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Mutual Funds

  • 7936. What are mutual funds?

    • A mutual fund is a company that offers investors an interest in a portfolio of professionally managed investment assets. Mutual funds are “open-ended” in the sense that they maintain a continuous market and a constantly changing number of outstanding shares. The term “mutual fund” is sometimes used (incorrectly) to refer to closed-end investment companies, which have a fixed number of outstanding shares and are actively traded on the secondary market (see Q 7954).

      Mutual funds are managed, in the sense that the underlying portfolio is changing as assets are bought and sold. Funds are generally designed to accomplish some primary investment objective, such as growth, income, capital appreciation, tax-exempt interest, international investing, etc., and therefore emphasize investments they consider appropriate to this purpose. Many funds (e.g., asset allocation funds, balanced funds, equity-income funds, hybrid funds) combine two or more investment objectives in an effort to maintain a more diversified portfolio. “Tax-managed” funds (i.e., tax-sensitive, tax-efficient funds) employ investment strategies designed to minimize current income taxes by keeping taxable gains and income as low as possible and emphasizing long-term growth. Although the specific methods vary from one fund to another, they generally include: (1) keeping turnover low; (2) offsetting capital gains with capital losses; and (3) keeping dividends and interest at a minimum. “Life cycle” funds (or “target date” funds) invest in stocks, bonds, and cash in a ratio considered appropriate for investors with a particular age and risk tolerance.1

      The Securities and Exchange Commission (SEC) requires mutual fund companies to disclose standardized after-tax returns for one-, five-, and ten-year periods to help investors understand the magnitude of tax costs and compare the impact of taxes on the performance of different funds. After-tax returns must accompany before-tax returns in a fund’s prospectus and must be presented in two ways: (1) returns after taxes on fund distributions only; and (2) returns after taxes on fund distributions and redemption of fund shares. The SEC also requires that funds include standardized after-tax returns in certain advertisements and other sales material.2


      1 .See United States Securities and Exchange Commission, Frequently Asked Questions about Rule 35d-1 (Investment Company Names), at www.sec.gov/divisions/investment/guidance/rule35d-1faq.htm.www.sec.gov/divisions/investment/guidance/rule35d-1faq.htm.(last accessed on May 12, 2020).

      2 .See 17 CFR Parts 230, 239, and 270.

  • 7937. What are portfolio investment programs?

    • Portfolio investment programs provide investors with the opportunity to use a sponsoring broker-dealer’s website to “create and manage portfolios of securities (‘baskets’) based on each investor’s individual needs and objectives.” (Portfolio investment programs are frequently referred to as “folios,” the name of the initial sponsor’s product.) However, unlike a mutual fund, “the investor does not hold an undivided interest in a pool of securities; rather the investor is the direct beneficial owner of each of the securities included in the portfolio. Each investor has all of the rights of ownership with respect to such securities.”1 The SEC denied a request from the Investment Company Institute (ICI) to adopt a rule that would deem portfolio investment programs to be regulated as mutual funds.2

      Because investors in investment portfolio programs own the stocks directly, they are taxed on distributions and the sale of their shares in the same manner as stockholders. For the treatment of cash dividends, see Q 7502. For the treatment of capital gain on the sale or exchange of stock, see Q 7517. For the treatment of capital gains and losses, see Q704.


      1 .U.S. Securities and Exchange Commission, Letter in Response to Petition for Rulemaking from Investment Company Institute, (August 23, 2001); Speech by Paul F. Roye (Director of Investment Management, U.S. Securities and Exchange Commission) to the American Law Institute – American Bar Association Conference on Investment Management Regulation, (October 11, 2001).

      2 .See Letter in Response to Petition for Rulemaking from Investment Company Institute, above.

  • 7938. What are ordinary income dividends from a mutual fund? How are ordinary income dividends received from a mutual fund taxed?

    • Mutual funds may pay three kinds of dividends to their shareholders; generally, taxable dividends will be reported to the shareholder on Form 1099-DIV.

