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From Wikipedia

Mutual funds pass taxable income on to their investors annually. The type of income they earn is unchanged as it passes through to the shareholders. For example, mutual fund distributions of dividend income are reported as dividend income by the investor. There is an exception: net losses incurred by a mutual fund are not distributed or passed through to fund investors.

I was wondering how to understand the last paragraph?

For example, after an investor purchases some shares of a mutual fund, he has

  • a net capital loss X (>0) in the first year,
  • a net capital gain Y (>0) in the second year,
  • a net capital gain Z (>0) in the third year, and then he sells all of his shares at the end of the third year.

According to the last sentence in the quote, is it correct that

  • for tax report of the first year, the net capital loss x is not reported for tax purpose,
  • for tax report of the second year, he has to pay the tax on the net capital gain Y,
  • for tax report of the third year, since he sells all his shares at the end of the third year, he has a net capital gain Y+Z-X and has to pay the tax on Y+Z-X.

If it is correct, I think it is not fair, because in the ideally fair case, he should have a net capital loss X reported for the first year and does not have to pay tax for the first year, and then he can use this loss to offset the net capital gains Y and Z in the second year and the third one. So he only has to pay the tax on Y+Z-X, the capital gain offset by the the capital loss.

So I wonder if my understanding is correct? If not, how shall I understand it?

Thanks and regards!

  • possible duplicate of "Cap gains exposure" of an ETF -- what does it mean? – Dilip Sarwate Jun 2 '12 at 12:57
  • You asked about capital gains in another question and in my answer there (which you accepted), I had pointed you to an answer to a different question "Cap gains exposure..." which fully explained what happens to capital losses in a mutual fund. Please read these items again. For these reasons, I have voted to close this question. Answering it will just be a rehash of what has been said (and accepted) before. – Dilip Sarwate Jun 2 '12 at 13:04
  • @DilipSarwate: Thanks for pointing out your replies! I think I didn't actually understand them. I have held two mutual funds (FSEAX and MCHFX) since the end of 2007, and up to now lost more than 50% of my original investment. (1) I don't know why I still get much smaller amounts of capital gain in 2008, 2010 and 2011 (about 7%, 0.02%, 3% of the original investment respectively), if the loss can be used to offset the gain in the following years? – Tim Jun 2 '12 at 21:33
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    @DilipSarwate: If you don't mind me asking, where did you get that expression "pretty please with sugar and knobs on"? (I've heard "with sugar and a cherry on top," but I've never heard your variant before. Also, does that refer to knobs of butter, or something else?) Oh, and thanks for the sage advice on those quarterly statements. – user6505 Jun 4 '12 at 13:31
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    @DilipSarwate: Just to echo J.R., there's a rather heated discussion going on over in EL&U that was born of your use of this phrase. Any chance you could chime in and offer some clarity? – Callithumpian Jun 5 '12 at 4:30
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When you invest (say $1000) in (say 100 shares) of a mutual fund at $10 per share, and the price of the shares changes, you do not have a capital gain or loss, and you do not have to declare anything to the IRS or make any entry on any line on Form 1040 or tell anyone else about it either. You can brag about it at parties if the share price has gone up, or weep bitter tears into your cocktail if the price has gone down, but the IRS not only does not care, but it will not let you deduct the paper loss or pay taxes on the paper gain.

What you put down on Form 1040 Schedules B and D is precisely what the mutual fund will tell you on Form 1099-DIV (and Form 1099-B), no more, no less.

If you did not report any of these amounts on your previous tax returns, you need to file amended tax returns, both Federal as well as State,

A stock mutual fund invests in stocks and the fund manager may buy and sell some stocks during the course of the year. If he makes a profit, that money will be distributed to the share holders of the mutual fund. That money can be re-invested in more shares of the same mutual fund or taken as cash (and possibly invested in some other fund). This capital gain distribution is reported to you on Form 1099-DIV and you have to report sit on your tax return even if you re-invested in more share of the same mutual fund, and the amount of the distribution is taxable income to you. Similarly, if the stocks owned by the mutual fund pay dividends, those will be passed on to you as a dividend distribution and all the above still applies. You can choose to reinvest, etc, the amount will be reported to you on Form 1099-DIV, and you need to report it to the IRS and include it in your taxable income.

If the mutual fund manager loses money in the buying and selling he will not tell you that he lost money but it will be visible as a reduction in the price of the shares. The loss will not be reported to you on Form 1099-DIV and you cannot do anything about it. Especially important, you cannot declare to the IRS that you have a loss and you cannot deduct the loss on your income tax returns that year.

