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Even With 1997 Loss, Tax Bill May Be Due

January 25, 1998|RUSS WILES | Russ Wiles is a mutual fund columnist for The Times and co-author of "How Mutual Funds Work," published by Simon & Schuster. He can be reached at

Now's the time when investors start to receive yearly tax statements from their mutual fund companies.

These forms, marked "1099-DIV," list ordinary dividends, capital gains distributions and non-taxed principal repayments that a fund made during the previous year.

Although most investors will not be surprised, some will see red because their statements show that they owe taxes on capital gains even though their mutual funds lost money in 1997.

This in itself is not a reason to dump a mutual fund. Nevertheless, the situation can be avoided.

To understand how it occurs, you need to realize that mutual funds are required to tally profits and losses from the stocks and bonds they sold during the year. When total gains exceed losses in these sales, funds wind up with a "net realized gain" that must be passed along to shareholders. When losses prevail, however, funds can use the "capital loss carry-forward" provision to shelter profits in future years.

Net realized gains don't always go hand in hand with recent fund performance, which is reflected in the daily calculations of the fund's net asset value. Funds with a net realized gain would distribute a taxable gain to shareholders even if they posted a loss for the year. The funds may have sold stocks that had increased in value in earlier years.

Dozens of stock funds that lost money in 1997 are in the process of distributing capital gains payments to shareholders. The situation is more prevalent among international portfolios, many of which were hit hard by the slump in Asian markets but had grown in value in previous years.

"I'd imagine that most of the Asian-oriented funds have actual or potential losses," said Sheldon Jacobs, editor of the No-Load Fund Investor newsletter in Irvington-on-Hudson, N.Y.

The Templeton Developing Markets I Fund, for example, one of the largest international portfolios, paid out 84 cents a share in capital gains last year despite posting a 9.4% negative return. A similar thing happened to various sector funds, such as Merrill Lynch Global Resources, a natural resources portfolio, and Fidelity Select Computer, a technology fund.

Funds make payments in one of two ways. If you instructed your fund company to shell out distributions in cash, you've probably already received a check reflecting 1997 payments, and there's nothing more to be done except report this as a taxable gain.

But if you asked that distributions be reinvested in new shares, there's a record-keeping task ahead.

You will want to keep track of distributions that were reinvested, to minimize your tax bite in future years. These will be combined with other additions to your original purchase to arrive at your adjusted "cost basis"--the amount of the investment on which you never owe taxes. If you don't keep a record, you might end up paying more taxes than you should when you sell the shares.

If you seek other ways to minimize taxes, you should consider "tax-efficient" funds, which pay out relatively little in terms of taxable dividends or capital gains.

Tax-efficient funds minimize their taxable distributions in several ways. In particular, they avoid bonds and dividend-paying stocks. Also, they minimize selling, period.

"When we do sell, we're selective about which lots we choose to sell," said Tom Faust, director of equity research at Boston-based Eaton Vance, which offers two tax-managed funds. "We'll sell our high-cost shares first."

Mutual funds typically buy a stock over several days or weeks, at different prices, rather than in a single transaction. This gives tax-conscious managers the opportunity to designate the highest-priced shares as the ones to sell when they unload lots, to show the widest loss or slimmest profit.

"We have cash flow all the time, so we're buying all the time," said Faust. "For a typical stock position, we might buy on 20 or 30 occasions."

Index funds often are highly tax-efficient. That's because they buy the same stocks that make up popular stock market averages such as the Standard & Poor's 500 and sell only when the stocks are taken off the index--a rare occurrence.

Of course, you can avoid such record-keeping altogether by buying funds in tax-deferred vehicles such as individual retirement accounts.

What about capital losses? The tax code prohibits fund companies from passing along losses as they do gains. Instead, they can carry forward these deficits to reduce taxable profits in future years. If you are focused on taxes, this might influence your decision to keep or buy a fund.

Recent losers that may carry forward losses (the fund will tell you) are funds that target gold, Asian shares or emerging markets. Assuming these funds have future gains, you will benefit because the gains will be lessened by the carry-forward losses.

Of course, a loss carry-forward doesn't necessarily make a fund a promising investment.

"Some funds that are in a loss carry-forward situation are there because they have crummy managers," said Tim Paulin, manager of advisory research for brokerage Dain Rauscher in Minneapolis.

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