Sales Load Deferral Rule

Some mutual funds charge a load, or sales commission, when you purchase shares. This payment doesn’t become part of your investment, but because it’s a cost of purchase, it’s included in your basis.

Example: You invest $10,000 in a fund that charges a 5% sales load. You receive shares worth $9,500, but your basis for those shares is $10,000. If you sold these shares for $9,500, you would report a loss of $500.

Generally you would not pay a load unless you intended to hold the shares for some time, anticipating that over a long enough period the benefits of holding this investment would justify the cost of paying the load. Yet some companies permit an investor who sold shares after paying a load to reinvest in the same fund, or in another fund offered by the same mutual fund company, at a reduced load. This reinvestment right makes it possible to buy a load fund while maintaining the flexibility to change investments without paying additional load charges. It’s sort of like having your hand stamped when you pay a cover charge at a night club so you can leave for a while and come back in later without paying again.

This is a sensible arrangement, but it creates a potential for tax abuse that’s blocked by a special provision called the sales load deferral rule.

Example: You intend to invest $10,000 in Fund A, which charges a 5% load. Instead of buying shares of that fund, however, you invest that amount in Fund B offered by the same company, paying a $500 load and receiving shares valued at $9,500. Immediately afterward you sell these shares for $9,500 and use your reinvestment right to buy $9,500 worth of shares in Fund A, without paying a load.

You end up in exactly the same place as if you simply invested in Fund A in the first place. This roundabout method of reaching your destination was intended to let you claim a $500 capital loss on the sale of the shares you bought first. Yet the purchase of Fund B wasn’t a legitimate investment. Its sole purpose was to convert the sales load you otherwise would have paid on your investment in Fund A as a capital loss.

When the rule applies

The sales load deferral prevents this maneuver. It may also apply in situations where the investor is simply changing to a new investment with no thought of tax avoidance. It applies when all of the following are true:

• You pay a load when buying mutual fund shares;
• As a result of paying this load you acquire a reinvestment right;
• You dispose of these shares within 90 days after acquiring them; and
• During the period from the date of that disposition until January 31 of the following year you buy shares of the same mutual fund, or of a different one, with the otherwise applicable load charge reduced as a result of the reinvestment right you acquired in connection with the first purchase.

The key condition is the third one. To avoid the sales load deferral rule, you have to hold the first fund at least 91 days.

What happens when the rule applies

When the conditions described above exist, the amount of sales load you’re allowed to take into account in determining gain or loss from selling the first investment is reduced by the amount of reduction in the sales load on the second investment, and this amount is added to the basis of the second investment. In effect, you’re treated as if you paid the load on the second investment instead of the first one.

Notice that this is not merely a loss disallowance rule. The basis is transferred from the first investment to the second even if the shares of the first one increased enough to produce a gain before they were sold.

Fund company may not apply this rule

The cost basis reporting regulations require mutual fund companies to apply this rule. It appears, however, that most fund companies, taking their lead from the Investment Company Institute, will not apply this rule unless you both investments are in the same fund (that is, in the example above you repurchased Fund B instead of buying Fund A in the second purchase) — even though the Treasury explicitly rejected that position in the final regulations. As a result, you will have to make your own adjustments in gain or loss from the first sale, and when you sell the second investment you’ll also account for the discrepancy between the basis reported by the fund company and the correct basis.