Online investing and toll-free telephone service make selling your mutual-fund shares a snap; accounting for that sale at tax time is anything but. The Internal Revenue Service allows investors to choose from several methods of reporting gains and losses, and which method you use to calculate those numbers makes all the difference.
Keep that in mind as account statements and 1099-Bs--the form the fund company will also send the IRS--arrive this month. If you sold mutual funds in a taxable account in 2001, you'll have to consider these issues before Apr. 15. Of course, it's even better if you think about the varied tax consequences before you sell a fund--or stocks for that matter, since the same rules apply to them.
The key to a smart sale is understanding "cost basis," the price you paid per share for a fund. Figuring that out can be tricky because investors rarely buy all of their fund shares at a single price. If they're putting a fixed amount of money into a fund every month, they'll own numerous share lots, each purchased at a different price. That's not all. Most investors reinvest their dividend and capital-gains distributions, which are also purchases, creating more share lots. These distributions, when reinvested, become part of your cost basis. And if you paid any transaction fees in buying or selling, you have to adjust your costs for those, too.
Most people use an average cost-basis calculation, in part because it's the simplest and often available from brokers and fund companies. The average cost is the total amount invested in the fund divided by the number of shares you have purchased. If the price at which you sold or plan to sell a fund is higher than the average cost, you've got a profit; lower, of course, produces a loss. But the simplest methods are not necessarily optimal for reducing your tax burden.
To see how these methods work, we have come up with a hypothetical account in a real fund, Vanguard Capital Opportunity Fund (table). We started with a $25,000 investment in January, 2000, made several other investments, and reinvested dividends and capital gains. We cashed out on the last day of 2001.
Start with the simplest calculation. You invested $50,000 out of your pocket over the two-year period and an additional $2,724.58 from distributions, so the total cost is $52,724.58. With those investments, you have accumulated 2,327.83 shares. (Unlike stocks, mutual-fund purchases almost always include fractional shares.) Divide the total cost by the number of shares, and you get an average cost per share of $22.65.
So is there a gain or loss? On Dec. 31, Capital Opportunity's share price was $23.62. Subtract your $22.65 average cost, and you get a capital gain of 97 cents a share. Simple, sure, but you're not finished. The IRS considers gains on fund shares held longer than one year as long-term capital gains and takes a maximum of 20% of the gain in taxes, vs. as much as 39.1% for short-term gains, the same rate as on ordinary income. In this case, you have 1,331.99 long-term shares (those purchased in 2000). Multiply that by your 97 cents average gain, and you have a $1,292.03 long-term profit. Do the same for your 995.84 remaining shares, and you have a $965.96 short-term gain. The IRS calls this formula the "single-category method" because you're calculating just one average cost for every share.
If you have both long- and short-term gains or losses, it's worth your trouble to consider the double-category method. That's when you calculate two average costs, one for your long-term shares, another for the short-term. Although your total gain will be the same with either method, the distribution between short- and long-term gains will differ. Whichever method realizes the least short-term gains is the right one for most investors.
Now, let's look at the two average costs. For the short-term shares, it would mean $20.25, for the long-term, $24.45. Since the fund's sale price was $23.62, you have a gain of $3.37 per share for the 995.84 short-term shares--a total of $3,355.98. Then you have a loss of 83 cents a share on the 1,331.99 long-term shares. That's a total loss of $1,105.55. Assuming you have no other long-term gains from your other investments, those long-term losses will offset some short-term gains. But you would still be left with a short-term gain of $2,250.43, compared with $965.96 in the single-category method. So, in this example, the single-category method works better.
Our example presumed you sold all the shares. But what if at yearend you sold only a portion of them? Then it gets trickier. You could use the average-cost basis employed in either the single- or double-category methods. When you're selling part of your stake, the double-category method has an advantage in that you have the flexibility of selling from either your long-term or short-term shares. With the single-category method, the IRS immediately assumes you are selling the oldest shares first.
The problem with using average cost is that you can't maximize your losses and minimize gains to the fullest extent. The best way to do that is the "specific share" method. In this approach, you get to cherry-pick the highest cost shares and hold on to the lower cost ones. "Ninety-five percent of the time, selling specific shares offers the optimal tax efficiency," says tax expert Brian Langstraat of Parametric Portfolio Associates in Seattle.
To see how this method works, go back to the table. Look at the shares purchased on Mar. 16, 2000, at $32.72 a share. They're the most expensive shares in the account, and they also happen to be long-term. Sold on Dec. 31, 2001, those shares would produce a long-term capital loss of $1,390.63. This can be used elsewhere to offset long-term gains you may have in your portfolio. Likewise, the shares purchased on May 22, 2001, at $27.23 would generate a $662.90 short-term loss, which could offset short-term profits. In the absence of any gains, you can deduct up to $3,000 a year in losses from your taxable income. If your losses exceed $3,000, you can carry the difference over until future years.
The problem with the specific share method is that it requires a lot of detailed record-keeping. You have to know exactly which shares to sell and, should you be audited, be able to prove to the IRS that you sold those specific lots. According to tax rules, you must receive written confirmation from your fund company or broker that you sold those specific shares. But in practice, few financial institutions keep records of individual share purchases, preferring to aggregate the total. (Fidelity Brokerage Services is one notable exception.) So the record-keeping really falls on you. "If you've done everything you can to keep accurate records, that's a pretty defensible position to the IRS," says Edward Fleming, a personal tax manager at PricewaterhouseCoopers.
If an IRS auditor thinks that you have skimped on the record-keeping--didn't keep trading statements or letters to your broker requesting specific shares be sold--the auditor will assume that you sold the oldest shares of your fund first. This is known as the first-in, first-out method and is often the least tax-efficient way of selling shares, as the oldest shares of your fund are often the cheapest. You must also notify the IRS on your Schedule D (the form for reporting capital gains and losses) as to which cost-basis method you are choosing for a particular fund and stick to that method. If you used average cost in tax reporting for 2001, you cannot switch to another method for reporting on the same fund in future years. You can, however, choose different methods for other funds.
Luckily, software programs such as Quicken 2002 Deluxe can greatly facilitate your record-keeping. Quicken's program lets you download every trade you make at your broker or fund company into a spreadsheet, and when you're ready to sell, you can click an "average cost" button--using the single-category method--or a "minimize gain" button. Clicking the latter identifies your highest cost shares. When you sell, the program will calculate the capital gains or losses you have generated. Quicken's Web site and a competitor, GainsKeeper.com, also let you track share lots, but their programs are not as comprehensive.
Although working through the permutations of different cost-basis calculations can provoke headaches, the tax savings gained may be worth the extra time. A couple of aspirin and a sharp pencil could go a long way toward keeping the IRS at bay. By Lewis Braham