Sell Before Fund Distribution?

Strategy depends on circumstances

By Kaye A. Thomas
Posted October 27, 2008

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Different treatment for short-term gain.

Tom Herman's tax column in the Wall Street Journal the other day points out that even in an ugly year for investors, many mutual funds will make taxable distributions of gains. "That means it may be a good time to consider selling some underperforming funds before they make a taxable distribution." In reality, there's no reason to sell a fund before a distribution of long-term capital gain. If you're planning to sell the fund, and complete the sale within the same year the distribution is taxable, the capital gain distribution will net out with your gain or loss on the sale.

Example: You bought mutual fund shares for $40,000 and they're now worth $30,000. The fund is getting ready to make a $1,000 capital gain distribution. If you sell now, you can claim a $10,000 loss and avoid reporting a $1,000 taxable distribution.

But if you receive the distribution in cash, you end up in the same position. The distribution puts $1,000 in your pocket and reduces the value of your shares to $29,000. Your basis for the shares is still $40,000, so a sale will produce a loss of $11,000, which you'll net against the $1,000 gain for an overall result of $10,000 loss.

You also get the same result if your distribution is reinvested. In this case, the value of your holdings will remain unchanged at $30,000, and your basis in the mutual fund will increase to $41,000 because you used the $1,000 distribution to buy additional shares. Once again, selling all your holdings will produce a $11,000 loss that nets against the $1,000 capital gain distribution.

Rules discussed in this article are covered in our book, Capital Gains, Minimal Taxes.

In this situation you don't gain any tax advantage by selling the mutual fund shares before the distribution. You do have to sell the shares in the same year you report the distribution, however. Most distributions are made in December, leaving you until the end of the year to make a sale that will net out against the loss. You aren't allowed to carry a capital loss back to an earlier year, so you may get an undesirable result if you sell the fund after the end of the year in which you receive the distribution.

Alert: Mutual funds are allowed to treat certain distributions made in January as if they were made in the previous year. By the time you receive one of these distributions it is too late to make a sale that will net out against any long-term capital gain.

Mutual fund distributions can include amounts other than long-term capital gain. These other amounts won't net out against a loss you have from selling the shares, so a sale before one of these distributions can produce a better tax result than a sale that occurs afterward. In this regard you should be aware that short-term capital gain doesn't "flow through" from a mutual fund. Individual taxpayers have to report these distributions as ordinary dividends, not short-term capital gain, so they won't net out against a capital loss on sale of the mutual fund shares. Making matters worse, these are not qualified dividends, so they aren't taxed at the special, lower rates; they're taxed the same as any other form of ordinary income.

Comment: We don't have data on the breakdown, but it seems reasonable to speculate that gain distributions this year will be more heavily weighted toward long-term gain than usual, as the decline in the stock market made it harder to secure short-term gains but may have forced mutual funds to liquidate long-term holdings to generate cash for investors who were bailing out.

Bear in mind that this discussion of selling before or after a mutual fund distribution doesn't necessarily apply to the reverse situation where you're buying shares. Normally you wouldn't buy shares with a plan to sell them in the same year, especially if you're buying late in the year when mutual funds make most of their distributions. For that reason, you generally get a better tax result if you buy just after a distribution than if you buy just before.

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