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Mutual Funds + December = Capital Gains?

Imagine this; your friend is preparing his tax returns and is confused as to why he owes taxes on a mutual fund position that he hasn’t sold, and it went down in value from the purchase price.

He bought $100,000 worth of a mutual fund on October 1st at $10.00 per share in a taxable brokerage account. On December 1st he received a capital gains distribution from the mutual fund. At the end of the year the mutual fund was worth $9.90 per share.

He didn’t sell any shares of the mutual fund and the price per share has gone down in value since the purchase. So why could he owe taxes in this scenario?

A potential reason taxes could be due is because a mutual fund realizes a capital gain when it sells an investment in the fund for more than its purchase price. Even though your friend didn’t sell any of his shares of the mutual fund, he still owes taxes for the net capital gains of the underlying holdings of the fund. These net capital gains are distributed to all shareholders of the mutual fund who own the fund on a certain date (this is the distribution that occurred on December 1st in our example).

Even though no mutual fund shares were sold, the shares did receive a capital gains distribution from the mutual fund. This distribution is a taxable event for the owner of the shares since it is owned in a taxable account.

It is possible that these capital gains occurred in the fund earlier in the year before the owner even bought the fund. The owner still owes taxes on these gains because they owned the fund when the distribution was paid.

Note that the fund owner owes taxes for this distribution regardless of whether the market value of the mutual fund shares is higher or lower than the purchase price of those mutual fund shares.

If this mutual fund regularly makes significant capital gains distributions, the fund’s owner could consider holding the fund in a tax deferred account such as an IRA.

The share owner could also consider a managed account solution where they would own the underlying holdings of a strategy but have a cost basis for each position that is unique to the account. Finally, the investor could also potentially take advantage of loss harvesting opportunities in a managed account where he could seek to offset realized gains with realized losses in his account and potentially reduce any capital gains taxes or even end up with a loss and owe nothing.

When wrestling with mutual funds and capital gains one should also seek advice from a tax professional who has experience with investment accounts and their taxability.

Any tax advice contained herein is of a general nature. Further, you should seek specific tax advice from your tax professional before pursuing any idea contemplated herein. Fee-Based Planning offered through W3 Wealth Advisors, LLC – a State Registered Investment Advisor – Third Party Money Management offered through ValMark Advisers, Inc. a SEC Registered Investment Advisor – Securities offered through ValMark Securities, Inc. Member FINRA, SIPC – 130 Springside Drive, Suite 300 Akron, Ohio 44333-2431 * 1-800-765-5201 – W3 Wealth Management, LLC and W3 Wealth Advisors, LLC are separate entities from ValMark Securities, Inc. and ValMark Advisers, Inc.

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