Sales, Exchanges, & Redemptions

When you sell or exchange your mutual fund shares, or if they are redeemed (a redemption), you will generally have a taxable gain or a deductible loss. This also applies to shares of a tax-exempt mutual fund. Sales, exchanges, and redemptions are all treated as sales of capital assets. The amount of the gain or loss is the difference between your adjusted basis (defined earlier) in the shares and the amount you realize from the sale, exchange, or redemption. This is explained further under Gains and Losses, later.

Sale. In general, a sale is a transfer of shares for money only.

Exchange. An exchange is a transfer of shares in return for other shares.

Redemption. A redemption occurs when a fund reacquires its shares from you in exchange for money or other property.

Recordkeeping. When there is a sale, exchange, or redemption of your shares in a fund, keep the confirmation statement you receive. The statement shows the price you received for the shares and other information you need to report gain or loss on your return.

Exchange of shares in one mutual fund for shares in another mutual fund. Any exchange of shares in one fund for shares in another fund is a taxable exchange. This is true even if you exchange shares in one fund for shares in another fund within the same family of funds. Report any gain or loss on the shares you gave up as a capital gain or loss in the year in which the exchange occurs. Usually, you can add any service charge or fee paid in connection with an exchange to the cost of the shares acquired. For an exception, see Commissions and load charges under Shares Acquired by Purchase, earlier.

Information returns. Mutual funds and brokers must report proceeds from sales, exchanges, or redemptions to the Internal Revenue Service. They must give each customer a written statement with that information by January 31 of the year following the calendar year the transaction occurred. Form 1099-B, or a substitute, may be used for this purpose.

Report your sales shown on Form(s) 1099-B (or substitute) on Schedule D (Form 1040) along with your other gains and losses. If the total of the sales price amounts reported on Form(s) 1099-B in box 2 is more than the total you report on lines 3 and 10 of Schedule D, attach a statement to your return explaining the difference.

Taxpayer identification number. You must give the broker your correct taxpayer identification number (TIN). Generally, an individual will use his or her social security number as the TIN.

If you do not provide your TIN, your broker is required to withhold tax on the gross proceeds of a transaction. For 2002, the withholding rate is 30%. In addition, you may be penalized.

Identifying the Shares Sold

To figure your gain or loss when you dispose of mutual fund shares, you need to determine which shares were sold and the basis of those shares. If your shares in a mutual fund were acquired all on the same day and for the same price, figuring their basis is not difficult. However, shares are generally acquired at various times, in various quantities, and at various prices. Therefore, figuring your basis can be more difficult. You can choose to use either a cost basis or an average basis to figure your gain or loss.

Cost Basis

You can figure your gain or loss using a cost basis only if you did not previously use an average basis for a sale, exchange, or redemption of other shares in the same mutual fund.

To figure cost basis, you can choose one of the following methods.

• Specific share identification.
• First-in first-out (FIFO).

Specific share identification. If you adequately identify the shares you sold, you can use the adjusted basis of those particular shares to figure your gain or loss.

You will adequately identify your mutual fund shares, even if you bought the shares in different lots at various prices and times, if you:

1. Specify to your broker or other agent the particular shares to be sold or transferred at the time of the sale or transfer, and
2. Receive confirmation of your specification from your broker in writing within a reasonable time.

The confirmation by the mutual fund must confirm that you instructed your broker to sell particular shares. You continue to have the burden of proving your basis in the specified shares at the time of sale or transfer.

First-in first-out (FIFO). If your shares were acquired at different times or at different prices and you cannot identify which shares you sold, use the basis of the shares you acquired first as the basis of the shares sold. In other words, the oldest shares you own are considered sold first. You should keep a separate record of each purchase and any dispositions of the shares until all shares purchased at the same time have been disposed of completely.

Table 3 illustrates the use of the FIFO method to figure the cost basis of shares sold, compared with the use of the single-category method to figure average basis (discussed next).

Average Basis

You can figure your gain or loss using an average basis only if you acquired the shares at various times and prices, and you left the shares on deposit in an account handled by a custodian or agent who acquires or redeems those shares.

To figure average basis, you can use one of the following methods.

• Single-category method.
• Double-category method.

