Chapter 40
Mutual funds
Useful Items
You may want to see:
Publication
- 550 Investment Income and Expenses
Tax Treatment of Distributions
A distribution you receive from a mutual fund may be an ordinary dividend, a qualified dividend, a capital gain distribution, an exempt-interest dividend, or a nondividend distribution. The fund will send you a Form 1099-DIV or similar statement telling you the kind of distribution you received. This section discusses the tax treatment of each kind of distribution, describes how to treat reinvested distributions, and explains how to report distributions on your return.
Community property states. If you and your spouse live in a community property state and receive a distribution that is community income, one-half of the distribution is considered received by each of you. If you file separate returns, each of you must generally report one-half of any taxable distribution. For more information about community property, see Pub. 555, Community Property.
If the distribution is not considered community income under state law and you and your spouse file separate returns, each of you must report your separate taxable distributions.
Share certificate in two or more names. If two or more persons, such as you and your spouse, hold shares as joint tenants, tenants by the entirety, or tenants in common, distributions on those shares are considered received by each of you to the extent provided by local law.
Tax-exempt mutual fund. Distributions from a tax-exempt mutual fund (one that invests primarily in tax-exempt securities) may consist of ordinary dividends, capital gain distributions, undistributed capital gains, or return of capital like any other mutual fund. These distributions generally are treated the same as distributions from a regular mutual fund. Distributions designated as exempt-interest dividends generally are not taxable. (See Exempt-Interest Dividends, later.)
All other distributions generally follow the same rules as a regular mutual fund. Regardless of what type of mutual fund you have (whether regular or tax-exempt), when you dispose of your shares (sell, exchange, or redeem), you usually will have a taxable gain or a deductible loss to report.
For more information on figuring taxable gains and losses see Sales, Exchanges, and Redemptions, later. Also see chapter 16, Reporting gains and losses, for further information.
Ordinary Dividends
Ordinary (taxable) dividends are the most common type of distribution from a mutual fund. They are paid out of earnings and profits and are ordinary income to you. This means they are not capital gains. You can assume that any dividend you receive on common or preferred stock is an ordinary dividend unless the mutual fund tells you otherwise. Ordinary dividends will be reported in box 1a of the Form 1099-DIV or on a similar statement you receive from the mutual fund.
Qualified Dividends
Qualified dividends are ordinary dividends subject to the same 0%, 15%, or 20% maximum tax rate that applies to net capital gain. They will be shown in box 1b of the Form 1099-DIV you receive.
Qualified dividends are subject to the 20% rate if your regular marginal tax rate is 39.6%. If your regular marginal tax rate is 25%, 28%, 33%, or 35%, then the tax rate on qualified dividends is 15%. If your regular marginal tax rate is either 10% or 15%, then qualified dividends are subject to a 0% tax rate.
To qualify for the 0%, 15%, or 20% maximum rate, all of the following requirements must be met:
- The dividends must have been paid by a U.S. corporation or a qualified foreign corporation. See chapter 1 of Pub. 550 for the definition of a qualified foreign corporation.
- The dividends are not of the type excluded by law from the definition of a qualified dividend. See chapter 1 of Pub. 550 for a list of these types of dividends.
- You must meet the holding period requirement (discussed next).
Holding Period
You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the buyer of a stock is not entitled to receive the next dividend payment. When counting the number of days you held the stock, include the day you disposed of the stock, but not the day you acquired it. See chapter 1 of Pub. 550 for more information about qualified dividends.
Capital Gain Distributions
Capital gain distributions (also called capital gain dividends) are paid to you or credited to your account by mutual funds. They will be shown in box 2a of the Form 1099-DIV (or similar statement) you receive from the mutual fund.
Report capital gain distributions as long-term capital gains, regardless of how long you owned your shares in the mutual fund.
Undistributed capital gains of mutual funds. Some mutual funds keep their long-term capital gains and pay tax on them. You must treat your share of these gains as distributions, even though you did not actually receive them. However, they are not included on Form 1099-DIV. Instead, they are reported to you in box 1a of Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains.
Form 2439 will also show how much, if any, of the undistributed capital gains is:
- Unrecaptured Section 1250 gain (box 1b),
- Gain from qualified small business stock (Section 1202 gain, box 1c), or
- Collectibles (28%) gain (box 1d).
The tax paid on these gains by the mutual fund is shown in box 2 of Form 2439.
Basis adjustment. Increase your basis in your mutual fund by the difference between the gain you report and the credit you claim for the tax paid.
Exempt-Interest Dividends
Exempt-interest dividends you receive from a mutual fund or other regulated investment company are not included in your taxable income. Exempt-interest dividends should be shown in box 10 of Form 1099-DIV.
