Short-Term Capital Losses

For shares held six months or less.

This page explains the special rules that apply to certain short-term losses from sales of mutual fund shares. These rules may convert some or all of your short-term loss into long-term loss — or into a nondeductible loss.

Overview

When a mutual fund pays a dividend, the value of the fund goes down by the amount of the dividend. For example, if your mutual fund shares are valued at $29.75 immediately before a dividend of $1.50 per share, the value will be $28.25 immediately after the dividend. No problem there — that's just the way stocks work in general. But it means a special rule is needed for certain capital losses on mutual fund shares.
    Suppose you bought the mutual fund shares just before the dividend and sold them shortly afterward. In that situation you might be able to claim a short-term capital loss that was really just a reflection of the dividend you received. If the dividend was an exempt interest dividend or a capital gain dividend, the combination of the dividend and the short-term loss would give you an unfair tax advantage. The special tax rules for short-term losses in mutual funds are designed to eliminate that advantage.

Capital Gain Dividends

Consider what would happen if you bought shares in a mutual fund at $29.75 just before the fund paid a capital gain dividend of $1.50. You'll treat that dividend as long-term capital gain even if you held the mutual fund shares only a day before the dividend. Then you sell the mutual fund at $28.25 — the value right after the dividend. Under the normal rules, you would get a short-term capital loss. And that could provide you with a significant tax advantage if you also have short-term capital gains.

Example: Throughout the year you had $15,000 of long-term capital gain and $5,000 of short-term capital gain. Your short-term gain will be taxed at your regular marginal rate of 31%.
    Being a crafty investor, but unaware of the special rule we are discussing, you find a mutual fund that's about to pay a capital gain dividend. You buy enough shares so you'll receive a $5,000 capital gain dividend. Then you sell the shares for a $5,000 short-term capital loss.
    Now your totals for the year are $20,000 of long-term capital gain and $0 of short-term capital gain. The $15,000 long-term gain you had before is increased by the $5,000 capital gain dividend from the mutual fund, and the $5,000 short-term gain you had before is eliminated by the $5,000 loss on sale of the mutual fund shares. Your total amount of gain is still $20,000, but now it's all long-term, meaning a lower rate of tax — if this special rule didn't apply!

The rule applies only if you sell your mutual fund shares at a loss six months or less after you bought them. (It's OK to sell less than six months after the dividend, as long as you held the shares more than six months.) Note that this doesn't match up with the amount of time you need to hold the shares to have a long-term capital gain or loss. The idea is that if you've held the shares six months, that's long enough so that your loss (if you have one) probably relates to genuine changes in the value of the mutual fund rather than the effect of a single dividend.
    When the rule applies, you have to treat some or all of your short-term loss as a long-term loss. The amount that's treated as a long-term loss is limited to the amount of the capital gain distribution or allocation you received. So if your loss is greater than the amount of that distribution or allocation, the remaining portion of the loss is treated as a short-term capital loss.

Exempt Interest Dividends

The same principle applies if you receive an exempt interest dividend and then sell shares at a loss. But in this case, your short-term loss becomes nondeductible.

Example: You buy shares in a municipal bond fund just before it pays an exempt interest dividend of $1,200. Then you sell the shares at a loss of $1,300. If you held the shares six months or less, you're permitted to deduct only $100. The remaining $1,200 represents the exempt interest dividend you received.

Double Category Averaging Method

A somewhat more complicated (but potentially tax-saving) alternative to the single-category averaging method.

This page explains the double-category averaging method for determining the basis of mutual fund shares you sell. This method is more complicated than the single-category method, and doesn't necessarily produce better results — but we explain it here for those who think it may be useful, or who have already elected this method.

Overview

We assume you're already familiar with the single-category averaging method when you come to this page. If not, visit Single-Category Averaging Method and then return here.
    When you use the double-category method, you keep track of your average basis for short-term shares separately from your average basis for long-term shares. You're allowed to choose at the time you make a sale whether you're selling long-term shares or short-term shares. This added flexibility may permit you to save tax dollars on particular sales. But you can also end up paying more tax under this method because you can't average the basis of your short-term shares with the basis of your long-term shares.