Once you elect to use an average basis, you must continue to use it for all accounts in the same fund. (You must also continue to use the same method.) However, you may use the cost basis (or a different method of figuring the average basis) for shares in other funds, even those within the same family of funds.

Example. You own two accounts that hold shares of the income fund issued by Company A. You also own 100 shares of the growth fund issued by Company A. If you elect to use average basis for the first account of the income fund, you must use average basis for the second account. However, you may use cost basis for the growth fund.

You may be able to find the average basis of your shares from information provided by the fund.

Single-category method. Under the single-category method, you find the average basis of all shares owned at the time of each disposition, regardless of how long you owned them. Include shares acquired with reinvested dividends or capital gain distributions.

Table 3 illustrates the use of the single-category method to figure the average basis of shares sold, compared with the use of the FIFO method to figure cost basis (discussed earlier).

Even though you include all unsold shares of a fund in a single category to compute average basis, you may have both short-term and long-term gains or losses when you sell these shares. To determine your holding period, the shares disposed of are considered to be those acquired first.

Example. You bought 400 shares in the LJO Mutual Fund: 200 shares on May 15, 2000, and 200 shares on May 15, 2001. On November 11, 2001, you sold 300 shares. The basis of all the shares sold is the same, but the holding period of 200 shares is long-term and the holding period of 100 shares is short-term.

How to figure the basis of shares sold. To figure the basis of shares you sell, use the steps in the following worksheet.

Example 1. You bought 300 shares in the LJP Mutual Fund: 100 shares in 1998 for $1,000 ($10 per share); 100 shares in 1999 for $1,200 ($12 per share); and 100 shares in 2000 for $2,600 ($26 per share). Thus, the total cost of your shares was $4,800 ($1,000 + $1,200 + $2,600). On May 16, 2001, you sold 150 shares. The basis of shares you sold is $2,400 ($16 per share), figured as follows.

Remaining shares. The average basis of the shares you still hold after a sale of some of your shares is the same as the average basis of the shares sold. The next time you make a sale, your average basis will still be the same, unless you have acquired additional shares (or have made a subsequent adjustment to basis).

Example 2. Using the same facts as in Example 1, assume you sold an additional 50 shares on December 15, 2001. You would not recompute the average basis of the 150 shares you owned at that time because no shares were acquired or sold since the last sale; rather, your basis is the $16 per share figured earlier.

Example 3. Using the same facts as in Example 1, assume you bought an additional 150 shares at $14 a share on September 19, 2001, and then sold 50 shares on December 15, 2001. The total adjusted basis of all the shares you owned just before the sale is $4,500, figured as follows.

The basis of the shares sold is $750 ($15 a share), figured as follows.

Double-category method. In the double-category method, all shares in an account at the time of each disposition are divided into two categories: short-term and long-term. Shares held one year or less are short-term. Shares held longer than one year are long-term.

The basis of each share in a category is the average basis for that category. This is the total remaining basis of all shares in that category at the time of disposition divided by the total shares in the category at that time. To use this method, you specify, to the custodian or agent handling your account, from which category the shares are to be sold or transferred. The custodian or agent must confirm in writing your specification. If you do not specify or receive confirmation, you must first charge the shares sold against the long-term category and then charge any remaining shares sold against the short-term category.

Changing categories. After you have held a mutual fund share for more than one year, you must transfer that share from the short-term category to the long-term category. The basis of a transferred share is its actual cost or other basis to you unless some of the shares in the short-term category have been disposed of. In that case, the basis of a transferred share is the average basis of the undisposed shares at the time of the most recent disposition from this category.

Making the choice. You choose to use the average basis of mutual fund shares by clearly showing on your income tax return, for each year the choice applies, that you used an average basis in reporting gain or loss from the sale or transfer of the shares. You must specify whether you used the single-category method or the double-category method in determining average basis. This choice is effective until you get permission from the IRS to revoke it.

Shares received as gift. If your account includes shares that you received by gift, and the fair market value of the shares at the time of the gift was not more than the donor's basis, special rules apply. You cannot choose to use the average basis for the account unless you submit a statement with your initial choice. It must state that the basis used in figuring the average basis of the gift shares will be the FMV at the time of the gift. This statement applies to gift shares received before and after making the choice, as long as the choice to use the average basis is in effect.