Information reporting requirement. Although exempt-interest dividends are not taxable, you must show them on your tax return if you have to file a return. This is an information reporting requirement and does not change the exempt-interest dividends to taxable income. See Reporting tax-exempt interest under How to Report Interest Income in chapter 1 of Pub. 550 for more information.
Alternative minimum tax treatment. Exempt-interest dividends paid from specified private activity bonds may be subject to the alternative minimum tax. The exempt-interest dividends subject to the alternative minimum tax should be shown in box 11 of Form 1099-DIV. See Form 6251 and its instructions for more information.
Nondividend Distributions
A nondividend distribution is a distribution that is not paid out of the earnings and profits of a mutual fund. You should receive a Form 1099-DIV or other statement showing you the nondividend distribution. On Form 1099-DIV, a nondividend distribution will be shown in box 3. If you do not receive such a statement, you report the distribution as an ordinary dividend.
Basis adjustment. A nondividend distribution reduces the basis of your mutual fund. It is not taxed until your basis in your shares is fully recovered. This nontaxable portion is also called a return of capital; it is a return of your investment in the company. If you buy mutual fund investments in different lots at different times, and you cannot definitely identify the shares subject to the nondividend distribution, reduce the basis of your earliest purchases first.
When the basis of your shares has been reduced to zero, report any additional nondividend distribution you receive as a capital gain. Whether you report it as a long-term or short-term capital gain depends on how long you have held the mutual fund. See chapter 4 of Pub. 550, Holding Period, for more information.
Reinvestment of Distributions. Most mutual funds permit shareholders to automatically reinvest distributions in more shares in the fund, instead of receiving cash. If you use your dividends to buy more shares at a price equal to its fair market value, you must still report the dividends as income. This means that reinvested ordinary dividends and capital gain distributions generally must be reported as income. Reinvested exempt-interest dividends generally are not reported as income. Reinvested return of capital distributions are reported as explained under Nondividend Distributions, earlier. See Keeping Track of Your Basis, later, to determine the basis of the additional shares.
Money Market Funds. Report amounts you receive from money market funds as dividend income. Money market funds are a type of mutual fund and should not be confused with bank money market accounts that pay interest.
How To Report
Generally, you can use either Form 1040 or Form 1040A to report your dividend income. Report the total of your ordinary dividends on line 9a of Form 1040 or Form 1040A. Report qualified dividends on line 9b.
If you receive capital gain distributions, you may be able to use Form 1040A or you may have to use Form 1040. See Capital gain distributions, earlier. If you receive nondividend distributions required to be reported as capital gains, you must use Form 1040. You cannot use Form 1040EZ if you receive any dividend income.
Table 40-1, Reporting Mutual Fund Distributions on Form 1040 or Form 1040A, explains where on Form 1040 or Form 1040A or its related schedules to report distributions from mutual funds.
Table 40.1 Reporting Mutual Fund Distributions on Form 1040 or 1040A
| Then report the distribution on | |||
| If you receive | AND | Form 1040 . . . | Form 1040A . . . |
| ordinary dividends (Form 1099-DIV, box 1a) | your total ordinary dividends received are $1,500 or less, and you did not receive any ordinary dividends as a nominee | line 9a | line 9a |
| your total ordinary dividends received are more than $1,500, or you received ordinary dividends as a nominee | line 9a, and Schedule B, line 5 | line 9a, and Schedule B, line 5 | |
| qualified dividends (Form 1099-DIV, box 1b) | line 9b, and Qualified Dividends and Capital Gain Tax Worksheet, line 2, or Schedule D Tax Worksheet, line 2, whichever applies | line 9b, and Qualified Dividends and Capital Gain Tax Worksheet, line 2 | |
| capital gain distributions (Form 1099-DIV, box 2a) | you do not have to file Form 1040, Schedule D | line 13, and Qualified Dividends and Capital Gain Tax Worksheet, line 3 | line 10, and Qualified Dividends and Capital Gain Tax Worksheet, line 3 |
| you have to file Form 1040, Schedule D (see Schedule D instructions for line 13) | Schedule D, line 13 | you must use Form 1040; you cannot use Form 1040A | |
| Section 1250, 1202, or collectibles gain (Form 1099-DIV, box 2b, 2c, or 2d) | Schedule D (see the Schedule D instructions) | you must use Form 1040; you cannot use Form 1040A | |
| nondividend distributions (Form 1099-DIV, box 3) | generally not reported* | generally not reported* | |
| exempt-interest dividends (Form 1099-DIV, box 10) | line 8b | line 8b | |
| undistributed capital gains (Form 2439, boxes 1a-1d) | Schedule D (see the Schedule D instructions) | you must use Form 1040; you cannot use Form 1040A | |
*Report any amount in any excess of your basis in your mutual fund shares on Form 8949. Use Part II if you held the shares more than one year. Use Part I if you held your mutual fund shares 1 year or less.
