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How is capital gain distribution calculated?

  1. I wonder what differences and relations are between capital gain distribution and capital gain/loss?

    Line 13 of IRS Form 1040 asks for capital gain and loss, but its instructions seem to say that capital gain distribution is reported on Line 13. I wonder if rigorously speaking, IRS messes up the difference between capital gain distribution and capital gain/loss?

  2. How is capital gain distribution related to whether capital gain/loss is realized or unrealized?

    Through 2011, I had been holding a mutual fund without selling it. So there is no realized capital gain or capital loss. I receive capital gain distribution at the end of the year.

    If capital gain distribution is calculated based on realized capital gain or capital loss, Why did I receive capital gain distribution?

    Does it mean that capital gain distribution is calculated based on unrealized instead of realized capital gain or capital loss?

  3. Is capital gain distribution taken from my shares?

    I was talking to a representative of a brokery company, who said that capital gain distribution is caculated based on my share values, but not taken from my shares.

    But I saw some definition on investorwords saying that "capital gains distributions reduce the value of the fund". Does it mean that it reduces the value per share?

    So I wonder if the two sayings are contrary to each other?

  4. My capital gain distribution was automatically used for reinvestment. Do I need to report it on Line 13 of Form 1040?

    Does investorwords say no need, by"many funds allow automatic reinvestment of capital gains, instead of distribution. ... Also, these distributions are taxable income for the recipient, so funds that allow reinvestment instead of distribution are sometimes preferred by investors in high tax brackets."?

Thanks and regards!

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1 Answer

up vote 6 down vote accepted

Edited in the light of comments and follow-on questions

Your mutual fund manager buys and sells securities in pursuit of the investment strategies of the fund as well as to invest new money coming in and to pay out investors wanting to take their money elsewhere.
This results in capital gains and losses for the fund. The net capital gain is taxable income (at corporate rates) to the fund unless the fund distributes the gains to the shareholders in which case the investors have to pay the taxes on the gains that they receive. For what happens if the fund experiences a net capital loss, see this answer to a related question.

You have to report the capital gains distributions from a mutual fund regardless of whether you chose to re-invest in the fund or received the distribution in cash, or had directed your broker (or the fund company) to reinvest the distribution into another fund etc. You do not report or pay taxes on any changes in the value of your mutual fund investment as share prices of the securities of the fund fluctuate; only when you sell any shares do you have a capital gain or capital loss on that portion of your investment.

With regard to your question about "taking from your shares", the value of your mutual fund shares is determined by the net value of the underlying securities held by the mutual fund plus any cash held by the mutual fund. When the mutual fund makes a capital gain (or dividend) distribution to its shareholders, the mutual fund assets decline in value by the amount of the distribution because that money is out the door. Consequently the share value falls proportionally. For those who choose to re-invest in the fund, they get to buy the fund at the reduced value. Put another way, suppose you bought 100 shares at $8 per share on January 1, 2010. Your basis (the amount invested) is thus $800. In 2010, the net capital gains of the fund were 0 and no distribution was made. In late 2011, the mutual fund shares were valued at $10 and so you have a unrealized gain of $200, not reportable, not taxable etc. But suppose that during 2011, the fund sold some securities for a capital gain, and so in late 2011, it made a distribution of $1 per share and "sent you" $100. After this distribution, each of your shares would have value only $9, and your net wealth would be $900 in shares plus $100 in cash. If you have chosen to reinvest the $100 in new shares, you would be buying 100/9 shares at $9 dollars each so that you now own (100+100/9) shares valued at $9 each, making your net wealth $(100 + 100/9)x9 = $1000 just as before. No change in value, but you have to report the $100 received on your tax return and pay taxes on the $100 received, even though you reinvested the whole amount. But now your basis in the fund is $900; the amount $800 you originally invested plus the $100 you plowed back into the fund. If at a later time, you decide to get out of the mutual fund, and the share price is still $9 that day, you will get $1000 for your 100+100/9 = 111.1111111 shares. Only $100 of that amount is taxable since your basis is $900. The point of JoeTaxpayer's comment below is that far too many people forget to add the reinvested amounts into the basis and say "I put in $800, got $1000 back, and so I owe taxes on $200 profit" quite forgetting that they actually invested $900, or equivalently, that they already paid taxes on 100 of the 200 dollars, and so taxes are owed only on the remaining $100.

(note from JoeTaxpayer added) - If reinvested, you must add the $100 to your basis, the same as if 'new' money came in. This point is often missed and tax paid twice in error.

There have been several years in the recent past where mutual funds declined in value over the course of a year (unrealized capital loss for the share holder) but still paid capital gains distributions which had to be reported and on which tax had to be paid.

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+1, I added one note to clarify what I though was an important point. Hope you're ok with that. –  JoeTaxpayer Apr 12 '12 at 21:21
@JoeTaxpayer: For your added part "If reinvested, you must add the $100 to your basis, the same as if 'new' money came in. This point is often missed and tax paid twice in error." (1) What is "basis"? What is a position then? Are they the same? (2) How is "tax paid twice" like? Why treating reinvestment as new money coming in will avoid "tax paid twice"? Thanks! –  Tim Apr 14 '12 at 12:00
Dilip: Very well written and helpful. Thanks! +1 –  Tim Apr 14 '12 at 12:05
I will stand by for a bit and let Dilip add to the answer if he wishes. Else, I'll update. it's too long to add as comment. (I'm sure he knows my train of thought on this) –  JoeTaxpayer Apr 14 '12 at 16:59
@Tim Thanks. I revised my answer to incorporate answers to your additional questions. If you like it, please consider accepting it so that this question is laid to rest. –  Dilip Sarwate Apr 15 '12 at 2:31
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