7950 / How does a shareholder determine the basis of mutual fund shares?

Generally a shareholder’s tax basis in mutual fund shares is the cost of acquiring them, including any load charges (i.e., sales or similar charges incurred to acquire mutual fund shares). (See Q 692 regarding the determination of basis.) However, a shareholder who exercises a reinvestment right, which was acquired as a result of the load charge, is subject to a 90-day holding period during which the load charge will not be fully included in basis. (“Reinvestment right” is defined to mean the right to acquire stock of one or more regulated investment companies without a load charge or at a reduced load charge.) If such a shareholder (1) disposes of the shares before the 91st day after the date of acquisition, and (2) subsequently acquires other shares (in the same or another mutual fund) and the otherwise applicable load charge is reduced as a result of the reinvestment right, then the initial load charge will not be included in basis for purposes of determining the gain or loss on the disposition (except to the extent that the initial load charge exceeds the reduction applicable to the second load charge). Instead, it will be includable in the basis in the newly acquired shares. If the original shares are transferred by gift, the donee succeeds to the treatment of the donor.¹

If all of a shareholder’s shares in a mutual fund were acquired on the same day and for the same price (or, if by gift or inheritance, at the same tax basis), the shareholder will have little difficulty in establishing tax basis and holding period of the shares sold or redeemed. However, if the shares were acquired at different times or prices (or bases), the process is more difficult. Unless the shareholder can “adequately identify” (see Q 700) the lot from which the shares being sold or redeemed originated, the shareholder must either treat the sale or redemption as disposing of shares from the earliest acquired lots (i.e., by a first-in, first-out (FIFO) method) or, if he or she qualifies, elect to use one of two average basis methods for determining adjusted basis and holding period of shares sold or redeemed.²

Effective January 1, 2012, in connection with their obligation to report sales of securities to the IRS, brokers are generally required to provide each customer’s bases in, and holding periods for, stock for which the average basis method is available. A broker’s obligations generally track the description above—i.e., to use the FIFO method unless adequate identification of the shares disposed of is possible.³

A shareholder may elect to use an “average basis” for the shares if (1) the shares are held in a custodial account maintained for the acquisition or redemption of shares in the fund, and (2) the shareholder purchased or acquired the shares at different prices or bases.⁴

Under the double-category method of determining average basis, all shares in the mutual fund account are divided into two categories: (1) those with a holding period of more than one year; and (2) those with a holding period of one year or less. The basis for each share in either category is the total cost (or other basis) of all the shares in that category, divided by the number of shares in that category. The shareholder can then elect to have the shares being sold come from either the “more than one year” category (thus recognizing long-term gain or loss), or the “one year or less” category (thus recognizing short-term gain or loss). If the shareholder does not designate the category from which the shares are to be sold, the shares are deemed to come from the “more than one year” category first.⁵

When shares in the “one year or less” category have been held for more than one year, they are transferred to the “more than one year” category. If some of the shares in the “one year or less” category have been sold or transferred, they are deemed to have been the earliest acquired shares (i.e., by a FIFO method). The basis of unsold shares transferred to the “more than one year” category is the average basis of the shares in the “one year or less” category at the time of the most recent sale, determined as discussed above. If no shares have been sold from the “one year or less” category, the basis of the shares transferred to the “more than one year” category is their cost or other basis (not the average basis).⁶

Under the single category method of determining average basis, all shares in the mutual fund account are added together. The basis of each share in the account is the total cost or other basis of all the shares in the account, divided by the total number of shares. Any shares sold or redeemed are deemed to be those acquired first. The single category method may not be used for the purpose of converting short-term gain or loss to long-term gain or loss, or vice versa.⁷

The election to use either of the “average basis” methods is made on the shareholder’s tax return for the first year for which he or she wishes the election to apply and will apply to all shares in the same mutual fund held by the shareholder, even if in different accounts. In reporting gain or loss, the taxpayer reports on the return for each year to which the election applies that an average basis is being used, and which method has been selected. An election may not be revoked without the consent of the IRS.⁸

In the case of shares acquired by gift, the basis in the hands of a donee is generally the same as it was in the hands of the donor; however, this rule applies only for purposes of determining gain. In the event that the shares’ adjusted basis exceeds their fair market value at the time of the gift, the basis in the hands of the donee for purposes of determining loss is their fair market value at the time the gift was made. Ordinarily, an average basis method may not be used on such shares; however, a donee shareholder can elect to apply an average basis method to accounts containing shares acquired by gift if the donee includes a statement with the tax return indicating that the donee will use the fair market value of the shares at the time of the gift in computing the average bases. The statement applies to all shares acquired either before or after the statement is filed, for as long as the election to use average basis remains in effect.⁹

A unit trust unit holder (see Q 7973) may not use either of the average basis methods discussed above unless the unit trust invests primarily in the securities of one management company, or one other corporation, and unless the trust has no power to invest in any other securities except those issued by a single other management company.¹⁰