When you finally sell your shares in the mutual fund, you will have a gain or loss that you can pay taxes on or deduct. Say the mutual fund paid a dividend of $33 one year and you re-invested the money into the mutual fund, buying 3 shares at the then cost of $11 per share. You declare the $33 on your tax return that year and pay taxes on it. Two years later, you sell all 103 shares that you own for $10.50 per share. Your total investment was $1000 + $33 = $1033. You get $1081.50 from the fund, and you will owe taxes on $1081.50 - $1033 = $48.50. You have a profit of $50 on the 100 shares originally bought and a loss of $1.50 on the 3 shares bought for $11: the net result is a gain of $48.50. You do not pay taxes on $81.50 as the profit from your original $1000 investment; you pay taxes only on $48.50 (remember that you already paid taxes on the $33). The mutual fund will report on Form 1099-B that you sold 103 shares for $1081.50 and that you bought the 103 shares for an average price of $1033/103 = $10.029 per share. The difference is taxable income to you.

If you sell the 103 shares for $9 per share (say), then you get $927 out of an investment of $1033 for a capital loss of $106. This will be reported to you on Form 1099-B and you will enter the amounts on Schedule D of Form 1040 as a capital loss.

What you actually pay taxes on is the net capital gain, if any, after combining all your capital gains and losses for the year. If the net is a loss, you can deduct up to $3000 in a year, and carry the rest forward to later years to offset capital gains in later years. But, your unrealized capital gains or losses (those that occur because the mutual fund share price goes up and down like a yoyo while you grin or grit your teeth and hang on to your shares) are not reported or deducted or taxed anywhere.

It is more complicated when you don't sell all the shares you own in the mutual fund or if you sell shares within one year of buying them, but let's stick to simple cases.

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I'll try to answer using your original example. First, let me restate your assumptions, slightly modified:

The mutual fund has:

  • a net realized capital loss of X in year 1
  • a net realized capital gain of Y in year 2
  • a net realized capital gain of Z in year 3

Note that I say the "mutual fund has" those gains and losses. That's because they occur inside the mutual fund and not directly to you as a shareholder. I use "realized" gains and losses because the only gains and losses handled this way are those causes by actual asset (stock) sales within the fund (as directed by fund management). Changes in the value of fund holdings that are not sold are not included in this.

As a holder of the fund, you learn the values of X, Y, and Z after the end of the year when the fund management reports the values. For gains, you will also typically see the values reported on your 1099-DIV under "capital gains distributions". For example, your 1099-DIV for year 3 will have the value Z for capital gains (besides reporting any ordinary dividends in another box).

Your year 1 1099 will have $0 "capital gains distributions" shown because of the rule you highlighted in bold: net realized losses are not distributed.

This capital loss however can later be used to the mutual fund holder's tax advantage. The fund's internal accounting carries forward the loss, and uses it to offset later realized gains. Thus your year 2 1099 will have a capital gain distribution of (Y-X), not Y, thus recognizing the loss which occurred.

Thus the loss is taken into account. Note that for capital gains you, the holder, pay no tax in year 1, pay tax in year 2 on Y-X, and pay tax in year 3 on Z.

All the above is the way it works whether or not you sell the shares immediately after the end of year 3 or you hold the shares for many more years. Whenever you do sell the shares, you will have a gain or loss, but that is different from the fund's realized losses we have been talking about (X, Y, and Z).

  • The value of X is usually not reported directly to the share holders, at least not on 1099-DIV, but is there in the fine print, and in some cases on the fund's website. Also, if Y is the net realized capital gain in the second year, the gross realized capital gain was actually X+Y, and X of that was offset against the previous year's loss so that only Y was reported as the net realized capital gain on 1099-DIV. – Dilip Sarwate Jun 3 '12 at 10:50
  • Yes, X is not on 1099, but it must be in public fund documents. Whether one calls year 2's 1099 value Y-X or Y depends on how "net" as used for "Y" is defined: if "net" is the combination of all realized transactions of year 2, then the 1099 value is Y-X since the carryforward X is from another year and not from year 2, and so is not included in Y (but is included in the 1099 value). Just semantics. – mgkrebbs Jun 3 '12 at 20:11
  • It is indeed semantics to those who understand how a fund operates and what unrealized gains and losses mean, but it seems impossible to convince the OP that unrealized gains and losses are irrelevant to taxation, and that he must report to the IRS exactly what the 1099-DIV (and possibly 1099-B) says, and not anything that he gleans from annual statements of fund operations or the fund manager's prefatory remarks such as "Due to uncertain economic conditions, the fund lost 3% in value this year." – Dilip Sarwate Jun 3 '12 at 22:49
  • @DilipSarwate: It seemed impossible. It doesn't now. – Tim Jun 4 '12 at 15:23

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