      Ordinary income dividends. Ordinary income dividends are derived from the mutual fund’s net investment income (i.e., interest and dividends on its holdings) and short-term capital gains. A shareholder generally includes ordinary income dividends in income for the year in which they are received by reporting them as “dividend income” on his or her income tax return.1

      However, under JGTRRA 2003, qualified dividend income (see Q 700) is treated in some respects like net capital gain and is, therefore, eligible for what are now the 20/15/0 percent tax rates instead of the higher ordinary income tax rates. (ATRA 2012 made the special treatment of “qualified dividends” permanent—or as permanent as anything in the IRC.) As a result of JGTRRA 2003, mutual funds are required to report on Form 1099-DIV the nature of the ordinary dividend being distributed to shareholders—that is, whether the ordinary dividend is a “qualified dividend” subject to the 20/15/0 percent rates (Box 1b), or a nonqualifying dividend subject to ordinary income tax rates (Box 1a). Unless otherwise designated by the mutual fund, all distributions to shareholders are to be treated as ordinary income dividends.

      Ordinary income dividends paid by mutual funds are eligible for the 20/15/0 percent rate if the income being passed from the fund to shareholders is qualified dividend income in the hands of the fund and not short-term capital gains or interest from bonds (both of which continue to be taxed at ordinary income tax rates).2

      The Service has stated that mutual funds that pass through dividend income to their shareholders must meet the holding period test (see Q 700) for the dividend-paying stocks that they pay out to be reported as qualified dividends on Form 1099-DIV. Investors must also meet the holding period test relative to the shares they hold directly, from which they received the qualified dividends that were reported to them.3 In summary, the holding period test (see Q 700) must be satisfied by both the mutual fund and the shareholder in order for the dividend to be eligible for the 20/15/0 percent rate.4

      The Service has ruled that in making dividend designations (under IRC Sections 852(b)(3)(C), 852(b)(5)(A), 854(b)(1), 854(b)(2), 871(k)(1)(C), and 871(k)(2)(C)), a mutual fund may designate the maximum amount permitted under each provision even if the aggregate of all the amounts so designated exceeds the total amount of the mutual fund’s dividend distributions. (IRC Section 852(b)(3) provides rules for determining the amount distributed by a mutual fund to its shareholders that may be treated by the shareholders as a capital gain dividend (see Q 7940).) IRC Section 854 provides rules for determining the amount distributed that may be treated as qualified dividend income. IRC Section 871(k) provides rules for determining the amount distributed that may be treated as interest-related dividends or short-term capital gain dividends). The Service further ruled that individual U.S. shareholders may apply designations to the dividends they receive from the mutual fund that differ from designations applied by shareholders who are nonresident alien individuals.5

      Varying distributions paid by a mutual fund to shareholders in different “qualified groups” (shares in the same portfolio of securities that have different arrangements for shareholder services or the distribution of shares, or based on investment performance) constitute deductible dividends for the mutual fund.6

      An award of points to a shareholder under an airline awards program, in which one point is awarded for each new dollar invested in the mutual fund, will not result in the payment of a preferential dividend by the fund; instead, the investor will be informed of the fair market value of the points and informed that the basis in the shares giving rise to the award of points should be adjusted downward by the fair market value of the points as a purchase price adjustment.7

      Certain pass-through entities are required to report as part of a shareholder’s ordinary income dividends the shareholder’s allocated share of certain investment expenses (i.e., those which would be classified as miscellaneous itemized deductions if incurred by an individual), in addition to ordinary income dividends actually paid to a shareholder. The shareholder then must include such additional amount in income and treat the amount as a miscellaneous itemized deduction (subject to the 2 percent floor) in the same year. However, publicly offered regulated investment companies (generally mutual funds) are excluded from the application of this provision.8

      See Q 7944 regarding dividends declared for a year prior to the year of receipt. See Q 7977 for the treatment of certain stock distributions by mutual funds.


      1 .Treas. Reg. §1.852-4(a).

      2 .See IRC Secs. 854(b)(1), 854(b)(2), 854(b)(5).

      3 .IRS News Release IR-2004-22 (2-19-2004).

      4 .See also IRS Pub. 550 (2019) (formerly IRS Pub. 564, p. 3 (2008)).

      5 .Rev. Rul. 2005-31, 2005-1 CB 1084.

      6 .Rev. Proc. 99-40, 1999-2 CB 565.