Gains and Losses

You figure gain or loss on the disposition of your shares by comparing the amount you realize with the adjusted basis of your shares. If the amount you realize is more than the adjusted basis of the shares, you have a gain. If the amount you realize is less than the adjusted basis of the shares, you have a loss.

Amount you realize. The amount you realize from a disposition of your shares is the money and value of any property you receive for the shares disposed of, minus your expenses of sale (such as redemption fees, sales commissions, sales charges, or exit fees).

Adjusted basis. Adjusted basis is explained under Keeping Track of Your Basis, earlier. Also see the explanations of cost basis and average basis under Identifying the Shares Sold, earlier.

Wash sales. If you sell mutual fund shares at a loss and within 30 days before or after the sale you buy, acquire in a taxable exchange, or acquire a contract or option to buy substantially identical shares, you have a wash sale. You cannot deduct losses from wash sales.

Substantially identical. In determining whether the shares are substantially identical, you must consider all the facts and circumstances. Ordinarily, shares issued by one mutual fund are not considered to be substantially identical to shares issued by another mutual fund.

For more information on wash sales, get Publication 550.

Reporting information from Form 1099-B. Mutual funds and brokers report dispositions of mutual fund shares on Form 1099-B, or a substitute form containing substantially the same language. The form shows the amount of the sales price and indicates whether the amount reported is the gross amount or the net amount (gross amount minus commissions).

If your Form 1099-B or similar statement from the payer shows the gross sales price, do not subtract the expenses of sale from it when reporting your sales price in column (d) on Schedule D. Instead, report the gross amount in column (d) and increase your cost or other basis, column (e), by any expense of the sale. If your Form 1099-B shows that the gross sales price less commissions was reported to IRS, enter the net amount in column (d) of Schedule D and do not increase your basis in column (e) by the sales commission.

Example 1. You sold 100 shares of Fund HIJ for $2,500. You paid a $75 commission to the broker for handling the sale. Your Form 1099-B shows that the net sales proceeds, $2,425 ($2,500 - $75), were reported to the IRS. Report $2,425 in column (d) of Schedule D.

Example 2. You sold 200 shares of Fund KLM for $10,000. You paid a $100 commission at the time of the sale. You bought the shares for $5,000. The broker reported the gross proceeds to IRS on Form 1099-B, so you enter $10,000 in column (d) of Schedule D and increase your basis in column (e) to $5,100.

Note. Whether you use Schedule D's line 1 (for a short-term gain or loss) or line 8 (for a long-term gain or loss) depends on how long you held the shares, discussed next.

Holding Period

When you dispose of your mutual fund shares, you must determine your holding period. Your holding period determines whether the gain or loss is a short-term capital gain or loss or a long-term capital gain or loss.

Short-term gain or loss. If you hold the shares for one year or less, your gain or loss will be a short-term gain or loss.

Long-term gain or loss. If you hold the shares for more than one year, your gain or loss will be a long-term gain or loss.

Determining period held. Determine your holding period by using the trade dates of your purchases and your sales. The trade date is the date on which you contract to buy or sell shares. Most mutual funds will show the trade dates on confirmation statements showing your purchases and sales.

Do not confuse the trade date with the settlement date, which is the date by which the mutual fund shares must be delivered and payment must be made.

To find out how long you have held your shares, begin counting on the day after the trade date on which you bought the shares. (Do not count the trade date itself.) The trade date on which you dispose of the shares is counted as part of your holding period.

Example. If you bought shares on January 11, 2000 (trade date), and sold them on January 11, 2001 (trade date), your holding period would not be more than one year. If you sold them on January 12, 2001, your holding period would be more than one year (12 months plus 1 day).

Mutual fund shares received as a gift. If you receive a gift of mutual fund shares and your basis is determined by the donor's basis, your holding period is considered to have started on the same day that the donor's holding period started.

Inherited mutual fund shares. If you inherit mutual fund shares, you are considered to have held the shares for more than one year, regardless of how long you actually held them. Report the sale of inherited mutual fund shares on line 8 of Schedule D and enter "INHERITED" in column (b) instead of the date you acquired the shares.

