Capital Gain Distributions

If you own shares in a mutual fund or REIT, the tax information you receive on Form 1099-DIV (or a substitute form) may include a figure for capital gain distributions. This page answers key questions about these distributions, including:

• What are capital gain distributions?
• How are capital gain distributions taxed?
• What strategies will minimize capital gain distributions?
• How are they reported?

What are capital gain distributions?

A mutual fund uses the money it receives from investors to buy shares of stock or other investments. From time to time the fund will sell some of its investments, to change its portfolio or to raise cash to cover shareholder redemptions. Similarly, a real estate investment trust, or REIT, may sell properties or securities in the course of its operations.

These sales can produce capital gain or loss. Tax rules require a mutual fund or REIT that has a net capital gain for the year to pay that amount out to its investors. These payments are called capital gain distributions.

A capital gain distribution is often part of a payment that includes other amounts, such as qualified dividends. You can’t tell how much of your payment is a capital gain distribution until you receive a tax report after the end of the year. This report may arrive as an IRS Form 1099-DIV, with boxes for various items you need to report. Capital gain distributions appear in box 2a.

More likely, the firm where you invest will send a substitute Form 1099-DIV. This report contains all the information that appears in the IRS form, but in a more convenient format. You will see lines of text rather than boxes. The labelling remains the same, though, so capital gain distributions are still item 2a.

How are capital gain distributions taxed?

When you hold your investment in a tax-qualified account, such as an IRA, HSA or 529 account, payments from a mutual fund or REIT, including capital gain distributions, are not taxable until withdrawn. Rules for that type of account will determine the tax consequences when you take money out. It won’t make any difference if some of the money in the account came from capital gain distributions.

In a taxable account, capital gain distributions are treated as the name suggests: as long-term capital gain. You will be treated the same as if you personally had gain on the sale of investments you held more than a year. This gain goes into your overall calculation of capital gains and losses. If you have a capital loss from some other transaction, that loss may offset the gain from this distribution.

In some ways this treatment is favorable. Your gain will be long-term, even if you held the mutual fund shares less than a year at the time of the distribution. Subject to caveats below, you pay tax at the favorable rates that apply to long-term capital gains: 0%, 15% or 20%, depending on your income level. (Visit our Reference Room for rates that apply at your level of income and filing status.) Even at higher income levels, you pay no tax at all if you manage to offset this gain with a capital loss.

Yet you may see an unfavorable mismatch between your investment experience and the gain you have to report.

• You didn’t sell anything, yet you’re being required to pay tax on gain as if you did sell something.
• You report this gain even if you didn’t receive the payment because you have distributions reinvested.
• The gain may represent growth in the underlying value of the assets sold by the mutual fund or REIT that occurred before you invested, providing no benefit to you.
• In fact, you have to pay tax on this gain even if the value of your shares in the mutual fund or REIT has gone down.
• What’s more, you pay tax on this gain even if the transaction that produced it occurred before you became an owner.

In short, receiving a capital gain distribution isn’t all good, despite the favorable tax rates for long-term capital gain. What’s more, you don’t always get the full benefit of those rates.

Gain taxed at higher rates. The maximum rate of tax on a normal long-term capital gain is 20%. You can pay another 3.9% in net investment income tax if your income is above the threshold for your filing status ($250,000 if married filing jointly, $200,000 if single or head of household). Certain categories of gain can be taxed at higher rates, though. One is called unrecaptured section 1250 gain. Usually seen only from REITs, or from mutual funds that invest in REITs, this category of income is taxed at rates up to 25%. Another you may see is Collectibles (28%) gain. The word collectibles here is more misleading than it is informative, but 28% tells you all you need to know.

Shares held six months or less. Here’s another rule that can prevent you from getting the favorable treatment you might expect. It applies when you sell shares at a loss after receiving a capital gain distribution, but only if the total amount of time you held those shares was six months or less. In that case, you have to treat your loss as long-term, up to the amount of the capital gain distribution.

Why is that? We saw that capital gain distributions are treated as long-term gain even if your holding period for the investment was less than a year. If you buy shares shortly before the fund or REIT makes a capital gain distribution, and sell them at a loss shortly thereafter, the combination of these transactions could allow you to convert short-term gain into long-term gain — if this rule didn’t apply.

Note that it doesn’t matter how long you held the shares before the capital gain distribution, or how long you held them after. This rule looks only at the total amount of time you held the shares. The time must be at least six months and a day to avoid this rule. For more details, see Shares Held Six Months or Less.

Strategies for capital gain distributions

Capital gain distributions can be a drag on the performance of your portfolio. The require you to report, and potentially pay tax on, capital gains you personally didn’t incur. Here are some strategies to minimize their impact.

Use tax-qualified accounts. Consider whether there’s a way to hold this investment in an account where distributions won’t be taxable. You can’t transfer the shares from your taxable account to a retirement account, HSA or 529 account, but you may be able to rearrange the investments in each so that holdings in your taxable account holds are more tax-efficient.

Choose an ETF. If there’s an exchange-traded fund, or ETF, that suits your investment needs as well as the fund that makes these capital gain distributions, you’re likely to find that the ETF makes smaller capital gain distributions, or none at all.

ETF share classes. Many of the largest mutual fund companies are seeking SEC approval to offer ETF share classes as part of existing or new mutual funds. This development could make the entire mutual fund more tax-efficient, reducing or eliminating capital gain distributions even for investors who continue to hold regular mutual fund shares.

Avoid untimely purchases. If you’re investing around the time a mutual fund or REIT will be making a distribution (usually late in the year), consider waiting until after the record date for that payment. Buying just before such a payment (known as “buying the dividend”) can incur a tax cost before you’ve had time to receive any benefit from the investment.

As always, before adopting a tax strategy, consider whether it may be detrimental to your overall investment strategy.

Reporting capital gain distributions

All the major providers of tax return preparation software make it easy to enter all the numbers that appear on Form 1099-DIV. Simply enter the number from box 2a (or line 2a) in the space they indicate for that information. When you review the tax return they prepare, you should see this figure appear on line 13 of Schedule D.