Complexity

The double-category averaging method is somewhat complicated. When you use the single-category method you don't need to keep track of your basis in particular shares. You merely need to know the total basis, and the total number of shares. But when you use the double-category method you need to know the basis of particular shares. That basis will start out being included in the average basis of your short-term shares. A year and a day after the day you acquired those shares, their basis is no longer part of the average short-term share basis because these shares have moved into the long-term category.

Tax Benefit

The tax benefit of this method comes primarily from its greater flexibility. For example, you may purchase shares in a mutual fund over a period of many years when its value was rising. Then you may have occasion to withdraw money from the fund shortly after a drop in value. If you're using the single-category method, you may recognize a gain despite the recent drop in value. Your average basis is still lower than the current value because you bought some shares many years ago. But if you use the double-category method, you can specify that you're selling the short-term shares, and report a short-term loss instead of a long-term gain. The result: lower taxes.
    Even if you don't specify which shares you're selling, the double-category method can produce savings. This might happen, for instance, if you recently bought shares after a significant decline in the value of the fund. The double-category method would keep the recent, low-basis shares out of the calculation of the average basis of the long-term shares you sold.
    Note that the tax benefit of using this method often depends on a decline in the value of a mutual fund. Because most funds go up over the long term, these savings opportunities may not occur very often.

Identification

If you're willing to endure the complexity of the double-category averaging method to obtain the benefits described above, you should consider not using any averaging method, and specifically identifying the shares you sell at the time of each sale. This method provides even greater flexibility, and the complexity may not be much greater than using the double-category method.

Single-Category Averaging Method

A (relatively) easy way to figure gain or loss when you sell mutual fund shares.

This page explains one of the methods used to determine the basis of mutual fund shares you sell: the single-category method. For many people this method is not only the simplest method, but also the method that produces the best tax result. If you elect to use this method, the basis of any share you sell is equal to the average basis of all shares you own in that mutual fund.

Overview

Your basis in anything you own is a measure of how large an investment you've made. It's used to determine how much gain or loss you report when you sell that item.
    When you sell shares of regular corporations, you have to determine what shares were sold according to rules set forth in the tax regulations. See Identifying the Shares You Sell. Then you use the basis of those particular shares to figure your gain or loss on the sale. You aren't allowed to use average basis for this purpose.
    When you sell mutual fund shares, you can use the same rules that apply to regular stocks — or you can elect to use an averaging method. There are two different averaging methods. This page describes the single-category method. This is the least flexible method of determining your basis but also by far the easiest. In fact, if you use this method some mutual funds will provide the calculations for you. In many cases this method produces the best tax results, too. But there are situations where you're better off using a different method.

Eligibility

You're eligible to use this method if you meet the following requirements:

• Your mutual fund shares are held in an account by a custodian or agent (such as a bank or stock broker). In other words, you don't have possession of certificates representing your shares.
• You haven't previously elected to use the double-category method for the same mutual fund.
• If your account for this mutual fund includes shares you received as a gift, you may have to meet an additional eligibility requirement.

You can use different methods for different mutual funds (including different funds within the same family of funds). And you can use the single-category method even if you previously sold shares without using an averaging method. In other words, you don't have to use it from day one. But once you elect an averaging method you're stuck with it for that fund. You have to continue to use that averaging method for all future transactions involving shares of that fund.
    There's one other eligibility rule. The IRS can deny you the use of this method if it appears you're using it to convert short-term gain to long-term gain, or long-term loss to short-term loss. You shouldn't need to worry about this rule unless you're planning something fancy. If you come up with a clever scheme to benefit from this type of conversion by using the single-category method, you should be aware that the IRS can deny the benefits under this rule.

How the Method Works

The single-category method requires you to add the basis of all shares you hold in the mutual fund and divide the total by the number of shares you hold. That average is used as the basis of the shares you sold.

Example: You contributed $100 per month to your mutual fund account for a period of 27 months. During that period, $147 of dividends were reinvested. Your total basis is $2,847. You own 112.342 shares, so your average basis is $25.34 per share.
    Then you take $500 from the fund, resulting in a sale of 18.277 shares. Your basis for those shares is $463.14 ($25.34 times 18.277). So you report a gain of $36.86 ($500 minus $463.14).

