Know Your Options in Figuring Mutual Fund Gains and Losses

The markets have not been kind to mutual fund investors this year. Bond prices were devastated by rising interest rates, and stock prices didn’t do a whole lot better.

While there has been no panic, numerous investors have been selling shares. In some cases, these sales locked in profits from earlier years, while others allowed investors to shift into bonds, Treasury securities and certificates of deposit, which have been paying rates well above inflation.

But whatever their reasons, mutual fund investors who sold shares this year face a chronic problem: figuring out their taxable gains or losses.

Broadly speaking, mutual fund shares are like stocks: Your gain or loss is what you sell it for minus what you paid for it. So in concept, determining gain or loss is simple.

But because investors tend to make repeated purchases of the same fund or have their dividends and capital gains reinvested in more shares, they typically end up with a mishmash of shares bought at different times and for different prices. That can turn figuring the gain or loss into a complicated computation.

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Adding to the difficulty, the Internal Revenue Service allows taxpayers to choose from four different methods of computing their gains. The agency, it should be noted, isn’t trying to torture taxpayers; the different methods have different advantages and disadvantages, and the choice gives taxpayers flexibility.

The good news, though, is that more and more mutual fund operators are providing investors with helpful information. With their increasingly computerized back offices, the big fund operators can keep track of investors’ transactions and provide them with data to compute their gains and losses.

For example, T. Rowe Price automatically sends any shareholder who has sold or exchanged shares during the year a statement that shows the investor’s average share cost and the gain or loss based on that cost.

However, before using the data the mutual fund sends out, investors should understand their options, because they may want to compute their gains or losses differently.

While you can’t change the price you got for selling, you can use different methods to figure out what you paid for the shares, a figure sometimes referred to as the “basis.”

The IRS allows four methods for calculating the basis:

* First in, first out. Known as FIFO, this method assumes you sell shares in the order in which you purchased them. In other words, the ones you sell first are the oldest ones you own. This method is relatively easy to use, and in fact, if you do not specify otherwise, the IRS will assume you are using it.

However, if the market has been rising, the oldest shares will show the biggest gain and thus incur the most tax. Especially considering that capital gains taxes may be reduced next year, you may want to use a different method that produces less immediate gain.

On the other hand, there can be reasons to use it. For example, if you had a big loss on some other asset you sold this year, you can use that loss to offset the gain on your older fund shares and save the newer, higher-cost ones--which will show less gain--to sell later.

* Specific identification. With this method, you specify the shares you are selling and use their basis in calculating gain or loss.

This is useful because by choosing certain shares, you can decide how much gain or loss to recognize. But there’s a hitch: You have to make the identification at the time you sell. You have to give specific instructions to the fund operator or broker as to which shares to sell, and you have to get back written confirmation after the sale.

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So if you sold shares earlier this year and didn’t identify them at the time, you can’t use this method. And if you are expecting to sell next week or next year and thus could still meet the requirements, check with your mutual fund. Not all of them are able to generate the kind of confirmation you need.

* Average basis, single category. With this method, which is probably the easiest, you simply add up the total cost of all your shares and divide by the number of shares. The result is your average basis. When you sell, it is assumed that the oldest shares are sold first.

This method offers less flexibility in managing gains and losses, but its simplicity--and the fact that the data is supplied by many fund operators--make it the method of choice for most taxpayers.

Remember, though: You must tell the IRS you are using the average basis method, or it will assume you are using FIFO. Also, once you start with this method--or the double-category method described below--you have to stay with it for all shares you sell from this same fund.

* Average basis, double category. In this method, you divide your shares into those you have held for a year or more and those you have bought more recently. The shareholder must specify which category shares are being sold from, and the fund must confirm this in writing. Otherwise the IRS will assume they are from the long-term category.

This is complicated, but it can be helpful for high-income investors trying to make maximum use of the tax break given for long-term gains.

Fund experts also caution investors to make sure they include all allowable costs in the basis. This means making sure you include the load, or sales charge, if you paid one and any reinvested dividends or capital gains you have received along the way.

Sometimes investors simply treat their original investment as the basis, forgetting those reinvested distributions. Since those were taxable when received, failure to include them results in paying taxes on them a second time.

On the other hand, some investors who exchange shares in one fund for shares in another run by the same company don’t realize that can be a taxable transaction, said Steven E. Norwitz of T. Rowe Price.

“Sometimes people have an exchange from one fund to another and don’t even think of it as a sale, (because) they didn’t get any cash. But for tax purposes it’s no different than a redemption,” he said.