Cost Basis

When mutual fund shares are sold, one of four methods will determine cost basis: specific identification, first in-first out (FIFO), average cost (single-category), or average cost (double-category). Several publications describe these cost methods. For example, mutual fund families such as Vanguard or Fidelity publish pamphlets describing the costing process and explaining the advantages of each method.

IRC Sec. 1012 and Reg. Sec. 1.1012-1 provide the official description of the four basis-determination methods. Taxpayers are required to use the specific identification method or elect one of the average cost methods. If specific identification is not possible and no average cost election has been made, then FIFO must be used.

It is generally advantageous to use the specific identification method, which minimizes taxable income by designating the sale of higher cost purchases first. A problem occurs when fund shares are held by a custodian. If the taxpayer fails 1) to specify to the custodian the shares that are to be sold (preferably by designating purchase dates or purchase prices), and 2) to receive written confirmation from the custodian that the designated shares were in fact sold (the adequate identification rule), the IRS will apply the FIFO costing method. The Tax Court has held that the adequate identification rule applies whether fund shares are held in certificate or noncertificate form.

Loss on Sale of Shares Held Six Months or Less

When fund shares have been held for six months or less and are sold at a loss, the loss must be treated as a long-term capital loss to the extent of capital gain dividends received. Only the amount of loss that exceeds the capital gain dividends can be treated as a short-term capital loss. For example, if a shareholder purchased shares in May, and received a $500 capital gain dividend in July, then sold the fund in September at a $2,000 loss, $500 of the loss must be treated as long-term capital loss. The remaining $1,500 is treated as a short-term capital loss.

Similarly, if fund shares are sold at a loss after being held for six months or less, loss is disallowed to the extent of any exempt interest dividends received. Using the previous example with a $500 exempt- interest dividend in July, $500 of the loss would be disallowed with the remaining $1,500 treated as a short-term capital loss.

Neither the capital gain dividend nor the exempt-interest dividend limitations apply if the loss is incurred pursuant to sales of shares as part of a periodic liquidation plan. However, the definition of periodic liquidation plan was left to the IRS, and regulations have yet to be issued. Perhaps periodic liquidations as part of a retirement plan were intended to qualify.

Exchanges of Shares Within Fund Families

Some mutual funds charge a sales commission (load charge) to purchase shares. Investors who invest in load charge funds with the option to exchange purchased shares for shares in other funds at no additional (or reduced) cost, are subject to a 90-day limitation with respect to basis determination of any shares exchanged. If shares are exchanged before the 91st day following purchase, then the load charge may not be included in the basis of the shares exchanged to the extent the load charge is reduced on shares acquired. In effect, the initial load charge carries over as part of the basis of the shares acquired in the exchange. The intent of the 90-day limitation is to prevent investors from recognizing a loss equivalent to the initial load charge, simply by moving within a family of funds.

Wash Sales

Mutual funds can distribute dividends and reinvest them as often as monthly. Because of automatic reinvestment, it is possible that a sale of fund shares at a loss can result in an unintended wash sale.

A wash sale is the sale (disposition) of a security at a loss and the acquisition of a substantially identical security within a period beginning 30 days before and ending 30 days after the date of sale. Losses resulting from wash sales are disallowed. Normally, investors are able to recognize the purchase of substantially identical stock within the 61-day period. However, with fund shares, taxpayers may not be aware that a purchase will occur within the 61-day period as a result of the automatic dividend reinvestment option.

Subsequent to a wash sale, the taxpayer must determine a new cost basis in the security purchased. For mutual fund shares the computation of the new cost basis can be complex, especially if the average cost method is used. Before selling any fund shares at a loss, investors who use automatic dividend reinvestment should check with the fund to determine whether a distribution has occurred or will occur within the 61-day period.

Many of the individuals now purchasing mutual fund shares are first-time equity investors, perhaps changing from certificates of deposit to mutual funds and unaware of the complex tax treatment they face. Tax advisors must be ready to help these new investors deal with the special tax problems associated with mutual fired investing.