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