After the sale, you should determine your total basis for the shares you have left. That will simply be the total basis before the sale minus the basis you claimed for the shares you sold. In the example, the remaining shares have a basis of $2,847 minus $463.14, or $2, 383.86. So the average basis of the remaining shares is $25.34 per share, the same as the shares you sold. Of course, that average basis will change the next time you buy shares (including shares you buy when you reinvest dividends).
    This may not seem like the easiest calculation in the world, but it's a far sight easier than determining exactly what shares you sold when you withdrew $500 and figuring the basis on those particular shares.

Holding Period

In addition to basis, you also have to know your holding period for the shares you sold. When you use the single-category method, you're required to treat the shares you sold as the earliest shares you bought. In other words, you use the first-in, first-out method. That means you'll sell any shares you held more than 12 months first. You'll sell the short-term shares only after you've sold all your long-term shares.
    In most cases the easiest way to determine whether you sold any shares with a holding period of 12 months or less is to look at the shares you didn't sell. If the number of shares remaining in your mutual fund account after the sale is greater than the number of shares you acquired (including dividend reinvestments) during the 12 months preceding the sale, then all of your gain or loss on the sale is long-term gain or loss. If not, you'll have to determine how many of the shares you sold were acquired during the twelve-month period preceding the sale.

Gift Shares

There's a special rule that applies to certain shares received by gift if you elect to use one of the averaging methods. The rule applies only if the shares have a basis greater than their value at the time of the gift. These shares present a special case because you're required to use the date-of-gift value, not the regular basis, of these shares to determine any loss on a sale of these shares, but use the regular basis to calculate any gain. The regulations prevent you from using the averaging methods to avoid the special basis rules for gifts.
    If you elect an averaging method and you hold such shares, you have a choice. You can include in your election a statement that you will use the date-of-gift value as the basis of the shares for all purposes. You might do this if the date-of-gift value was nearly the same as the regular basis. Bear in mind though, the election will apply to any gift shares you receive in the future, too. Your other alternative is to hold the gift shares in a separate account that's excluded from your averaging calculations.

Electing an Averaging Method

To elect an averaging method, you should attach a statement to your return for the first year you want the election to apply. Remember that the election applies only to a particular mutual fund, so you need to make another election every time you start to use averaging with a new mutual fund (including a different fund in the same family of funds).
    Your election should state that an averaging method has been used to determine gain or loss, specify the fund to which it applies and the method used. The election might look like this:

The single-category averaging method has been used to determine gain or loss for shares of the XYZ Mutual Fund.

That's all you need to do if you don't have any gift shares and aren't expecting to receive any. If you have gift shares and want the election to apply to them as described earlier, you would include an additional statement:

In the case of shares acquired by gift, if the donor's adjusted basis in the shares immediately before the gift is greater than fair market value, such shares shall be included in the calculation of average basis using the fair market value of such shares at the time they were acquired by gift.

If you don't want the election to apply to gift shares described earlier, you need to keep those shares in a separate account and include an additional statement:

In the case of shares acquired by gift, if the donor's adjusted basis in the shares immediately before the gift is greater than fair market value, such shares shall maintained in a separate account and excluded from the average basis calculation.

Be sure to maintain good records of all calculations relating to the use of an averaging method.

Selling Mutual Fund Shares

General rules for determining the amount and type of gain or loss to report when you sell mutual fund shares.

When you withdraw money from a mutual fund account, you're actually selling shares of stock in the mutual fund. As a general rule, that sale results in capital gain or loss. The tax law provides special rules for determining how much gain or loss you have, and in what categories, when you sell mutual fund shares.

Money market funds. There's an exception to the general rule. Most money market funds are set up so that you have no gain or loss when you sell shares to make a withdrawal. These mutual funds constantly adjust the number of shares so that each share has a basis, and a value, equal to $1.00.