      7 .Let. Rul. 199920031.

      8 .IRC Sec. 67(c).

  • 7939. What are exempt interest dividends? How are exempt interest dividends received from a mutual fund taxed?

    • Mutual funds may pay three kinds of dividends to their shareholders; generally, taxable dividends will be reported to the shareholder on Form 1099-DIV.

      Exempt interest dividends. Some mutual funds invest in securities that pay interest exempt from federal income tax. This interest may be passed through to the fund’s shareholders, retaining its tax-exempt status, provided at least 50 percent of the fund’s assets consist of such tax-exempt securities. Thus, a shareholder does not include exempt-interest dividends in income. The mutual fund will send written notice to its shareholders advising them of the amount of any exempt-interest dividends.1 Any person required to file a tax return must report the amount of tax-exempt interest received or accrued during the taxable year on that return.2 Under JGTRRA 2003, exempt-interest dividends do not count as qualified dividend income (see Q 700) for purposes of the 20/15/0 percent tax rates.3


      1 .IRC Sec. 852(b)(5).

      2 .IRC Sec. 6012(d).

      3 .See IRC Sec. 1(h)(11)(B).

  • 7940. What are capital gain dividends? How are capital gain dividends received from a mutual fund taxed?

    • Mutual funds may pay three kinds of dividends to their shareholders; generally, taxable dividends will be reported to the shareholder on Form 1099-DIV.

      Capital gain dividends. Capital gain dividends result from sales by the mutual fund of stocks and securities that result in long-term capital gains. The mutual fund will notify shareholders in writing of the amount of any capital gain dividend. The shareholder reports a capital gain dividend on the federal income tax return for the year in which it is received as a long-term capital gain regardless of how long the shareholder has owned shares in the mutual fund.1 As such, a capital gain dividend may be partially or totally offset by the shareholder’s capital losses (if any); if not totally offset by capital losses, the excess (i.e., net capital gain) will be taxed at the applicable capital gains rate.2 For additional guidance on designations of capital gain dividends, see Revenue Ruling 2005-31, Q 7938.

      The Service issued guidance clarifying that capital gain dividends received from a mutual fund in 2004 would be taxed at the lower capital gain rates enacted under JGTRRA 2003. Concern had been expressed that the prior rules for dividend designation and the transition to the new, lower capital gain rates might cause some 2004 capital gain dividends to be taxed to mutual fund shareholders at the old, higher rates. However, the guidance clarified that this would not occur.3

      See Q 700 for the treatment of capital gains and losses, including the lower rates (20/15/0 percent) for long-term capital gain. (These rates were made as permanent as anything in the IRC for tax years beginning after 2012.) See Q 7943 for the taxation of undistributed capital gains.

      Generally, a shareholder may elect to treat all or a portion of net capital gain (i.e., the excess of long-term capital gain over short-term capital loss) as investment income.4 If the election is made, the amount of any gain so included is taxed as investment income. This election may be advantageous if the shareholder’s investment interest expense would otherwise exceed his investment income for the year. If the shareholder makes the election, the shareholder must also reduce net capital gain by the amount treated as investment income (see Q 700).

      Detailed instructions for reporting mutual fund distributions on Form 1040 or Form 1040A are set forth in IRS Publication 550, Investment Income and Expenses formerly Publication 564, Mutual Fund Distributions (2011)).


      1 .IRC Sec. 852(b)(3)(B); Treas. Reg. §1.852-4(b)(1).

      2 .IRC Sec. 1(h).

      3 .See Notice 2004-39, 2004-1 CB 982.

      4 .IRC Sec. 163(d)(4); Treas. Reg. §1.163(d)-1.

  • 7941. How is the shareholder taxed if the mutual fund pays a dividend in its portfolio stock or securities rather than in cash?

    • The taxability of a dividend distribution is the same whether the distribution is in cash or portfolio stock or securities; thus, the distribution will be treated as an ordinary income dividend, exempt-interest dividend, or capital gains dividend, as the case may be (see Q 7928 to Q 7940). The amount (if any) that the shareholder reports on the income tax return is the fair market value of the stocks or securities received as of the date of distribution.1

      For temporary guidance regarding certain distributions declared on or after January 1, 2008, and on or before December 31, 2012, by publicly traded mutual funds when shareholders have the ability to elect to receive stock instead of cash, see the discussion of Revenue Procedure 2010-12 in Q 7977.


