Mutual Funds/cost at selling fund

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Question
QUESTION: Hi, I need your advice and help
I bought a fund 500 shares at $20/sh total $10,000 in 2005. The total dividend in 7 years is $2,200 (that  I reported as taxable income), total capital gain $1,000 (that  I reported as taxable income),  and the total no-dividend distribution is $5,200 (that I did not report as income).
If I sell the fund, the cost will be  
1). $10,000 + $2,200+$1,000 =$13,200 (original cost + dividend +capital gain) or  
2). $10,000+$2,200=$12,200 (original cost + dividend) or
3). $10,000 + $2,200+$1,000 -$4,200=$9,000 (original cost + dividend +capital gain- nodividend distribution)  or  
4).$10,000 + $2,200 -$4,200= $8,000(original cost + dividend - nodividend distribution)
Which one is correct?
In 2009, the total dividend was $0, but the no-dividend distribution was $890. When sell it, why should I reduce the cost by $890 that I had never received?
Sincerely,
David yu

ANSWER: David:

This is the answer from Kenneth B. Shapiro, CPA/PFS, CFP, of the Shapiro Security Financial Group in Hazlet, N.J. -- Warren

It is usually pretty easy for investors to identify that the tax cost for an initial investment to be what was paid for the investment.
It is also common for taxpayer to understand that if all of the future distributions received from the fund were paid in cash to the investor, that the distributions should as a general rule be reported as taxable income in the calendar year received.  The distributions are taxable to the investor because the company made a profit during the year, and has voted to share part of that income with the investor.

Just because an investor does not physically receive the distribution, does not mean the distribution would not be taxable.  An investor often has "constructive receipt" of the income, when at the time the investment is made or the distribution was declared, they had the choice whether to receive the distribution as cash or have the amount directly reinvested to purchase more shares.

If payment was made in cash, and an investor includes the distribution as taxable income, the "after-tax" proceeds are available for reinvestment.  If the investor elects to send more money to the fund to make subsequent purchases, or voluntarily leaves the distribution with the fund for direct reinvestment into the fund, there is a new cost being established for the additional shares acquired.  This new cost should then be added to the original cost to calculate a new overall cost for the investment

In the example provided, the initial cost would be the $10,000 for the original 500 shares purchased at $20 per share.  As the $2,200 in regular dividends and the $1,000 in capital gain dividends  were used to acquire additional shares, there investor initially increased the total cost in to the investment by $3,200 to $13,200.

There are some transactions that exist where distributions are made to a shareholder that are classified as a "non-taxable, return of capital" distributions.  This usually happens when the company has lost money, yet still votes to make a distribution to its shareholders.  For tax purposes, the investor does not include the value received as income, but instead is required to reduce their total cost in the investment by the amount of the non-taxable distribution received.

If the amount of the distribution received is greater than the taxpayer's "total cost",  the investor is treated as recovering all of their original investment with the excess creating a capital gain.  This would be the same result had the investor sold the investment for the same amount of the "non-taxable" distribution.

Using the facts of this case, if the taxpayer elected to keep this special distribution and not reinvest the amount into the company, the taxpayer should reduce the $13,200 prior cost by the $5,200 non-taxable distribution, resulting in a remaining "adjusted cost" for the shares still owned of $8,000.

If the taxpayer takes only $2,600 or one-half received from the distribution, or from any other source and acquires more shares with the $2,600, the "adjusted cost" after the purchase would go back up to the $10,600.  Based upon the fact pattern, it sounds like the taxpayer reinvested the entire $5,200 distribution, increasing the "adjusted cost" after the purchase back up to $13,200.


Let me know if you have any questions


---------- FOLLOW-UP ----------

QUESTION: Dear Mr. Warren Boroson: Thank you very much for your prompt and detailed reply even during the holiday season that I am so impressed. But I still have some questions.
1 The nondividend distribution happens when the company lost money. In my case In 2009, the total dividend was $0, but the no-dividend distribution was $890. Even I had elected taking the dividend, I received $0. Should the adjusted cost be reduced by $890? or $0?
2 When bought the fund, I elected reinvesting dividend and capital gain (never took out any of them but paid tax on them). It must include the no-dividend distribution. If it is correct that the no-dividend distribution will not reduce the adjusted cost, or my adjusted cost at selling is $13,200 ?

Thanks again! Merry Christmas!
David

Answer
Here is Ken Shapiro's followup answer:


The fact pattern in the question is a little ambiguous, but I'm responding to what I believe the person is asking.  I am assuming that all of the dividends received were reinvested to acquire additional shares of the fund.

It is usually pretty easy for investors to identify that the tax cost for an initial investment to be what was paid for the investment.
It is also common for taxpayer to understand that if all of the future distributions received from the fund were paid in cash to the investor, that the distributions should as a general rule be reported as taxable income in the calendar year received.  The distributions are taxable to the investor because the company made a profit during the year, and has voted to share part of that income with the investor.

Just because an investor does not physically receive the distribution, does not mean the distribution would not be taxable.  An investor often has "constructive receipt" of the income, when at the time the investment is made or the distribution was declared, they had the choice whether to receive the distribution as cash or have the amount directly reinvested to purchase more shares.

If payment was made in cash, and an investor includes the distribution as taxable income, the "after-tax" proceeds are available for reinvestment.  If the investor elects to send more money to the fund to make subsequent purchases, or voluntarily leaves the distribution with the fund for direct reinvestment into the fund, there is a new cost being established for the additional shares acquired.  This new cost should then be added to the original cost to calculate a new overall cost for the investment

In the example provided, the initial cost would be the $10,000 for the original 500 shares purchased at $20 per share.  As the $2,200 in regular dividends and the $1,000 in capital gain dividends  were used to acquire additional shares, there investor initially increased the total cost in to the investment by $3,200 to $13,200.

There are some transactions that exist where distributions are made to a shareholder that are classified as a "non-taxable, return of capital" distributions.  This usually happens when the company has lost money, yet still votes to make a distribution to its shareholders.  For tax purposes, the investor does not include the value received as income, but instead is required to reduce their total cost in the investment by the amount of the non-taxable distribution received.

If the amount of the distribution received is greater than the taxpayer's "total cost",  the investor is treated as recovering all of their original investment with the excess creating a capital gain.  This would be the same result had the investor sold the investment for the same amount of the "non-taxable" distribution.

Using the facts of this case, if the taxpayer elected to keep this special distribution and not reinvest the amount into the company, the taxpayer should reduce the $13,200 prior cost by the $5,200 non-taxable distribution, resulting in a remaining "adjusted cost" for the shares still owned of $8,000.

If the taxpayer takes only $2,600 or one-half received from the distribution, or from any other source and acquires more shares with the $2,600, the "adjusted cost" after the purchase would go back up to the $10,600.  Based upon the fact pattern, it sounds like the taxpayer reinvested the entire $5,200 distribution, increasing the "adjusted cost" after the purchase back up to $13,200.  

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Warren Boroson

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Author of "Keys to Investing in Mutual Funds" (Barrons), "Ultimate Mutual Fund Guide" (Probus), "How to Pick Stocks Like Warren Buffett" (JKLasser), and "The Reverse Mortgage Advantage" (McGraw-Hill). Former financial columnist for Gannett News Service.

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Author of 20 books; winner of 1996 Personal Finance award from Investment Company Institute and Washington University. Formerly on staffs of Money and Sylvia Porter's Magazine. Had a radio program (on WEVD) about mutual funds and a newsletter, FundDigest.

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