Nature of the Problem

It's not terribly difficult to figure the amount and category of your gain or loss if you buy all your shares on the same date at the same price, then sell them all at once on some later date at the same price. But things get more difficult when you buy shares on different dates at different prices, and later sell only some of the shares you own. Which shares did you sell? And what is the basis (cost) of the shares you sold? The rules described on this page are designed to answer these questions.
    Finding the correct answer can be difficult for regular stocks, but it's likely to be much more difficult if you invest in mutual funds. The reason is that mutual fund investors tend to accumulate savings over a period of time and often choose to reinvest dividends. This means they have many purchases of shares, often including fractional shares, on many different dates, and all at different prices.
    To make things easier for mutual fund investors, the tax law provides averaging rules. You can't use these rules for sales of regular stocks; they're only for mutual funds. You lose some flexibility when you use these rules – but you gain some convenience. It's up to you whether to use these rules. You should elect to use them if the added convenience is more important to you than the loss of flexibility.

Using the Regular Rules

Before we turn to the special rules for mutual funds, we should have in mind the rules that apply to other stocks. These rules apply to mutual funds, too. You only use the special averaging rules if you elect to use them, and you shouldn't do that unless you feel that they give you a better result than the regular rules.

If You Hold Certificates

Most investors nowadays don't take possession of stock certificates representing their shares. Instead, they leave the shares with the broker, mutual fund company or other entity. But it's still possible for investors to hold certificates. If you do, none of the rules described below (including the averaging rules) apply. Those rules are only for shares that are held in an account. In general, if you sell shares by transferring one or more certificates in your possession, you determine which shares you sold by determining which certificates you transferred.

Example: You bought 100 shares of XYZ at $22, receiving certificate number 11497. Later, you bought another 100 shares at $28, receiving certificate 17866. If you sell 100 shares, the amount of gain or loss you report will depend on which certificate you deliver.

If You Do Nothing

If you sell shares that are held in a brokerage account and don't take action to specify which shares you are selling, the tax law treats you as if you sold the first shares you acquired. This rule is sometimes called the first-in, first-out rule, or the FIFO rule.

Example: You bought 100 shares of XYZ in January, another 100 in March and another 100 in April. In May you sold 150 shares without specifying which shares you were selling. You are treated as if you sold all of the shares you bought in January and 50 of the shares you bought in March.

It doesn't matter if the broker actually transferred some other certificates. The tax law says you automatically sold the first shares you acquired.

Identifying Shares

The tax law also lets you identify the shares you are selling, so you can choose to sell shares other than the first ones you bought. You might choose to do this, for example, if the newer shares had a higher cost basis, so you would report a smaller gain when you sold these shares. If you properly identify the shares you are selling, then the FIFO rule described above doesn't apply.

Example: Same as the preceding example, but when you sold the shares in May you specified to the broker that you were selling the most recent shares you bought, and the broker provided written confirmation of this instruction. You are treated as if you sold the shares you specified in the instruction.

Specific identification of shares provides you with the greatest possible flexibility in planning the tax consequences when you sell stock — including stock of mutual funds. Relatively few people take advantage of this flexibility, though. If you aren't the type for this kind of detailed tax planning, you may not be giving up much when you elect to use one of the averaging methods described below.

Averaging Rules for
Mutual Fund Shares

We come at last to the averaging rules. These rules apply only to mutual fund shares. You can't use them for regular stocks. There are two different rules, and you get to choose which one you use.
    You'll see that these methods involve some learning, and some calculations. At first it may seem to be more trouble than it's worth. And if it truly is, you don't have to use these methods: they're purely elective. But many people find that after they get "over the hump" of learning about these methods, they make it much easier to calculate gain or loss on sale of mutual fund shares.

Single-Category Method

When you use the single-category method, you add up the basis of all the shares you hold in a particular mutual fund. Then you divide by the number of shares to determine the basis per share. Any sales are considered to come from the oldest shares first for purposes of determining whether you have long-term or short-term gain or loss.

Double-Category Method

The double-category method is a little more complicated. You add up the basis of all the shares you have held for a year or less (short-term shares) and find the average basis of those shares. You also find the average basis of the long-term shares. When you use this method, you're allowed to identify whether you are selling short-term shares or long-term shares. Then you determine your gain or loss based on the average basis for that type of share.