Computerized Investing - Spreadsheet Collection/Spreadsheet Collection.iso/pc/ibm12/avgcstmf.doc

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Determining the Cost Basis of Mutual Fund Shares
By Edward L. Ostrom Jr., CFP, CLI
March/April 1990, Computerized Investing

Simplicity. That's an excellent word to describe mutual funds. The
simplicity of mutual funds has permitted millions of people to
participate in the opportunities and profits derived from the
ownership of American business. Investment selection, timing,
diversification, and monitoring are fundamental aspects of modern-
day mutual funds, and by simply checking off the appropriate box on
an application, income and capital gains can be automatically
reinvested to acquire more shares. An investor can even redeem
mutual fund shares with checkwriting privileges that accompany many
mutual funds today. It would seem to follow that paying income tax
generated by fund ownership would be simple too--but that can be a
trap. The ability to invest and redeem shares easily and in small
amounts complicates the correct determination of capital gains
incurred in the sale of mutual fund shares.

During the investment and reinvestment phases, the taxation of
mutual funds is uncomplicated. Mutual funds send out a Form 1099
which summarizes the dividend income, interest income, and capital
gains distributed to investors during the year. Things get a bit
more complicated when shares are sold. An investor first needs to
determine which mutual fund transactions constitute a sale, and,
secondly, he must determine the cost basis of the sold shares.

What's a Sale?

Often, an investor is surprised to learn that certain types of
transactions are considered sales by the IRS. For example, a
transfer of assets from one mutual fund to another in the same fund
family is not considered a transfer for tax purposes; rather, it
represents the sale of one fund and the purchase of another.
Redemptions by checks are also considered sales, as are redemptions
derived from an investor's participation in a systematic withdrawal
plan.

Sometimes the reverse is true--what an investor thinks is a sale
may not be. Falling victim to the wash sale rule is the most
probable cause of this kind of confusion. The wash sale rule
prohibits an investor from selling an asset to realize a tax loss
if the purchase and sale of the same asset occur within 30 days of
each other. If this happens, that portion of the tax loss
attributable to the repurchase can not be declared. In the case of
mutual funds, the wash sale rule can be triggered accidentally--and
therein lies the difficulty. Further elaboration about these rules
and the ways to minimize problems are presented later in this
article.

Cost Basis

The second mutual fund tax problem lies in how to determine the
cost basis of the shares sold. Cost basis information is the key to
determining taxable profit or loss. If 12 monthly systematic
withdrawals are made, for example, 12 separate sales must be
reported, requiring the determination of 12 separate cost bases so
that the appropriate profit or loss for each sale may be deter-
mined.

This is also true for mutual funds that purchase only tax-exempt
municipal bonds. Although the interest from such bonds escapes
income taxation, the sale of municipal bond fund shares, as with
any other mutual fund, is still a reportable capital transaction.
A cost basis determination must therefore be made for tax-exempt
funds. The cost basis problem, however, does not exist for money
market mutual funds because the share value remains constant.

The information necessary to report a sale on Schedule D, Form 1040
includes:

1) date(s) of purchase(s), 2) date of sale, 3) proceeds from the
sale, and 4) the cost basis of shares sold.

The date of purchase in the case of mutual funds can, under certain
circumstances, be satisfied by use of the word "various" because,
in fact, the sold shares are likely to include those that were
acquired in small share increments over long time periods through
dividend and capital gain reinvestment. The date of sale and the
proceeds from the sale are items easily plucked from recent
confirmation statements. The difficult task is determining the cost
basis of the sold shares.

The concept of cost basis is new to many mutual fund owners. Most
of the time, the cost basis of an investment is represented by its
original cost. Thus, if an investment of $4,000 is used to buy an
asset that is later sold for $6,000, determining the profit is
easy--the proceeds of the sale, $6,000, less the cost basis of the
shares, $4,000, provide a taxable profit of $2,000.

There are, however, many circumstances and many financial
transactions that can alter the cost basis of an investment.
Depreciation, for example, will decrease the cost basis of an
investment. Assume a piece of income producing real estate costs
$400,000 and that over the years, the investor takes tax deductions
for depreciation that total $100,000. If the property is sold for
$600,000, the profit will not be $200,000--it will be $300,000, be-
cause the tax law required that the $100,000 of depreciation be
used to reduce the cost basis of the investment from $400,000 to
$300,000.

An ironic example of a situation that can favorably impact cost
basis is death. Assume that the investor who purchased the 100
shares of ABC for $4,000 dies at a time when the shares are worth
$6,000. The inheritor of the shares holds them until they are worth
$7,000 and then sells them. The profit will not be $3,000--it will
be only $1,000, because estate tax law permits inherited property
to have its cost basis "stepped-up" to the value of the property at
the time of the owner's death, in this case, $6,000. These are but
two examples; there are many other situations that affect the cost
basis as well.