      1 .IRC Sec. 301(b); see Rev. Rul. 57-421, 1957-2 CB 367.

  • 7942. How are dividends that are automatically reinvested taxed?

    • Some mutual funds automatically reinvest shareholder dividends under a plan that credits the shareholder with additional shares, but gives the shareholder the right to withdraw the dividends at any time. Even though the dividend is not distributed directly to the shareholder, it is credited to his or her account. Such dividends are considered “constructively” received by the shareholder and are included in the shareholder’s income for the year in which they are credited to the shareholder’s account.1 The basis of the new shares is the net asset value used to determine the dividend (i.e., the amount of the dividend used to purchase the new shares).2


      1 .Rev. Rul. 72-410, 1972-2 CB 412.

      2 .See IRS Pub. 550; Treas. Reg. §1.305-2.

  • 7943. How is a mutual fund shareholder taxed on undistributed capital gains?

    • A mutual fund may declare but retain a capital gain dividend. If it does so, the mutual fund will notify its shareholders of the amount of the undistributed dividend and will pay federal income tax on the undistributed amount at the corporate alternative capital gain rate, which is currently 35 percent.1

      A shareholder who is notified of an undistributed capital gain dividend includes the amount of the dividend in income in the same manner as a normal capital gain dividend (see Q 7938). However, the shareholder is also credited with having paid his or her share of the tax paid by the mutual fund on the undistributed amount; thus, on the shareholder’s income tax return, the shareholder is treated as though he or she has made an advance payment of tax equal to 35 percent of the amount of the undistributed dividend reported. The shareholder reports the undistributed dividend and is credited with the payment of tax for the calendar year that includes the last day of the mutual fund’s taxable year during which the dividend was declared.2

      Generally, a shareholder who reports an undistributed capital gain dividend increases the tax basis in his or her shares of the mutual fund by the difference between the amount of the undistributed capital gain dividend and the tax deemed paid by the shareholder in respect of such shares.3

      See Q 700 for the treatment of capital gains and losses.


      1 .See IRC Sec. 1201(a); IRC Sec. 852(b)(3)(A).

      2 .IRC Sec. 852(b)(3)(D).

      3 .IRC Sec. 852(b)(3)(D)(iii); Treas. Reg. §1.852-4(b)(2).

  • 7944. How is a mutual fund dividend taxed if it is declared for a prior year?

    • In some cases, a mutual fund may declare a dividend after the close of its taxable year and treat the dividend as having been paid in the prior year. This is often done in order for the fund to retain its status as a regulated investment company (because it must distribute a certain percentage of its income).

      As a general rule, ordinary income dividends and capital gain dividends declared for a prior mutual fund tax year are treated as received and included in income (as discussed in Q 7938) by the shareholder in the year in which the distribution is made. Similarly, exempt-interest dividends for a prior mutual fund tax year are treated as received in the year when the distribution is made, but are not included in the shareholder’s income (see Q 7938).1

      However, if a mutual fund declares a dividend in October, November, or December of a calendar year, which is payable to the shareholders on a specified date in such a month, the dividend is treated as having been received by the shareholders on December 31 of that year (so long as the dividend is actually paid during January of the subsequent calendar year).2 This rule applies to ordinary income dividends, capital gain dividends, and exempt-interest dividends.


      1 .IRC Sec. 855; Treas. Reg. §1.855-1.

      2 .IRC Sec. 852(b)(7).

  • 7945. How is a return of capital taxed?

    • A distribution from a mutual fund that does not come from its earnings is a return of capital distribution (sometimes incorrectly referred to as a “nontaxable dividend” or “tax-free dividend”). These often occur when the fund is liquidating. The shareholder treats the return of capital as nontaxable to the extent of tax basis in the shares. Any excess over the shareholder’s basis is treated as a capital gain, which will be long-term or short-term depending on how long the shareholder held the mutual fund shares with respect to which the distribution was made. The shareholder must also reduce tax basis (but not below zero) in those shares by the amount of the return of capital distribution.1 See Q 700 for the treatment of capital gain.


