Wednesday, August 29, 2007


I received the following email from a WANDERING TAX PRO reader:
Q. I read your article {“Back to Basics”} regarding mutual fund cost basis. I am in the process of consolidating a number of funds I've held for too long into a more manageable portfolio. One fund was opened in 1987 and the fund has basically grown and grown. I have to sell it to move the proceeds into another investment. I've read about the 4 methods and for determining the basis and know that I have to include the original investment (less expenses) and the reinvested dividends which bought more shares of the fund - in the basis. I never sold anything from the fund since I invested in it.
My question concerns the treatment of the 1099-DIV amounts that I paid taxes on just about every year, specifically the amounts that are in boxes:
1a (Ordinary dividends)
1b (Qualified divs)
2a (Total capital gain distrib)
Should they be included in the basis? Seems like since I've already paid taxes on these amounts, they should somehow go into the basis....?
Thx much.
Dave C

A. If you are selling your entire investment in a fund, and you have not sold any shares of this fund in the past, you do not need to consider the 4 methods – they will all provide the same result.

You indicate that you know you have to include the reinvested dividends in your basis. If all of the dividends and distributions you received from the fund over the years were reinvested then the amounts reported in box 1a (Ordinary Dividends) and Box 2a (Total Capital Gain Distributions) of the Form 1099-DIVs represent your dividend reinvestment and should indeed be added to your original investment to determine your cost when calculating the capital gain.

The amounts reported in Box 1b (Qualified Dividends) are already included in Box 1a (Ordinary Dividends) and should not be added to your cost. Similarly, any amounts reported on Lines 2b, c and d are already included in Box 2a (Total Capital Gain Distributions) and should not be added to basis.

You would reduce the amount of Qualified Dividends and Capital Gain Distributions by any amounts reported in Box 4 (Federal Income Tax Withheld), Box 5 (Investment Expenses) and Box 6 (Foreign Tax Paid).

If the dividends and distributions were not always reinvested, or only certain distributions were reinvested (i.e. ordinary dividends paid in cash and capital gain distributions reinvested), then you should only add the actual amounts reinvested to your cost basis.

Amounts reported in Box 3 (Nondividend Distributions) generally represent a return of capital and are basically a wash (you would add the amount of the distribution to basis as a reinvestment, but then subtract it out as a return of capital) and should not be added to your cost. You would not have included these distributions in income on your Form 1040 in the year(s) received

Basically your cost basis is the original investment in the fund, plus any additional share purchases and the net amount of total dividends and distributions reinvested, less any distributions classified as a return of capital.

It would be helpful to review the annual fund statements showing all activity for the year when determining your cost basis. You should be able to reconcile the Form1099-DIVs to these statements.

If your capital gain is substantial enough, and you will not be covered under the “safe harbor”, you may want to consider making federal and state estimated tax payments to “cover your arse” and avoid potential underpayment penalties.

A substantial long term capital gain, while taxed separately under both regular tax and the dreaded Alternative Minimum Tax (AMT), may also cause you to become a victim of AMT.
Your tax professional can help you determine your cost basis and if you would need to make estimated tax payments.

I hope I have been of help.

1 comment:

Unknown said...

Excellent explanation. Thanks much. It makes perfect sense and helped be slog through the annual statements and the 1099s.