I have both purchased and sold shares in a money-market mutual fund. The fund is managed so the share price is constant. All gain is reported as dividends. Do I have to report the sale of these shares?

Yes, you report the sale of your shares on Form 1040, Schedule D (PDF), Capital Gains and Losses. Generally, whenever you sell, exchange, or otherwise dispose of a capital asset, you report it on Schedule D.

If the share price were constant, you would have neither a gain nor a loss when you sell shares because you are selling the shares for the same price you purchased them.

If you actually owned shares that were later sold, the fund or the broker should have issued a Form 1099-B There is no requirement with that form that there be gain or loss on the sale, only a sale or exchange of an investment asset and sales proceeds.

How do return of principal payments affect my cost basis when I sell mutual funds?

A return of principal (or return of capital) reduces your basis in your mutual fund shares. Unlike a dividend or a capital gain distribution, a return of capital is a return of part of your investment (cost). However, basis cannot be reduced below zero. Once your basis reaches zero, any return of principal is capital gain and must be reported on Form 1040 Schedule D (PDF), Capital Gains and Losses.

How do I calculate the average basis for the sale of mutual fund shares?

In order to figure your gain or loss using an average basis, you must have acquired the shares at various times and prices and have left them on deposit in a managed account.

There are two average basis methods:

Single-category method. First, add up the cost of all the shares you own in the mutual fund. Divide that result by the total number of shares you own. This gives you your average per share. Multiply that number by the number of shares sold.

Double-category method. First, divide your shares into two categories, long-term and short-term. Then use the steps above to get an average basis for each category. The average basis for that category is then the basis of each share in the sale from that category.

Once you elect to use an average basis method, you must continue to use it for all accounts in the same fund. You must clearly identify on your tax return the average basis method that you have elected to use. You do this identification by including "AVGB" in column (a) of Form 1040, Schedule D (PDF) .

Refer to Publication 564 , Mutual Fund Distributions, Sales, Exchanges and Redemptions .

If I used an average basis method for shares of one mutual fund I sold, do I have to use it for all mutual funds I sell?

No, you may use a different method, as long as you have not used an average basis method for that fund previously. Once you have elected to use an average basis method to compute the gain or loss on shares in a mutual fund, you must use that same method for the sale of shares from any account in that same fund.

How do I calculate the average cost method of a mutual fund if the fund price splits?

If your mutual fund splits, or adjusts its price, it is treated like a stock split. Your total basis doesn't change after the split, but since you now own more shares without paying any more money, your per-share basis will decrease. To calculate your per-share basis, divide the total cost that you have invested in the fund (minus any shares previously sold) by the current number of shares that you hold.

I received a 1099-DIV showing a capital gain. Why do I have to report capital gains from my mutual funds if I never sold any shares?

A mutual fund is a regulated investment company that pools funds of investors allowing them to take advantage of a diversity of investments and professional asset management. You own shares in the fund, but the fund owns assets such as shares of stock, corporate bonds, government obligations, etc. One of the ways the fund makes money for its investors is to sell these assets at a gain. If the asset was held by the mutual fund for more than one year, the nature of the income is capital gain, which gets passed on to you. These are called capital gain distributions, which are distinguished on Form 1099-DIV (PDF) , from income that is from other profits, called ordinary dividends.

Capital gains distribution are taxed as long term capital gains regardless of how long you have owned the shares in the mutual fund. If your capital gains distribution is automatically reinvested, the reinvested amount is the basis of the additional shares purchased.