Foreign tax deduction or credit. Some mutual funds invest in foreign securities or other instruments. Your mutual fund may choose to allow you to claim a deduction or credit for the taxes it paid to a foreign country or U.S. possession. The fund will notify you if this applies to you. The notice will include your share of the foreign taxes paid to each country or possession and the part the dividend derived from sources in each country or possession.
Sales, Exchanges, and Redemptions
When you sell or exchange your mutual fund shares, or if they are redeemed (a redemption), you will generally have a taxable gain or a deductible loss. This also applies to shares of a tax-exempt mutual fund. Sales, exchanges, and redemptions are all treated as sales of capital assets. The amount of the gain or loss is the difference between your adjusted basis (defined later) in the shares and the amount you realize from the sale, exchange, or redemption.
In general, a sale is a transfer of shares for money only. An exchange is a transfer of shares in return for other shares. A redemption occurs when a fund reacquires its shares from you in exchange for money or other property.
You will not have to recognize a capital gain or loss, however, if the shares in one mutual fund are converted to the shares of another pursuant to a tax-free merger of the two funds, or if the redemption of your shares is treated as a dividend.
Taxpayer identification number. You must give the broker your correct taxpayer identification number (TIN). Generally, an individual will use his or her social security number as the TIN. If you do not provide your TIN, your broker is required to withhold tax at a rate of 28% on the gross proceeds of a transaction, and you may be penalized.
Keeping Track of Your Basis
Original basis. As explained in the following paragraphs, original basis depends on how you acquired your shares.
Adjusted basis. As described later under Adjusted Basis, your original basis is adjusted (increased or decreased) by certain events. You must keep accurate records of all events that affect basis so you can figure the proper amount of gain or loss.
Shares Acquired by Purchase
The original basis of mutual fund shares you bought is usually their cost or purchase price. The purchase price usually includes any commissions or load charges paid for the purchase.
Commissions and load charges. The fees and charges you pay to acquire or redeem shares of a mutual fund are not deductible. You can usually add acquisition fees and charges to your cost of the shares and thereby increase your basis. A fee paid to redeem the shares is usually a reduction in the redemption price (sales price).
You cannot add your entire acquisition fee or load charge to the cost of mutual fund shares if all of the following conditions apply.
- You get a reinvestment right because of the purchase of the shares or the payment of the fee or charge.
- You dispose of the shares within 90 days of the purchase date.
- You acquire new shares in the same mutual fund or another mutual fund, for which the fee or charge is reduced or waived because of the reinvestment right you got when you acquired the original shares.
The amount of the original fee or charge in excess of the reduction in (3) is added to the cost of the original shares. The rest of the original fee or charge is added to the cost basis of the new shares (unless all three conditions above apply to the purchase of the new shares).
Shares Acquired by Reinvestment
Reinvestment right. This is the right to acquire mutual fund shares in the same or another mutual fund without paying a fee or load charge, or by paying a reduced fee or load charge.
The original cost basis of mutual fund shares you acquire by reinvesting your distributions is the amount of the distributions used to purchase each full or fractional share. This rule applies even if the distribution is an exempt-interest dividend that you do not report as income.
Shares Acquired by Gift or Inheritance
Mutual fund shares received as a gift. If you receive a gift of appreciated mutual fund shares, your basis is determined by the donor’s basis). Your holding period is considered to have started on the same day that the donor’s holding period started. However, special rules apply for gifts where the donor’s basis is higher than fair market value on the date of the transfer. See Pub. 551, Basis of Assets, for more information.
Adjusted Basis
Addition to basis. Increase the basis in your shares by the difference between the amount of undistributed capital gain you include in income and the tax considered paid by you on that income.
The mutual fund reports the amount of your undistributed capital gain in box 1a of Form 2439 and any tax paid by the mutual fund in box 2. You should keep Copy C of all Forms 2439 to show increases in the basis of your shares.
Reduction of basis. You must reduce your basis in your shares by any nondividend distributions that you receive from the fund. The mutual fund reports the amount of any nondividend distributions on Form 1099-DIV, box 3. You should keep the form to show the decrease in the basis of your shares.
Basis cannot go below zero. Your basis cannot be reduced below zero. If your basis is zero, you must report the nondividend distribution on your tax return as a capital gain. Report this capital gain on Schedule D (Form 1040). Whether it is a long-term or short-term capital gain depends on how long you held the shares.
