methods. However, the single-category method produces a different categorization of the resulting capital gain or loss than does the FIFO or double-category method. The examples presented above reflect typical results when redemptions occur during periods of rising or falling prices, and can be used by tax advisers as a general guide to potential outcomes when sales occur. Because actual mutual fund prices will usually vary over time, computations of the adjusted basis in redemption situations should be carefully considered under each metho d to determine current and future tax consequences.
1In determining adjusted basis, special care should be taken when a wash sale occurs and mutual fund basis has been calculated using an average method; see Regs. Sec. 1.1012-1(e)(3)(iii)(c) and (d). |
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