June 22, 1998

The Taxpayer Relief Act of 1997 reduced the tax rate on long-term capital gains, but increased the complexity of tracking and computing an investor’s cost basis in shares of mutual funds. Investors must compute the cost basis in mutual fund shares in order to determine the gain/loss from a sale, and the method used to compute basis can affect the amount and type of gain/loss realized.

The tax rate differential between capital gains and ordinary income can exceed 19.6% for high-income taxpayers. The lowest capital gains tax rate is currently 20% (for taxpayers above the 15% federal tax bracket). Because of the tax rate differential, investors should maintain records of their mutual fund basis (rather than rely on reports provided by the mutual fund company).

Basis in Shares: The original basis in a mutual fund share is generally the purchase price, plus any fees paid in connection with buying or selling the share (front- or back-end load). Other items that increase basis include reinvested dividends (taxable and nontaxable), reinvested capital gains, and undistributed long-term capital gains. Among the items that reduce basis are nontaxable distributions and taxes paid by the mutual fund on undistributed long-term capital gains. Failure to consider reinvested dividends is a common mistake taxpayers make when computing basis in mutual fund shares sold -- a mistake that results in double taxation of dividends (as ordinary income and increased capital gain).

Alternative Methods for Determining Basis: For mutual fund shares purchased at various times and prices, the IRS permits two basic methods of computing basis -- cost and average basis (with two subcategories for each method). Under the cost method, specific share identification or first-in, first-out (FIFO) options are available. For the average basis method, single- or double-category computations can be made. It is acceptable to use different methods for different mutual fund accounts. These alternative methods are only used for determining basis -- the classification of a capital gain as short- or long-term is determined by the actual holding period for the shares sold.

The Cost Method of Determining Basis: The IRS allows two methods to be used:

1. Specific Share Identification: This method allows the investor to select the shares he/she wants to sell, and provides the greatest flexibility for managing gains and losses to complement tax planning strategies (for example, offsetting capital losses with capital gains). The specific share identification method, however, requires the investor to maintain detailed records of activity in the mutual fund account. Additionally, IRS rules require the taxpayer to inform his/her broker at the time of the sale which shares are to be sold. The broker must provide a written confirmation of the taxpayer’s instructions within a reasonable period of time.
   
   
2. First-In, First-Out: The FIFO method is the simplest alternative, and if average basis or specific identification is not used, FIFO is the IRS-default method. Under FIFO, the basis of shares sold is assumed to be the basis in the shares acquired first. There are no special IRS reporting requirements associated with this alternative. During a rising market, the FIFO method will usually result in a higher tax liability; however, over the long-term, the tax consequences from using FIFO will be comparable to the tax consequences from using average basis.
   
   

The Average Basis Method: If a taxpayer decides to use the average basis method, an election is made on the tax return in the year shares are first sold (and in subsequent years). The election cannot be made on an amended return, unless it is filed by the normal due date of the tax return (including extensions). The taxpayer selects either the single- or double-category computation. Once a method is chosen, it must be used for all sales of the particular mutual fund (unless the IRS grants the taxpayer permission to revoke the election):

• Single Category: Under this method, the average cost (total cost divided by number of shares) of all shares owned at the time of each disposition (regardless of the holding period) is used to determine the per share basis. The holding period for shares sold is determined under the FIFO methodology. If additional shares are acquired after a sale transaction, the average basis must be recalculated.
  
  
• Double Category: When calculating the average cost, shares held for less than one year (short-term) are separated from shares held for more than one year (long-term), and an average basis for each group is calculated. The average cost must be recomputed each time new shares are purchased, or when short-term holdings become long-term. Taxpayers can select the category (short- or long-term) from which shares are to be sold. As with specific identification, the broker must provide a written confirmation of the category selected. If the taxpayer does not select a category, or if a written confirmation is not received from the broker, a FIFO methodology will be applied to determine which shares are sold. The new tax law adds a step to the calculation, because taxpayers must now track mid-term holdings (shares held 12 through 18 month) as well as long-term holdings (shares held over 18 months). Currently, the IRS procedure recognizes only short- and long-term categories (that is, it does not recognize the mid-term category).

Example: Consider the situation where 100 shares of XYZ mutual fund were purchased on Jan. 1, 1996, at $20 per share, 200 shares purchased on June 1, 1997, at $22 per share, 200 shares purchased on Dec. 31, 1997, at $30 per share, and 400 shares sold on Sept. 30, 1998, for $32 per share. The following chart illustrates the basis computation and the resulting gain under each method.

$400

$2,000

None

$200

$2,000

$1,200

$720

$1,440

$720

$200

$2,134

$1,067

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