      1 .IRC Sec. 301(c); See Rev. Rul. 57-421, 1957-2 CB 367; IRS Pub. 550.

  • 7946. How is a shareholder taxed when a mutual fund passes through a foreign tax credit?

    • Mutual funds with more than 50 percent of the value of their total assets invested in stock or securities of foreign corporations may elect to give the benefit of the foreign tax credit to their shareholders.1

      When a mutual fund makes this election, each shareholder, in addition to reporting any ordinary income and capital gains dividends, includes in income his or her proportionate share of foreign taxes paid by the fund. Each shareholder then treats the proportionate share of foreign taxes paid by the mutual fund as if paid by the shareholder for which he or she may take a tax credit or an itemized deduction. (In calculating the credit or deduction, each shareholder treats his or her share of the foreign taxes and the amount of any dividends paid with respect to the foreign income of the fund as foreign income.)2 The shareholder may take the deduction or the credit, but not both.3

      A mutual fund that makes this election must notify each shareholder of his or her share of the foreign taxes paid by the fund and the portion of the dividend that represents foreign income.4 The Service released regulations in 2007 that generally eliminate country-by-country reporting by a mutual fund to its shareholders of foreign source income that the mutual fund takes into account and foreign taxes that it pays. Accordingly, the regulations require that a mutual fund provide aggregate per-country information on a statement filed with its tax return, and require that only summary foreign income and foreign tax amounts be reported to the fund’s shareholders.5


      1 .IRC Sec. 853.

      2 .IRC Sec. 853(b); Treas. Reg. §1.853-2(b).

      3 .IRC Sec. 275.

      4 .IRC Sec. 853(c); Treas. Reg. §1.853-3(a).

      5 .Treas. Reg. §§1.853-3, 1.853-4; TD 9357, 72 Fed. Reg. 48551 (8-24-2007).

  • 7947. Do mutual fund dividends give rise to tax preference items for purposes of the alternative minimum tax?

    • Editor’s Note: The 2017 Tax Act eliminated the corporate AMT for tax years beginning after 2017.

      The receipt of an exempt-interest dividend creates a tax preference to the extent that the dividend is derived from interest paid on certain private activity bonds issued after August 7, 1986 (see Q 775).1 (The receipt of capital gain and ordinary income mutual fund dividends generally does not create tax preferences.) Also, mutual funds do pass through, and each shareholder must report a proportionate share of, the fund’s own tax preference items.2

      For an explanation of the alternative minimum tax, see Q 775.


      1. IRC Sec. 57(a)(5)(B).

      2. IRC Sec. 59(d).

  • 7948. Can a shareholder deduct the interest paid on a loan used to purchase mutual fund shares?

    • Yes, subject to the general limitation applicable to the deduction for investment interest (see Q 8037) and subject to total or partial disallowance if the company pays an exempt-interest dividend.

      A shareholder may not deduct interest on indebtedness incurred or continued to purchase or carry shares of a mutual fund to the extent that the company distributed exempt-interest dividends to the shareholder during the year.[2] The amount of interest disallowed is the amount that bears the same ratio to total interest paid on the indebtedness for the year as the exempt-interest dividends bear to exempt interest and taxable dividends received by the shareholder (excluding capital gains dividends).[3]

      In determining whether the indebtedness was “incurred or continued to purchase or carry” shares, one should be able to look to interpretations of comparable language with respect to deductions for interest on “indebtedness incurred or continued to purchase or carry” certain other property (see, for example, Q 8041).[4] For purposes of determining whether interest is investment interest, temporary regulations provide complex rules under which interest expense is allocated on the basis of the use of the proceeds of the underlying debt (see Q 8040).

      [1].     IRC Secs. 163(d), 265(a)(4).

      [2].     IRC Sec. 265(a)(4); Treas. Reg. §1.265-3.

      [3].     Treas. Reg. §1.265-3(b)(2).

      [4].     Rev. Rul. 95-53, 1995-2 CB 30; Rev. Rul. 82-163, 1982-2 CB 57.

  • 7949. How is a shareholder taxed when selling, exchanging, or redeeming mutual fund shares?

