Calculating Capital Gains on Mutual Fund Shares

Dear Tax Guide,
I'm reading your article on capital gains, and would like to ask a question: Am I correct in assuming that each time I purchase additional funds in my one mutual fund, the one year period for avoiding capital gains taxes is extended by the date of the last purchase? My original investment of, say 100 shares, was made over a year ago. But since then, each month I have bought additional shares. If I sell tomorrow, will I be liable for capital gains for all purchases made within the last 12 months?

Dear Reader,
Thanks for the great question about capital gains in mutual funds.

As an investor in mutual funds, you are responsible for capital gains taxes in three scenarios. First, mutual funds often sell off profitable investments throughout the year, and pass along the profits to you in the form of a capital gain distribution. Second, many mutual funds distribute dividend income. Third, you will be responsible for calculating your overall gain or loss when you sell any or all of your mutual fund shares.

The biggest complication is figuring out how to calculate your capital gain on mutual fund shares. This can be a little complicated since you have bought shares at different prices over time. Each purchase of shares has its own cost basis and its own holding period. Adding to the complexity, the IRS allows you to use one of four accounting methods to determine your capital gain. If this is the first time you are selling shares from this mutual fund, you will need to choose which accounting method to use for this fund. You can use different methods for each fund you own, however once you make a choice for a particular fund you must stick with that method until you completely liquidate your investment in that fund.

In order to help point you in the right direction, here's a sample mutual fund cost basis spreadsheet that I created using the scenario you mentioned. Our hypothetical shareholder invested $10,000 in a large, well-known mutual fund on September 3rd, 2004, and subsequently made additional monthly investments of $250 on the first of each month. The mutual fund distributed dividend income, which the shareholder reinvested. The cost basis using the specific identification method is shown. Also, the holding periods are shown as of October 2005.

Our hypothetical investor may want to sell all, some, or none of her shares. However, knowing the cost basis is crucial to figuring out the potential capital gains. If the investor is going to sell some of her shares, she will use one of the four accounting methods for calculating capital gain on mutual fund shares.