Mutual Fund Redemptions: A Guide to Helping Clients Minimize the Tax Bite

Knight, Lee G., Knight, Ray A., Journal of Accountancy

The downward spiral of the stock market over the last three years will go on record as one of the worst bear markets in U.S. history. Financial experts cite the sluggish economy, anemic corporate profits, the possibility of war with Iraq, the ongoing battle against terrorism and the accounting scandals as contributing factors. Nonprofessional mutual fund investors are more concerned about surviving the downturn than what caused it. Surprisingly, during most of the decline, mutual fund investors followed professional money managers' advice to stay the course and avoid panic selling.

In July 2002 mutual fund investors apparently hit their psychological limit on losses and withdrew a record $49 billion from mutual funds--significantly higher than the $30 billion they had pulled out after September 11, 2001. The July withdrawals followed $18 billion in June 2002. In August 2002 withdrawals slowed to $9 billion, but most financial experts said this level still was too high to support a sustained recovery.

Whether mutual fund redemptions lock in profits earned during the 1990s or produce losses, CPAs can provide critical tax-planning guidance to their clients. While the best time to counsel clients is before a transaction closes, some planning opportunities remain open until a client files his or her tax return. This article shows how CPAs can help clients make the most of the current investment environment by using the basis elections in Treasury regulations section 1.1012-1 and the capital loss provisions in IRC sections 1211 and 1212(b). It also includes guidance on how to convert paper losses into realized capital losses without triggering the wash sale rule and how to use the charitable contribution provisions to mitigate the current market's negative effects. CPAs will need to counsel clients carefully because of the detailed implementation and documentation requirements, as well as the IRS's strict interpretation and enforcement of these rules.

USING BASIS TO SAVE TAXES

When an investor sells, exchanges or redeems a mutual fund share, the gain or loss generally equals the amount realized (sales price less expenses of sale) minus the share's adjusted tax basis (IRC section 1001). The gain or loss is capital in nature--long-term if held for more than one year and short-term if held for one year or less. Under IRC section 1(h), investors pay a maximum rate of 20% on net long-term capital gains. Ordinary income tax rates (up to 38.6%) apply to net short-term capital gains, making it desirable to have gains characterized as long-term.

Sections 1211 and 1212(b) say investors must use capital losses to first offset any capital gains realized during the year. They then can use the excess losses to offset up to $3,000 of ordinary income in the current year and carry forward any remaining loss to offset income in future years.

Original cost basis. The adjusted tax basis used to compute the gain or loss on a sale begins with the original cost basis unless the investor acquired the shares by gift or inheritance. IRC sections 1014 and 1015 delineate the rules for determining the basis of mutual fund shares in this situation. This article assumes the investor purchased the mutual fund shares, either directly or via a dividend-reinvestment program.

The original cost basis of a mutual fund share generally is its purchase price in cash or property, plus an allocable portion of load charges (sales or similar charges). IRC section 852(f) limits the amount of load charges added to a mutual fund share's basis if all of the following conditions exist. The investor

* Receives a reinvestment right because of the purchase of the shares or the payment of the fees or load charges.

* Disposes of the shares within 90 days of purchase.

* Subsequently acquires shares in the same mutual fund or another fund for which the mutual fund company waives the load charge because of the reinvestment right. The investor adds the amount of any load charge excluded from the basis of the original shares to the basis of subsequently acquired shares (unless, of course, the three conditions are met).

Example. Mary Darby invests $100,000 in shares of Prime Fund, which deducts a 3% up-front load charge, or $3,000, from her initial purchase and invests the $97,000 …

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Publication information: Article title: Mutual Fund Redemptions: A Guide to Helping Clients Minimize the Tax Bite. Contributors: Knight, Lee G. - Author, Knight, Ray A. - Author. Journal title: Journal of Accountancy. Volume: 195. Issue: 3 Publication date: March 2003. Page number: 55+. © 2009 American Institute of CPA's. COPYRIGHT 2003 Gale Group.

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