Reinvested distributions. If your dividends and capital gain distributions are reinvested in new shares, the holding period of each new share begins the day after that share was purchased. Therefore, if you sell both the new shares and the original shares, you might have both short-term and long-term gains and losses.

Certain short-term losses. Special rules may apply if you have a short-term loss on the sale of shares on which you received an exempt-interest dividend or a capital gain distribution.

Exempt-interest dividends before short-term loss. If you received exempt-interest dividends on mutual fund shares that you held for 6 months or less and sold at a loss, you may claim only the part of the loss that is more than the exempt-interest dividends. On Schedule D, column (d), increase the sales price by the amount of exempt-interest dividends. Report the loss as a short-term capital loss.

Example. On January 8, 2001, you bought a mutual fund share for $40. On February 3, 2001, the mutual fund paid a $5 dividend from tax-exempt interest, which is not taxable to you. On February 12, 2001, you sold the share for $34. If it were not for the tax-exempt dividend, your loss would be $6 ($40 - $34). However, you must increase the sales price from $34 to $39 (to account for the $5 portion of the loss that is not deductible). You can deduct only $1 as a short-term capital loss.

Capital gain distribution before short-term loss. Generally, if you received capital gain distributions (or had to report undistributed capital gains) on mutual fund shares that you held for 6 months or less and sold at a loss, report only the part of the loss that is more than the capital gain distribution (or undistributed capital gain) as a short-term capital loss. The rest of the loss is reported as a long-term capital loss.

Example. On April 7, 2001, you bought a mutual fund share for $20. On June 25, 2001, the mutual fund paid a capital gain distribution of $2 a share, which is taxed as a long-term capital gain. On July 13, 2001, you sold the share for $17.50. If it were not for the capital gain distribution, your loss would be a short-term loss of $2.50. However, the part of the loss that is not more than the capital gain distribution ($2) must be reported as a long-term capital loss. The remaining $0.50 of the loss can be reported as a short-term capital loss.

How To Figure Net Gain or Loss

Separate your short-term gains and losses from your long-term gains and losses on all the mutual fund shares and other capital assets you disposed of during the year. Then determine your net short-term gain or loss and your net long-term gain or loss.

Net short-term capital gain or loss. Net short-term capital gain or loss is determined by adding the gains and losses from lines 1 through 6 in column (f) of Part I, Schedule D (Form 1040), Capital Gains and Losses. Line 7 is the net short-term capital gain or loss.

Net long-term capital gain or loss. Net long-term capital gain or loss is determined by adding the gains and losses from lines 8 through 14 in column (f) of Part II, Schedule D (Form 1040). Line 16 is the net long-term capital gain or loss.

In figuring the net long-term capital gain or loss, you should include any undistributed capital gain you reported on line 11 of Schedule D and any capital gain distributions you reported on line 13 of Schedule D.

Total net gain or loss. The total net gain or loss is determined by combining the net short-term capital gain or loss on line 7 with the net long-term capital gain or loss on line 16. Enter the result on line 17 of Part III, Schedule D (Form 1040). If line 17 shows a gain, enter the amount on line 13 of Form 1040. If line 17 shows a loss, see Limit on Capital Loss Deduction, later.

Figuring Your Tax

If you are reporting capital gain distributions on Form 1040A, use the Capital Gain Tax Worksheet in the Form 1040A instructions to figure your tax. See How To Report, earlier, to see whether you can report your capital gain distributions on Form 1040A.

If you are reporting capital gain distributions on Form 1040, but are not required to file Schedule D, use the Capital Gain Tax Worksheet in the Form 1040 instructions to figure your tax. See How To Report, earlier, to see whether you must file Schedule D.

If you are required to file Schedule D, you will need to use Part IV of Schedule D (Form 1040) to figure your tax if both of the following are true.

1. You have a net capital gain. You have a net capital gain if both lines 16 and 17 of Schedule D are gains.
2. Your taxable income on Form 1040, line 39, is more than zero.

If you have any collectibles gain, gain on qualified small business stock, or unrecaptured section 1250 gain, you may also have to use the Schedule D Tax Worksheet in the Schedule D instructions to figure your tax. See the directions below line 19 of Schedule D.

Capital Gain Tax Rates

The tax rates that apply to a net capital gain are generally lower than the tax rates that apply to other income. These lower rates are called the maximum capital gain rates.

