Deciphering The Fund Statement

By Humberto Cruz
Tribune Media Services

[Ed. note: A reader recently sent columnist Humberto Cruz a note, asking for an explanation of some confusing language in his fund's statement. The question and Humberto's detailed response follow.]

I am on a monthly automatic purchase and reinvestment plan with a mutual fund. Recently, I received this statement:

“The fund declared a long-term capital gain distribution of $0.986 per share on Nov. 5, 1999. Additional shares of the fund were purchased for your account in the amount of your proportional distribution as a shareholder of record. The net asset value per share was reduced accordingly; however, the total equity in your account remains unchanged, as reflected in the enclosed confirmation.

“The gain that you realized this year will increase your cost basis and thus reduce the amount of the gain that is subject to taxation whenever you sell your fund shares.”

What the heck does this mean?

Humberto: It means your mutual fund desperately needs to hire somebody who can write in plain English.

Let me give it a shot. This is what this means, step by step:

— The manager who runs your mutual fund made changes in the portfolio during the year. We know at least that the manager sold some securities — selling is the only way to generate or “realize” a gain or a loss, depending on whether the manager sold for more or for less than for what he or she bought.

— From all that trading, the manager — and therefore the fund — made a profit on the securities that had been held in the fund for more than a year before they were sold. (That’s what a long-term capital gain means). That does not mean that every trade necessarily made money but that, overall, there was a profit or “net gain.”

— The size of the long-term capital gain amounted to $0.986 per share. That is, the total dollar amount of the gain divided by the number of shares in the fund came out to 98.6 cents.

— Therefore, the price of each share of the fund at this point includes the 98.6 cents that represents the long-term capital gain realized by the fund.

— If that gain stays in the fund, the fund would have to pay capital gains taxes to the government. The fund doesn’t want to do that. The fund avoids having to pay taxes by “distributing” the gain to you, that is, giving you 98.6 cents in cash for each share of the fund you own. It did that on Nov. 5.

— You, not the fund, now owe the long-term capital gains tax on that gain of 98.6 cents per share. That is true whether you take the “distribution” in cash or use it to buy more shares.

— Therefore, you have to report the long-term capital gain distribution in your 1999 income tax return that is due by April 17, 2000. (April 15 falls on a Saturday this year).

— Once the gain of 98.6 cents per share has been distributed to you and the other shareholders of the fund, it is of course no longer in the fund. Therefore, the price of each fund share drops by 98.6 cents.

— You use the distribution to buy more shares. You now have more shares than you did before the distribution, but each share is worth 98.6 cents less. If you do the math you will see that, after reinvesting a distribution, no matter what size, you end up with exactly the same amount of money as before.

That is what it meant by “the total equity in your account remains unchanged.”

— But the total price you have paid by your shares has gone up. It includes not only what you paid for each original purchase but also for the additional shares you bought with the distribution.

Example: If you had 100 shares before the distribution and received 98.6 cents per share, the total distribution was $98.60. You used the $98.60 to buy more shares. For tax purposes, you need to record that purchase as a separate transaction, just as if you had used $98.60 of your money to buy the new shares.

Therefore, when computing the total price you paid for all your shares — that is what is called your “cost basis” — you have to remember to add the $98.60 to whatever you paid for the original 100 shares.

— Therefore, when you finally sell your shares, you will not have any gains to report unless you receive more than your “cost basis,” which includes the $98.60.

In effect, by receiving the distribution and paying taxes now you lower the taxes you may pay in the future. That is what is meant by “the gain that you realized this year will increase your cost basis and thus reduce the amount of the gain that is subject to taxation whenever you sell your fund shares.”

Get it? We all need to because this is the time of year that mutual fund companies mail out the distribution information we need to complete our 1999 tax returns.

Copyright © 2000 Tribune Media Services Inc.  Reprinted with permission.

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