    • When a shareholder sells, exchanges, or redeems mutual fund shares, the shareholder will generally have a capital gain or loss. Whether such gain or loss is short-term or long-term usually depends on how long the shareholder held the shares before selling (or exchanging) them.1 If the shares were held for one year or less, the capital gain or loss will generally be short-term; the capital gain will generally be long-term if the shares were held for more than one year. See Q 700 for an explanation of the holding period calculation, and Q 700 for the treatment of capital gains and losses.

      The gain or loss is the difference between the shareholder’s adjusted tax basis in the shares (see below) and the amount realized from the sale, exchange, or redemption (which includes money plus the fair market value of any property received).2 For the taxation of a wash sale of mutual fund shares, see Q 7951. For the treatment of mutual fund shares that were held as part of a conversion transaction, see Q 7615 and Q 7616.

      In some cases, a company that manages mutual funds will allow shareholders in one mutual fund to exchange their shares for shares in another mutual fund managed by the same company without payment of an additional sales charge. Nevertheless, the exchange is treated as a taxable transaction; any gain or loss on the original shares must be reported as a capital gain or loss in the year the exchange occurs. The exchange does not qualify as a “like-kind” exchange, nor as a tax-free exchange of common stock for common stock, or preferred for preferred, in the same corporation. Because stock in each fund is “backed” by a different set of assets (i.e., the portfolio securities held by each fund), shares in the funds are neither common nor preferred stock in the managing company.3 Furthermore, such an exchange may be subject to special rules delaying an adjustment to basis for load charges if the exchanged shares were held for less than ninety days (see below).

      In Paradiso v. Commissioner,4 the Tax Court stated that IRC Section 1031(a)(1), which provides for nonrecognition of gain or loss from like-kind exchanges, expressly does not apply to the sale of stock or other securities (citing IRC Sections 1031(a)(2)(B) and 1031(a)(2)(C)). Accordingly, the court held that the taxpayer realized taxable income from sales of mutual fund shares at a gain.

      The Service has privately ruled that a mutual fund’s redemption of stock pursuant to a tender offer would constitute a single and isolated transaction that was not part of a periodic redemption plan; thus, the transaction would not result in an IRC Section 305 deemed distribution to any of the fund’s shareholders.5 The Service has also stated that no gain or loss was required to be recognized by shareholders on the conversion of institutional class shares to Class A shares of the same mutual fund. Each shareholder’s basis in the Class A shares would equal the shareholder’s basis in the converted institutional class shares immediately before the conversion, and each shareholder’s holding period for the Class A shares would include the shareholder’s holding period for the converted institutional class shares, provided that the shareholder held those converted shares as capital assets immediately before the conversion.6 In addition, the Service privately ruled that the conversion of two classes of mutual fund shares into a single class of shares, based on the relative net asset value of the respective shares, did not result in gain or loss to the shareholders.7

      If a shareholder purchases mutual fund shares, receives a capital gain dividend (or is credited with an undistributed capital gain), and then sells the shares at a loss within six months after purchasing the shares, the loss is treated as a long-term capital loss to the extent of the capital gain dividend (or undistributed capital gain).8 Similarly, if a shareholder purchases mutual fund shares, receives an exempt-interest dividend, and then sells the shares at a loss within six months after purchasing the shares, the loss (to the extent of the amount of the dividend) will be disallowed.9 In the case of a fund that regularly distributes at least 90 percent of its net tax-exempt interest, the regulations may prescribe that the holding period for application of the loss disallowance rule is less than six months (but not less than the longer of thirty-one days or the period between the regular distributions of exempt-interest dividends).10 For purposes of calculating the six-month period, periods during which the shareholder’s risk of loss is diminished as a result of holding other positions in substantially similar or related property, or through certain options or short sales, are not counted.11 Regulations will provide a limited exception to these rules for shares sold pursuant to a periodic redemption plan.12


      1 .See IRC Secs. 1222, 1223.

      2 .IRC Sec. 1001.

      3 .Rev. Rul. 54-65, 1954-1 CB 101. See IRS Pub. 550 (formerly IRS Pub. 564).

      4 .TC Memo 2005-187.

      5 .Let. Rul. 200025046.

      6 .Let. Rul. 199941016.

