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SPECIAL REPORT: YOUR TAXES | Funds and 401(k)s

4 Methods to Madness of Figuring Gains, Losses

Partial sales of fund shares can present a daunting challenge for investors trying to do tax math. Here's help in sorting it all out.

March 05, 2000|PAUL J. LIM

Maybe you were invested in a red-hot tech fund last year. You know, one of those funds that returned more than 100%. And maybe you decided to sell a few shares at the end of the year to lock in some profit.

Or perhaps you owned a value-oriented fund, and watched in frustration as it slumped for the year. Finally, you sold some shares to put that money elsewhere.

If you sold fund shares last year in an account that isn't tax-deferred--that is, not within an IRA or 401(k)--you triggered either a taxable capital gain or a deductible loss. Which means you have to deal with the Internal Revenue Service. Ugh.

First, some good news: Even if you have a capital gain on a fund sale, your tax bill might not be as big as you think. Why? If you've owned the fund for several years, you've probably been paying taxes all along. A fund is required to distribute to shareholders each year all net realized capital gains. You've been recording those distributions on your tax return each year, and paying taxes accordingly.

Let's say you invested $10,000 in XYZ Fund at $10 a share in 1997. That means you held 1,000 shares of the fund. Now, let's say that in 1998, XYZ made a capital gains distribution of $2 a share. You received a payment of $2,000 ($2 x 1,000 shares), either in cash or, more likely, in new shares of the fund (since most fund owners reinvest their gains).

That distribution was reported as part of your investment income for 1998, and taxed as such. In addition, when the distribution was paid, your fund company reduced the market price of the fund's shares to reflect it. To simplify the example, assume the market price of the fund--the net asset value, or NAV, was $12.50 a share when the distribution was paid. A distribution of $2 a share would have reduced the fund price to $10.50 a share.

The upshot is that when you finally sell a fund, the difference between your original per-share purchase price and the current market price per share may be surprisingly narrow, thanks to those distributions. And any long-term capital gain--a gain on a security held more than one year--is taxed at a maximum of 20%, well below regular income tax rates.

Now comes the bad news: Even though any capital gains tax bill from a fund sale may be smaller than you fear, calculating your net gain or loss can be a nightmare, especially if you want to minimize your tax bite.

The biggest challenge faces investors who sell a portion of their shares in a particular fund, rather than the entire position.

For starters, you have the issue of those reinvested capital gains.

Let's say you bought 1,000 shares of ABC Fund in 1996 at a price of $10 a share. In 1997, the fund distributed gains of $1 a share, giving you $1,000 ($1 x 1,000 shares). Because you arranged with your fund company to automatically reinvest distributions, you received additional shares of ABC.

Shares received through distributions are priced at the new NAV on the day the money is reinvested. Let's say in this case that the new NAV on that day was $12. Let's further assume that in 1998, you plowed an additional $25,000 into ABC at $13 a share.

It's 1999. Assume you sell 1,000 shares at $14 a share. How much did you make on the sale? Was it a profit of $4 a share, based on the original $10 price paid in 1996? Was it a profit of $2 a share, based on the shares received via reinvestment at $12 in 1997? Or was it a profit of just $1 a share, based on the new shares you bought at $13 in 1998?

You can see the potential for a huge math headache. And just imagine if you've owned the fund for decades, constantly investing and reinvesting.

But you do have choices when it comes to fund accounting. Boni Callaway, education coordinator for Invesco Funds, notes that the IRS allows four ways to calculate gains or losses on sales of fund shares. Which method you choose can make a big difference in how much you'll owe.

Even before explaining the methods, a very important note: Once you choose one of these methods for a particular fund, you're stuck with that method until you completely sell out of that investment. So, if you selected a method for your fund a couple of years ago, and sold additional shares in 1999, you'll have to use whichever method you used in the past.

You must save past tax returns and fund statements, because neither the IRS nor the fund company will remind you which method you used in the past.

However, you can use different methods for different funds.

Here's a look at each accounting method:

* First in, first out. The name speaks for itself. Under FIFO, if you're making a partial sale of your fund shares, the first shares you purchased are the first shares you sell.

Chances are, if you're a long-term investor, you saw your stock funds rise in value significantly throughout the '90s bull market. By using this method, you'd be selling the oldest--and presumably, lowest-cost--shares first, thereby recording the biggest capital gains. And paying the most taxes.

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