Mutual Fund Owners Face Special Issues at Tax Time

Mutual fund investors also may be in for some surprises this tax season.

Even if your fund lost money last year, you may be shocked to learn that you still realized capital gains earnings, on which you’ll owe taxes to Uncle Sam and to the state.

How so? Many mutual funds are constantly recording gains and losses as they sell stocks during the year. Any net realized gains must be distributed to fund shareholders.

Even if a fund declined in value between Jan. 1 and Dec. 31, it may have racked up plenty of trading gains. Those gains would have been distributed to fund investors during the year.

Most fund investors reinvest their capital gains and dividend payments, automatically buying more shares of the fund when those payments are made (which, for capital gains, often is in the last two months of the year). But for tax purposes, you still owe Uncle Sam even if your gains were reinvested.

By now, you should have received statements from your fund companies detailing exactly what your capital gains distributions totaled, and separating the short-term gains distributed from the long-term gains.

As with other investment earnings, short-term gains are taxed as ordinary income, while long-term gains are taxed at the lower capital gains tax rate.

Your short-term gains and dividends must be listed individually on your tax return on federal Schedule B.

Your total long-term capital gains distributions should be reported on Schedule D, line 13.

Meanwhile, if you sold any fund shares during the year, you’ll have to report those transactions separately on Schedule D.

That could open a new can of worms: figuring your “tax basis” on the shares you sold, so that you can accurately report the size of any long-term or short-term gain or loss.

Your fund basis can be calculated using one of four methods the IRS allows, which can be found in IRS publications or in literature provided by many fund companies.