The term "net capital gain" means the amount by which your net long-term capital gain for the year is more than any net short-term capital loss.

The maximum capital gain rate can be 8%, 10%, 20%, 25%, or 28%. See Table 4.

The maximum capital gain rate does not apply if it is higher than your regular tax rate.

Table 4. What Is Your Maximum Capital Gain Rate?

Example. You have a capital gain distribution that is a section 1202 gain, so the maximum capital gain rate on the distribution is 28%. Because you are single and your taxable income is $25,000, your regular tax rate is 15%. All your taxable income will be taxed at the 15% rate. The 28% rate does not apply.

8% rate. Beginning in 2001, the 10% capital gain rate is lowered to 8% for "qualified 5-year gain."

Qualified 5-year gain. Qualified 5-year gain is capital gain from the sale of property that was held for more than 5 years.

Note. Your mutual fund may issue Form 1099-DIV or Form 2439 showing qualified 5-year gain. Enter these amounts and any other qualified 5-year gain on the Qualified 5-Year Gain Worksheet, in the instructions for Schedule D (Form 1040).

18% capital gain rate. Beginning in 2006, the 20% capital gain rate will be lowered to 18% for qualified 5-year gain. The holding period for the property sold must have begun after 2000.

Election to recognize gain on certain mutual fund shares held on January 1, 2001. To qualify future gains for the 18% rate, you can elect to treat certain assets you held on January 1, 2001, as having been sold and then repurchased. The assets eligible for this treatment include shares issued by an open-end mutual fund.

Shares for which the election is made are deemed to have been sold at the closing market price on January 2, 2001, and repurchased on the same date for the same amount. You must pay tax for 2001 on any gains resulting from this election. The holding period of your shares, which will have to be more than 5 years to qualify future gains for the 18% rate, begins on the repurchase date.

A loss from a deemed sale of shares is not allowed, but your basis for figuring future gains or losses is the closing market price on the date of the deemed sale and repurchase.

You cannot make this election for any shares that you disposed of (in a transaction in which gain or loss is recognized in whole or in part) within the 1-year period beginning on the date the shares would have been treated as sold under the election.

How to make the election. Report the deemed sale on your 2001 tax return. If the deemed sale results in a loss, enter zero instead of the amount of the loss. Attach a statement to the return stating that you are making an election under section 311 of the Taxpayer Relief Act of 1997 and specifying the shares for which you are making the election. If a valid election is made, it is irrevocable.

Limit on Capital Loss Deduction

If line 17 of Part III, Schedule D (Form 1040) shows a loss, your allowable capital loss deduction is the smaller of:

1. $3,000 ($1,500 if you are married and filing a separate return), or
2. Your total net loss shown on line 17 of Schedule D.

Enter your allowable loss on line 13 of Form 1040.

Example. Bob and Gloria sold all of their shares in a mutual fund. The sale resulted in a capital loss of $7,000. They had no other sales of capital assets during the year. On their joint return, they can deduct $3,000, which is the smaller of their loss or the net capital loss limit.

If Bob and Gloria's capital loss had been $2,000, their capital loss deduction would have been $2,000, because it is less than the $3,000 limit.

Capital loss carryover. If your total net loss is more than your allowable capital loss deduction, you may carry over the excess to later years until it is completely used up. To determine your capital loss carryover, subtract from your total net loss the lesser of:

1. Your allowable capital loss deduction for the year, or
2. Your taxable income increased by your allowable capital loss deduction for the year and by your deduction for personal exemptions.

If your deductions exceed your gross income, you start the computation in (2) above with a negative number.

Use the Capital Loss Carryover Worksheet in the Schedule D instructions to figure your capital loss carryover.

When carried over, the loss will keep its original character as long-term or short-term. Therefore, a long-term capital loss carried over from a previous year will offset long-term gains of the current year before it offsets short-term gains of the current year. For more information on figuring capital loss carryovers, get Publication 550.

Separate returns. Capital loss carryovers from separate returns are combined if you now file a joint return. However, if you once filed jointly and are now filing separately, a capital loss carryover from the joint return can be deducted only on the separate return of the spouse who actually had the loss.

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