The Cost Basis of Mutual Funds

Unfortunately, determining the cost basis of mutual funds can be
quite complex. Yet ironically, the two "simple" attributes of
mutual funds--the ease of making small and frequent additional
investments and the ability to reinvest dividends and capital
gains--are at the root of the problem. Regardless of the amount or
the frequency, each additional investment and each reinvestment of
distributions constitutes a new purchase. When shares are
subsequently sold, the question is: Which shares were sold? Under
the appropriate circumstances, investors can select specific
shares, first purchased, or the shares that carry an average price.

To select the best method for you requires your understanding of
the benefits and problems associated with each method because once
a cost basis method is selected for a given fund with a given
registration, the method must be continued until the fund is
eventually liquidated. Any subsequent change in method will require
IRS approval and, unfortunately, the IRS tends to be stingy in
giving such approval without very good cause.

The Specific Identification Method

The specific identification method gives an investor the most
flexibility and therefore the best opportunity to achieve the
lowest tax cost. The disadvantage is that the process requires
accurate and thorough recordkeeping, and extra effort on your part
to meet IRS requirements at the time of sale. The method, however,
allows the investor to pick and choose which shares to sell, or for
that matter, donate. An investor should sell only shares with the
highest cost basis in order to minimize the personal tax burden,
and donate only shares with the lowest cost basis to an authorized
charity. Donations of appreciated shares to IRS-authorized
charities allow an investor to avoid having to declare as taxable
income the difference between the property's cost basis and the
fair market value, while permitting the investor to deduct from
taxes the fair market value of the.gift. Please note, however, that
such gifts may precipitate an undesirable "alternate minimum tax"
for some large-income taxpayers. Investors should therefore
investigate this potential complication before making charitable
gifts of any appreciated property.

Unfortunately, there are some disadvantages to the specific
identification method. First, keeping records to separately
identify each and every "purchase batch" of shares is very
cumbersome--so awkward in fact, that one investor/engineer resorted
to color-coding transactions in order to keep them straight. The
problem is that there are likely to be a large number of buys with
a small monetary value to match up with a single sell. When the IRS
wrote the regulations for the specific identification method, they
obviously did not have mutual funds in mind. They were thinking
about common stock purchases and sales. The vast majority of mutual
fund investors keep their securities on deposit with the sponsor
and reinvest income and capital gains distributions. Every time
shares are acquired through reinvestment, such shares represent
another "batch," and short of asking for delivery, there is no way
to physically isolate them from all the other batches. In addition,
if delivery is taken, an investor still has a problem because
delivery cannot be made for fractional shares. Such fractional
shares are automatically sold and the sale produces a capital
gain/loss tax problem.

To take advantage of specific identification to compute the cost
basis of shares sold you must clearly identify the origin of the
shares at the time of the sale. It is best to keep a copy of all
letters sent to the fund specifying the purchase date and price of
the sold shares, and to request written confirmations from the
fund. When making telephone redemptions, you should follow up the
call with a letter. A sample redemption is illustrated below:

"RE: ABC Mutual Fund, Account No. 12345, registered to (whomever)

Please redeem 57.728 shares and remit the cash proceeds to my
address of record. I wish to designate that you sell the 12.345
shares acquired on August 12, 1979, at $28.47/share; the 23.896
shares acquired on December 18, 1979, at $31.12/share; and the
21.487 shares acquired on February 12, 1980, for $30.88/share."

The FIFO Method

The FIFO approach to the cost basis problem is the "default" method
taken by the IRS in the event the investor fails to choose a method
or reports a sale improperly. FIFO stands for first-in, first-out--
in other words, the first shares purchased, or the oldest shares
left in your inventory, are considered the first shares sold. Most
of the time, this approach produces the largest profit and thus the
largest tax because mutual fund prices tend to increase with the
passing of time. Thus, the oldest shares will probably have the
lowest cost basis. The accounting required to keep this system
"straight" isn't easy either, but at least, if done consistently
and accurately, it will always be found acceptable by the IRS. Most
investors would be ill-advised to use the FIFO method however
because it is likely to generate the highest tax burden.

The Average Cost Method

The Average Cost Method represents a compromise for mutual fund
investors. As the name implies, a running average cost is
maintained by dividing the current number of shares into the total
dollars invested and reinvested. With this method, every share,
regardless of when it was acquired, will carry the same cost basis.
Although there is less planning flexibility than with the specific
identification method, there is greater income tax saving than with
the FIFO method. Accounting complexity, too, is reduced--especially
if the worksheet presented here is used.

Factors that Change the Average Cost Basis

A number of different kinds of transactions can alter the average
cost basis: the purchase of additional shares through cash
contributions, the reinvestment of distributions, redemptions,
share splits, share dividends, and perhaps the most difficult of
all, distributions that have been reclassified as "return of
capital" after the fact.

1) Cash Purchases increase the total cost and the total shares, and
therefore influence the average cost per share.

2) Reinvestment should be treated exactly like purchases, i.e.,
they increase the total cost and the total shares, and therefore
influence the average cost per share.