No reduction of basis. You do not reduce your basis for distributions from the fund that are exempt-interest dividends.
Identifying the Shares Sold
To figure your gain or loss when you dispose of mutual fund shares, you need to determine which shares were sold and the basis of those shares. If your shares in a mutual fund were acquired all on the same day and for the same price, figuring their basis is not difficult. However, shares are generally acquired at various times, in various quantities, and at various prices. Therefore, figuring your basis can be more difficult. You can choose to use either a cost basis or an average basis to figure your gain or loss. See Table 40.2, Choosing a Basis Method.
Table 40.2 Choosing a Basis Method
| Basis Method | Advantages/Disadvantages |
| Specific identification | The most flexible way to determine your gains and losses. But there are important restrictions governing its use. |
| FIFO (first-in, first-out) | The simplest approach. But it may mean a large gain if your shares have appreciated significantly and you are redeeming only part of your account. |
| Average cost | The middle ground. A more modest tax burden than the FIFO method but more tedious calculations if you sell shares frequently. |
Cost Basis
- You can figure your gain or loss using a cost basis only if you did not previously use an average basis for sale, exchange, or redemption of other shares in the same mutual fund. To figure cost basis, you can choose one of the following methods.
- Specific share identification, or
- First-in, first-out (FIFO)
It is important to remember that any mutual funds acquired before January 1, 2012, will be treated as a separate account from any mutual fund acquired on or after January 1, 2012. Therefore, if the average basis method has been elected for shares acquired after January 1, 2012, the average basis must be computed without regard to any shares acquired before January 1, 2012. A mutual fund company has the ability to elect on a shareholder-by-shareholder basis to treat all mutual fund shares held by the customer as covered securities without regard to when the securities were purchased. If this election applies, the average basis of a customer’s mutual fund shares will be determined by taking into account all shares before, on, or after January 1, 2012.
Specific share identification. If you can adequately identify the shares you sold, you can use the adjusted basis of those particular shares to figure your gain or loss.
You will adequately identify your mutual fund shares, even if you bought the shares in different lots at various prices and times, if you:
- Specify to your broker or other agent the particular shares to be sold or transferred at the time of the sale or transfer, and
- Receive confirmation in writing from your broker or other agent within a reasonable time of your specification of the particular shares sold or transferred.
You continue to have the burden of proving your basis in the specified shares at the time of sale or transfer.
First-in, first-out (FIFO). If the shares were acquired at different times or at different prices and you cannot identify which shares you sold, use the basis of the shares you acquired first as the basis of the shares sold. In other words, the oldest shares still available are considered sold first. You should keep a separate record of each purchase and any dispositions of the shares until all shares purchased at the same time have been disposed of completely. Table 40-3, How to Figure Basis of Shares Sold, illustrates the use of the FIFO method to figure the cost basis of shares sold, compared with the use of the average basis method (discussed next).
Table 40-3. How to Figure Basis of Shares Sold
Average Basis
You can figure your gain or loss using an average basis only if you acquired identical shares at various times and prices, or you acquired the shares after December 31, 2010, in connection with a dividend reinvestment plan, and you left the shares on deposit in an account handled by a custodian or agent who acquires or redeems those shares.
Average basis method illustrated. Table 40-3 illustrates the average basis method of shares sold, compared with the use of the FIFO method to figure cost basis (discussed earlier).
Even though you include all unsold shares of identical stock in an account to compute average basis, you may have both short-term and long-term gains or losses when you sell these shares. To determine your holding period, the shares disposed of are considered to be those acquired first.
Remaining shares. The average basis of the shares you still hold after a sale of some of your shares is the same as the average basis of the shares sold. The next time you make a sale, your average basis will still be the same, unless you have acquired additional shares (or have made a subsequent adjustment to basis).
Gains and Losses
You figure gain or loss on the disposition of your shares by comparing the amount you realize with the adjusted basis of your shares. If the amount you realize is more than the adjusted basis of the shares, you have a gain. If the amount you realize is less than the adjusted basis of the shares, you have a loss.
Amount you realize. The amount you realize from a disposition of your shares is the money and value of any property you receive for the shares disposed of, minus your expenses of sale (such as redemption fees, sales commissions, sales charges, or exit fees).
Adjusted basis. Adjusted basis is explained under Keeping Track of Your Basis, earlier.
All details on specific sales of mutual fund shares you made during the year are reported on Form 8949. Prior to 2011, such details were reported on Schedule D. You have to use a different copy of Form 8949 for each of the following conditions:
- Basis was reported on Form 1099-B
- Basis was NOT reported on Form 1099-B
- Sale not reported on Form 1099-B
The totals from each Form 8949 flow to Schedule D and onward to Form 1040.