      7 .Let. Rul. 9807026.

      8 .IRC Sec. 852(b)(4).

      9 .IRC Sec. 852(b)(4)(B).

      10 .IRC Sec. 852(b)(4)(E).

      11 .IRC Secs. 852(b)(4)(C), 246(c).

      12 .IRC Sec. 852(b)(4)(D).

  • 7950. How does a shareholder determine the basis of mutual fund shares?

    • Generally a shareholder’s tax basis in mutual fund shares is the cost of acquiring them, including any load charges (i.e., sales or similar charges incurred to acquire mutual fund shares). (See Q 690 regarding the determination of basis.) However, a shareholder who exercises a reinvestment right, which was acquired as a result of the load charge, is subject to a ninety-day holding period during which the load charge will not be fully included in basis. (“Reinvestment right” is defined to mean the right to acquire stock of one or more regulated investment companies without a load charge or at a reduced load charge.) If such a shareholder (1) disposes of the shares before the ninety-first day after the date of acquisition, and (2) subsequently acquires other shares (in the same or another mutual fund) and the otherwise applicable load charge is reduced as a result of the reinvestment right, then the initial load charge will not be included in basis for purposes of determining the gain or loss on the disposition (except to the extent that the initial load charge exceeds the reduction applicable to the second load charge). Instead, it will be includable in the basis in the newly acquired shares. If the original shares are transferred by gift, the donee succeeds to the treatment of the donor.1

      If all of a shareholder’s shares in a mutual fund were acquired on the same day and for the same price (or, if by gift or inheritance, at the same tax basis), the shareholder will have little difficulty in establishing tax basis and holding period of the shares sold or redeemed. However, if the shares were acquired at different times or prices (or bases), the process is more difficult. Unless the shareholder can “adequately identify” (see Q 698) the lot from which the shares being sold or redeemed originated, the shareholder must either treat the sale or redemption as disposing of shares from the earliest acquired lots (i.e., by a first-in, first-out (FIFO) method) or, if he or she qualifies, elect to use one of two average basis methods for determining adjusted basis and holding period of shares sold or redeemed.2

      Effective January 1, 2012, in connection with their obligation to report sales of securities to the IRS, brokers are generally required to provide each customer’s bases in, and holding periods for, stock for which the average basis method is available. A broker’s obligations generally track the description above—i.e., to use the FIFO method unless adequate identification of the shares disposed of is possible.3

      A shareholder may elect to use an “average basis” for the shares if (1) the shares are held in a custodial account maintained for the acquisition or redemption of shares in the fund, and (2) the shareholder purchased or acquired the shares at different prices or bases.4

      Under the double-category method of determining average basis, all shares in the mutual fund account are divided into two categories: (1) those with a holding period of more than one year; and (2) those with a holding period of one year or less. The basis for each share in either category is the total cost (or other basis) of all the shares in that category, divided by the number of shares in that category. The shareholder can then elect to have the shares being sold come from either the “more than one year” category (thus recognizing long-term gain or loss), or the “one year or less” category (thus recognizing short-term gain or loss). If the shareholder does not designate the category from which the shares are to be sold, the shares are deemed to come from the “more than one year” category first.5

      When shares in the “one year or less” category have been held for more than one year, they are transferred to the “more than one year” category. If some of the shares in the “one year or less” category have been sold or transferred, they are deemed to have been the earliest acquired shares (i.e., by a FIFO method). The basis of unsold shares transferred to the “more than one year” category is the average basis of the shares in the “one year or less” category at the time of the most recent sale, determined as discussed above. If no shares have been sold from the “one year or less” category, the basis of the shares transferred to the “more than one year” category is their cost or other basis (not the average basis).6

      Under the single category method of determining average basis, all shares in the mutual fund account are added together. The basis of each share in the account is the total cost or other basis of all the shares in the account, divided by the total number of shares. Any shares sold or redeemed are deemed to be those acquired first. The single category method may not be used for the purpose of converting short-term gain or loss to long-term gain or loss, or vice versa.7

      The election to use either of the “average basis” methods is made on the shareholder’s tax return for the first year for which he or she wishes the election to apply and will apply to all shares in the same mutual fund held by the shareholder, even if in different accounts. In reporting gain or loss, the taxpayer reports on the return for each year to which the election applies that an average basis is being used, and which method has been selected. An election may not be revoked without the consent of the IRS.8

