7949 / How is a shareholder taxed when selling, exchanging, or redeeming mutual fund shares?

When a shareholder sells, exchanges, or redeems mutual fund shares, the shareholder will generally have a capital gain or loss. Whether such gain or loss is short-term or long-term usually depends on how long the shareholder held the shares before selling (or exchanging) them.¹ If the shares were held for one year or less, the capital gain or loss will generally be short-term; the capital gain will generally be long-term if the shares were held for more than one year. See Q 699 for an explanation of the holding period calculation, and Q 702 for the treatment of capital gains and losses.

The gain or loss is the difference between the shareholder’s adjusted tax basis in the shares (see below) and the amount realized from the sale, exchange, or redemption (which includes money plus the fair market value of any property received).² For the taxation of a wash sale of mutual fund shares, see Q 7951. For the treatment of mutual fund shares that were held as part of a conversion transaction, see Q 7615 and Q 7616.

In some cases, a company that manages mutual funds will allow shareholders in one mutual fund to exchange their shares for shares in another mutual fund managed by the same company without payment of an additional sales charge. Nevertheless, the exchange is treated as a taxable transaction; any gain or loss on the original shares must be reported as a capital gain or loss in the year the exchange occurs. The exchange does not qualify as a “like-kind” exchange, nor as a tax-free exchange of common stock for common stock, or preferred for preferred, in the same corporation. Because stock in each fund is “backed” by a different set of assets (i.e., the portfolio securities held by each fund), shares in the funds are neither common nor preferred stock in the managing company.³ Furthermore, such an exchange may be subject to special rules delaying an adjustment to basis for load charges if the exchanged shares were held for less than 90 days (see below).

In Paradiso v. Commissioner,⁴ the Tax Court stated that IRC Section 1031(a)(1), which provides for nonrecognition of gain or loss from like-kind exchanges, expressly does not apply to the sale of stock or other securities (citing IRC Sections 1031(a)(2)(B) and 1031(a)(2)(C)). Accordingly, the court held that the taxpayer realized taxable income from sales of mutual fund shares at a gain.

The Service has privately ruled that a mutual fund’s redemption of stock pursuant to a tender offer would constitute a single and isolated transaction that was not part of a periodic redemption plan; thus, the transaction would not result in an IRC Section 305 deemed distribution to any of the fund’s shareholders.⁵ The Service has also stated that no gain or loss was required to be recognized by shareholders on the conversion of institutional class shares to Class A shares of the same mutual fund. Each shareholder’s basis in the Class A shares would equal the shareholder’s basis in the converted institutional class shares immediately before the conversion, and each shareholder’s holding period for the Class A shares would include the shareholder’s holding period for the converted institutional class shares, provided that the shareholder held those converted shares as capital assets immediately before the conversion.⁶ In addition, the Service privately ruled that the conversion of two classes of mutual fund shares into a single class of shares, based on the relative net asset value of the respective shares, did not result in gain or loss to the shareholders.⁷

If a shareholder purchases mutual fund shares, receives a capital gain dividend (or is credited with an undistributed capital gain), and then sells the shares at a loss within six months after purchasing the shares, the loss is treated as a long-term capital loss to the extent of the capital gain dividend (or undistributed capital gain).⁸ Similarly, if a shareholder purchases mutual fund shares, receives an exempt-interest dividend, and then sells the shares at a loss within six months after purchasing the shares, the loss (to the extent of the amount of the dividend) will be disallowed.⁹ In the case of a fund that regularly distributes at least 90 percent of its net tax-exempt interest, the regulations may prescribe that the holding period for application of the loss disallowance rule is less than six months (but not less than the longer of 31 days or the period between the regular distributions of exempt-interest dividends).¹⁰ For purposes of calculating the six-month period, periods during which the shareholder’s risk of loss is diminished as a result of holding other positions in substantially similar or related property, or through certain options or short sales, are not counted.¹¹ Regulations will provide a limited exception to these rules for shares sold pursuant to a periodic redemption plan.¹²