7940 / What are capital gain dividends? How are capital gain dividends received from a mutual fund taxed?

Capital gain dividends. Capital gain dividends result from sales by the mutual fund of stocks and securities that result in long-term capital gains. The mutual fund will notify shareholders in writing of the amount of any capital gain dividend. The shareholder reports a capital gain dividend on the federal income tax return for the year in which it is received as a long-term capital gain regardless of how long the shareholder has owned shares in the mutual fund.¹ As such, a capital gain dividend may be partially or totally offset by the shareholder’s capital losses (if any); if not totally offset by capital losses, the excess (i.e., net capital gain) will be taxed at the applicable capital gains rate.² For additional guidance on designations of capital gain dividends, see Revenue Ruling 2005-31, Q 7938.

The Service issued guidance clarifying that capital gain dividends received from a mutual fund in 2004 would be taxed at the lower capital gain rates enacted under JGTRRA 2003. Concern had been expressed that the prior rules for dividend designation and the transition to the new, lower capital gain rates might cause some 2004 capital gain dividends to be taxed to mutual fund shareholders at the old, higher rates. However, the guidance clarified that this would not occur.³

See Q 702 for the treatment of capital gains and losses, including the lower rates (20/15/0 percent) for long-term capital gain. (These rates were made as permanent as anything in the IRC for tax years beginning after 2012.) See Q 7943 for the taxation of undistributed capital gains.

Generally, a shareholder may elect to treat all or a portion of net capital gain (i.e., the excess of long-term capital gain over short-term capital loss) as investment income.⁴ If the election is made, the amount of any gain so included is taxed as investment income. This election may be advantageous if the shareholder’s investment interest expense would otherwise exceed his investment income for the year. If the shareholder makes the election, the shareholder must also reduce net capital gain by the amount treated as investment income (see Q 702).

Detailed instructions for reporting mutual fund distributions on Form 1040 or Form 1040A are set forth in IRS Publication 550, Investment Income and Expenses formerly Publication 564, Mutual Fund Distributions (2011).