      In the case of shares acquired by gift, the basis in the hands of a donee is generally the same as it was in the hands of the donor; however, this rule applies only for purposes of determining gain. In the event that the shares’ adjusted basis exceeds their fair market value at the time of the gift, the basis in the hands of the donee for purposes of determining loss is their fair market value at the time the gift was made. Ordinarily, an average basis method may not be used on such shares; however, a donee shareholder can elect to apply an average basis method to accounts containing shares acquired by gift if the donee includes a statement with the tax return indicating that the donee will use the fair market value of the shares at the time of the gift in computing the average bases. The statement applies to all shares acquired either before or after the statement is filed, for as long as the election to use average basis remains in effect.9

      A unit trust unit holder (see Q 7973) may not use either of the average basis methods discussed above unless the unit trust invests primarily in the securities of one management company, or one other corporation, and unless the trust has no power to invest in any other securities except those issued by a single other management company.10


      1 .IRC Sec. 852(f).

      2 .Treas. Reg. §§1.1012-1(c), 1.1012-1(e). See IRS Pub. 550 (formerly IRS Pub. 564).

      3 .See IRC Sec. 6045(g).

      4 .Treas. Reg. §1.1012-1(e).

      5 .Treas. Reg. §1.1012-1(e)(3).

      6 .Treas. Reg. §1.1012-1(e)(3)(iii).

      7 .Treas. Reg. §1.1012-1(e)(4).

      8 .Treas. Reg. §1.1012-1(e)(6).

      9 .Treas. Reg. §1.1012-1(e)(1)(ii).

      10 .Treas. Reg. §1.1012-1(e)(5)(ii).

  • 7951. How is a wash sale of mutual fund shares taxed?

    • A wash sale of mutual fund shares is taxed in the same manner as a wash sale of regular corporation stock or other securities (see Q 7536 to Q 7539).

      However, when the double category method is used for determining basis and holding period, a wash sale of mutual fund shares from the “one year or less” category after acquisition of the replacement shares will result in the aggregate basis of the shares remaining in the “one year or less” category being increased by the amount of the loss that is disallowed.1 When the single category method is used for determining basis, or when an average basis method is not used, the general wash sale tax basis rules apply.2


      1 .Treas. Reg. §1.1012-1(e)(3)(iii)(d); IRC Sec. 1091(d).

      2 .See Treas. Reg. §1.1012-1(e)(4)(iv).

  • 7952. What is a “money market fund”?

    • A money market fund is a mutual fund generally seeking maximum current income and liquidity through investment in short-term money market instruments, such as Treasury bills, certificates of deposit, or commercial paper. Dividends are customarily declared daily, and automatically reinvested in additional shares, unless a distribution option is elected. Shares may be redeemed at any time.

  • 7953. How is a money market fund shareholder taxed?

    • Because a money market fund is a mutual fund, its shareholders are taxed in the manner discussed in Q 7938 through Q 7951. Money market funds ordinarily do not have capital gain dividends because of their general policy of investing in short-term securities. Note that money market fund dividends are not qualified dividends and, thus, do not qualify for the lower tax rates (20%/15%/0%) (see Q 700).

  • 7954. What is a closed-end fund? How are shareholders in a closed-end fund taxed?

    • A closed-end fund holds a portfolio of investment assets, but does not ordinarily redeem shares at net asset value or sell new shares. Shares of the fund itself are actively traded on the secondary market.

      Although a closed-end fund is not actually a mutual fund, if the fund qualifies and makes the necessary election to be taxed as a regulated investment company (RIC), its shareholders will be taxed like shareholders of a mutual fund. See Q 7938 through Q 7951 for details. If, on the other hand, the closed-end fund is established as a regular corporation, its shareholders will be taxed accordingly (see Q 7501 to Q 7540).

      Because closed-end fund shares are traded in the open market or on an exchange and are not redeemed by the company, capital gain or loss on sale is based on the sale price and not on redemption price.

      See Q 7922 to Q 7935 for a discussion of RICs and their tax treatment.