Holding Period
If you sold or traded mutual fund shares, you must determine your holding period. Your holding period determines whether any capital gain or loss was a short-term capital gain or loss or a long-term capital gain or loss.
Long-term or short-term. If you hold your shares more than one year, any capital gain or loss is a long-term capital gain or loss. If you hold your shares one year or less, any capital gain or loss is a short-term capital gain or loss.
To determine how long you held your shares, begin counting on the date after the day you acquired the property. The day you disposed of the property is part of your holding period.
Mutual fund shares received as a gift. If you receive a gift of mutual fund shares and your basis is determined by the donor’s adjusted basis, your holding period is considered to have started on the same day that the donor’s holding period started. If your basis is determined by the fair market value of the property, your holding period starts on the day after the date of the gift.
Loss on mutual fund held 6 months or less. If you hold stock in a mutual fund (or other regulated investment company) for 6 months or less and then sell it at a loss (other than under a periodic liquidation plan), special rules may apply.
Capital gain distributions received. The loss (after reduction for any exempt-interest dividends you received, as explained later) is treated as a long-term capital loss up to the total of any capital gain distributions you received and your share of any undistributed capital gains. Any remaining loss is short-term capital loss.
Reinvested distributions. If your dividends and capital gain distributions are reinvested in new shares, the holding period of each new share begins the day after that share was purchased. Therefore, if you sell both the new shares and the original shares, you might have both short-term and long-term gains and losses.
How To Figure Gains and Losses on Form 8949 and Schedule D
Separate your short-term gains and losses from your long-term gains and losses on all the mutual fund shares and other capital assets you disposed of during the year. Then determine your net short-term gain or loss and your net long-term gain or loss.
Capital Losses
If your capital losses are more than your capital gains, you can claim a capital loss deduction. Report the deduction on line 13 of Form 1040, enclosed in parentheses.
Limit on deduction. Your allowable capital loss deduction, figured on Schedule D, is the lesser of:
$3,000 ($1,500 if you are married and file a separate return), or
Your total net loss as shown on line 16 of Schedule D.
You can use your total net loss to reduce your income dollar for dollar, up to the $3,000 limit.
Capital loss carryover. If you have a total net loss on line 16 of Schedule D that is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you had incurred it in that next year. If part of the loss is still unused, you can carry it over to later years until it is completely used up.
When you figure the amount of any capital loss carryover to the next year, you must take the current year’s allowable deduction into account, whether or not you claimed it and whether or not you filed a return for the current year.
When you carry over a loss, it remains long-term or short-term. A long-term capital loss you carry over to the next tax year will reduce that year’s long-term capital gains before it reduces that year’s short-term capital gains.
Figuring your carryover. The amount of your capital loss carryover is the amount of your total net loss that is more than the lesser of:
Your allowable capital loss deduction for the year, or
Your taxable income increased by your allowable capital loss deduction for the year and your deduction for personal exemptions.
If your deductions are more than your gross income for the tax year, use your negative taxable income in computing the amount in item (2).
Use the Capital Loss Carryover Worksheet at the end of chapter 16, Reporting gains and losses, to figure your capital loss carryover.
Investment Expenses
You can generally deduct the expenses of producing investment income. These include expenses for investment counseling and advice, legal and accounting fees, and investment newsletters. These expenses are deductible as miscellaneous itemized deductions to the extent that they exceed 2% of your adjusted gross income. See chapter 29 for further information.
Nonpublicly offered mutual funds. If you own shares in a nonpublicly offered mutual fund during the year, you can deduct your share of the investment expenses on your Schedule A (Form 1040) as a miscellaneous itemized deduction to the extent your miscellaneous deduction exceeds 2% of your adjusted gross income. Your share of the expenses will be shown in box 5 of Form 1099-DIV. A nonpublicly offered mutual fund is one that:
- Is not continuously offered pursuant to a public offering.
- Is not regularly traded on an established securities market.
- Is not held by at least 500 persons at all times during the tax year.
Contact your mutual fund if you are not sure whether it is nonpublicly offered.
Expenses allocable to exempt-interest dividends. You cannot deduct expenses that are for the collection or production of exempt-interest dividends. Expenses must be allocated if they were partly for both taxable and tax-exempt income. One accepted method for allocating expenses is to divide them in the same proportion that your tax-exempt income from the mutual fund is to your total income from the fund.
Limit on Investment Interest Expense
The amount you can deduct as an investment interest expense may be limited. See chapter 24, Interest expense.