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.