3) Partial or complete redemptions reduce the total cost and the
total shares, but do not impact on the average cost per share.

4) Stock Splits or Stock Dividends do not change the total cost,
but they do increase the total shares and decrease the average cost
per share.

5) Return of Capital is the most difficult category to handle,
principally because the investor generally does not know that this
has occurred until the Form 1099 has arrived. The amount determined
to be return of capital needs to be backed out of the cost data.
Thus, a return of capital reduces the total cost, does not change
the total shares, but decreases the average cost per share.

Don't Be Too Creative

Unfortunately, some mutual fund shareholders become "creative" by
inventing their own methods for determining the taxable profit of
mutual funds sales. Or worse, they neglect to report such sales or
fail to realize that what they interpreted as a transfer is,
instead, a "sale" as defined by the IRS. It typically takes several
years for the IRS to catch up with such an "oversight." When they
do, this creativity or neglect can cause an investor problems such
as additional taxes, with interest and penalties calculated
retroactively from the year in question. But that's not all: Under
some circumstances, failure to report sales can constitute criminal
neglect--and that can open up entirely new cans of most unpleasant
worms.

Maintaining Good Records Is Not an Elective

Thus determining and maintaining accurate cost basis information on
mutual funds is not an elective; it is a requirement of the law. In
fact, it is essential that every investor maintain a complete
chronology of all mutual fund transactions. This chronology should
be maintained not only during the period of ownership but for as
long as six years after the last shares of a given mutual fund are
sold--under some circumstances, the IRS has that much time to pull
an audit.

Investors tend to go to extremes when it comes to retaining mutual
fund confirmation statements. They either toss them all out--
retaining only the last statement--or they maintain every statement
they've ever received. Although it's a lot easier to handle the
latter situation than the former, keeping only the minimum required
statements makes a lot more sense. If the average cost basis method
will be used, retaining just the last confirmation statement each
year is enough--the one that shows the cumulative summary of all
transactions for that year. Moreover, the summary statement should
be retained as a permanent record for at least six years following
the sale of the last of the shares in the account.

Good Records Result in Lower Taxes

Fortunately, there is a benefit for the investor from all this
recordkeeping. Most investors overstate profits from their mutual
fund sales because of poor records. These overstatements inevitably
are the result of failing to take into consideration the fact that
tax has already been paid on reinvested distributions that have
therefore increased the cost basis. Ironically, it is the investor
who fails to keep good records that falls victim to this tax trap.
Thus, good records not only confirm the proper payment of taxes,
but they help you avoid possible overstatements of profits as well.

Using the Worksheet

The data entry rules are presented below:

1) The dollar value of a purchase or reinvestment should be entered
in column E as a positive number with
the price per share entered in column F also as a positive
number.

2) The dollar value of a partial or complete redemption
should be entered in column E as a negative number,
with the price per share entered in column F as a positive
number.

3) The number of shares received as a result of a stock
split or stock dividend should be entered in column G as
a positive number, with zeros entered in columns E & F.

4) The dollar value of amounts determined to be a re-
turn of capital should be entered in column E as a nega-
tive number, and zero entered in column F.

The Wash Sale Rule

As previously stated, the wash sale rule prohibits an
investor from selling an asset to realize a tax loss if the
purchase and sale of the same asset should occur within 30 days of
each other. If this happens, that portion of the tax loss
attributable to the repurchase cannot be declared. In the case of
mutual funds, the wash sale rule can be triggered accidentally.

Here's an example of the problem: A capital gains distribution is
reinvested a few days after the investor requests a partial
liquidation. Because the cost basis of the redeemed shares exceeds
the selling price, the investor anticipates declaring a tax loss.
What a surprise to learn the capital gains distribution took place
within 30 days of the redemption. The wash sale rule would not have
been a factor had the redemption resulted in a profit.

Three actions can be taken to avoid the problem--and again,
remember, if the redemption will produce a profit, the wash rule
won't be applicable. First, prior to initiating the redemption,
contact the fund to determine the date for their next capital gains
distribution, so that the conflict, if it does occur, won't be an
accident. Secondly, notify the fund not to reinvest that particular
capital gains distribution; instead, have it distributed as cash.
Lastly, if all else fails, adjust the cost basis of the remaining
shares to reflect the fact that a portion of the loss was
disallowed.

Conclusion

The moral of the story is indeed simple--it is absolutely vital for
mutual fund investors to keep complete records of purchases,
redemptions, splits, and even gifts, whether to family members or
to charities. In the case of charitable gifts, records should also
be maintained of the fair market value at the close of business on
the day the gift is officially accepted.

But, retaining fund confirmation statements isn't enough. Such
statements are not adequate to establish the cost basis of an
investor's holdings. An investor should establish and maintain cost
basis worksheets as well. By doing so, tax problems and income
taxes can both be minimized.

(c) Copyright 1991 by the
American Association of Individual Investors