Mutual Funds

March 13, 2024

7952 / What is a "money market fund"?

<div class="Section1"> A money market fund is a mutual fund generally seeking maximum current income and liquidity through investment in short-term money market instruments, such as Treasury bills, certificates of deposit, or commercial paper. Dividends are customarily declared daily, and automatically reinvested in additional shares, unless a distribution option is elected. Shares may be redeemed at any time. </div>

March 13, 2024

7954 / What is a closed-end fund? How are shareholders in a closed-end fund taxed?

<div class="Section1"> A closed-end fund holds a portfolio of investment assets, but does not ordinarily redeem shares at net asset value or sell new shares. Shares of the fund itself are actively traded on the secondary market. Although a closed-end fund is not actually a mutual fund, if the fund qualifies and makes the necessary election to be taxed as a regulated investment company (RIC), its shareholders will be taxed like shareholders of a mutual fund. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7938">7938</a> through Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7951">7951</a> for details. If, on the other hand, the closed-end fund is established as a regular corporation, its shareholders will be taxed accordingly (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7501">7501</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7540">7540</a>). Because closed-end fund shares are traded in the open market or on an exchange and are not redeemed by the company, capital gain or loss on sale is based on the sale price and not on redemption price. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7922">7922</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7935">7935</a> for a discussion of RICs and their tax treatment. </div>

March 13, 2024

7951 / How is a wash sale of mutual fund shares taxed?

<div class="Section1"> A wash sale of mutual fund shares is taxed in the same manner as a wash sale of regular corporation stock or other securities (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7536">7536</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7539">7539</a>). However, when the double category method is used for determining basis and holding period, a wash sale of mutual fund shares from the “one year or less” category after acquisition of the replacement shares will result in the aggregate basis of the shares remaining in the “one year or less” category being increased by the amount of the loss that is disallowed.<a href="#_ftn1" name="_ftnref1">1</a> When the single category method is used for determining basis, or when an average basis method is not used, the general wash sale tax basis rules apply.<a href="#_ftn2" name="_ftnref2">2</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. § 1.1012-1(e)(3)(iii)(d); IRC § 1091(d). <a href="#_ftnref2" name="_ftn2">2</a>. See Treas. Reg. § 1.1012-1(e)(4)(iv). </div></div>

March 13, 2024

7953 / How is a money market fund shareholder taxed?

<div class="Section1"> Because a money market fund is a mutual fund, its shareholders are taxed in the manner discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7938">7938</a> through Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7951">7951</a>.Money market funds ordinarily do not have capital gain dividends because of their general policy of investing in short-term securities. Note that money market fund dividends are not qualified dividends and, thus, do not qualify for the lower tax rates (20%/15%/0%) (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>). Money market funds (MMFs) that are neither government MMFs nor retail MMFs must value portfolio securities using market-based factors and compute their price per share by rounding the fund’s net asset value (NAV) to a minimum of the fourth decimal place (or, for MMFs with a share price other than $1.0000, an equal or greater level of precision). These MMFs have a share price that is likely to change often, but within a narrow range due to the limited types of investments that MMFs may hold (potentially generating a loss). The wash sale rule disallows a loss realized on a sale or disposition of stock or securities if, within a period beginning 30 days before and ending 30 days after, the taxpayer acquires, or enters into a contract to acquire, substantially identical stock or securities. Because many MMF shareholders engage in frequent redemptions and purchases of MMF shares (e.g., due to sweep arrangements and automatic reinvestments), a shareholder that realizes a loss on a redemption of MMF shares will often acquire shares in that MMF within 30 days before or after the redemption. In Revenue Procedure 2023-35, the IRS extended the wash sale relief that it had already provided to shares in floating-NAV MMFs and will not treat a redemption of a share in any MMF as part of a wash sale. </div>

March 13, 2024

7946 / How is a shareholder taxed when a mutual fund passes through a foreign tax credit?

<div class="Section1"> Mutual funds with more than 50 percent of the value of their total assets invested in stock or securities of foreign corporations may elect to give the benefit of the foreign tax credit to their shareholders.<a href="#_ftn1" name="_ftnref1">1</a> When a mutual fund makes this election, each shareholder, in addition to reporting any ordinary income and capital gains dividends, includes in income his or her proportionate share of foreign taxes paid by the fund. Each shareholder then treats the proportionate share of foreign taxes paid by the mutual fund as if paid by the shareholder for which he or she may take a tax credit or an itemized deduction. (In calculating the credit or deduction, each shareholder treats his or her share of the foreign taxes and the amount of any dividends paid with respect to the foreign income of the fund as foreign income.)<a href="#_ftn2" name="_ftnref2">2</a> The shareholder may take the deduction or the credit, but not both.<a href="#_ftn3" name="_ftnref3">3</a> A mutual fund that makes this election must notify each shareholder of his or her share of the foreign taxes paid by the fund and the portion of the dividend that represents foreign income.<a href="#_ftn4" name="_ftnref4">4</a> The Service released regulations in 2007 that generally eliminate country-by-country reporting by a mutual fund to its shareholders of foreign source income that the mutual fund takes into account and foreign taxes that it pays. Accordingly, the regulations require that a mutual fund provide aggregate per-country information on a statement filed with its tax return, and require that only summary foreign income and foreign tax amounts be reported to the fund’s shareholders.<a href="#_ftn5" name="_ftnref5">5</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 853. <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 853(b); Treas. Reg. § 1.853(b). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 275. <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 853(c); Treas. Reg. § 1.853-3(a). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. §§ 1.853-3, 1.853-4; TD 9357, 72 Fed. Reg. 48551 (Aug. 24, 2007). </div></div>

March 13, 2024

7947 / Do mutual fund dividends give rise to tax preference items for purposes of the alternative minimum tax?

<div class="Section1"> Editor’s Note: The 2017 tax reform legislation eliminated the corporate AMT for tax years beginning after 2017. The receipt of an exempt-interest dividend creates a tax preference to the extent that the dividend is derived from interest paid on certain private activity bonds issued after August 7, 1986 (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="777">777</a>).<a href="#_ftn1" name="_ftnref1">1</a> (The receipt of capital gain and ordinary income mutual fund dividends generally does not create tax preferences.) Also, mutual funds do pass through, and each shareholder must report a proportionate share of, the fund’s own tax preference items.<a href="#_ftn2" name="_ftnref2">2</a> For an explanation of the alternative minimum tax, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="777">777</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 57(a)(5)(B). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 59(d). </div></div>

March 13, 2024

7948 / Can a shareholder deduct the interest paid on a loan used to purchase mutual fund shares?

<div class="Section1"> Yes, subject to the general limitation applicable to the deduction for investment interest (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8040">8040</a>) and subject to total or partial disallowance if the company pays an exempt-interest dividend.<a href="#_ftn1" name="_ftnref1">1</a> A shareholder may not deduct interest on indebtedness incurred or continued to purchase or carry shares of a mutual fund to the extent that the company distributed exempt-interest dividends to the shareholder during the year.<a href="#_ftn2" name="_ftnref2">2</a> The amount of interest disallowed is the amount that bears the same ratio to total interest paid on the indebtedness for the year as the exempt-interest dividends bear to exempt interest and taxable dividends received by the shareholder (excluding capital gains dividends).<a href="#_ftn3" name="_ftnref3">3</a> In determining whether the indebtedness was “incurred or continued to purchase or carry” shares, one should be able to look to interpretations of comparable language with respect to deductions for interest on “indebtedness incurred or continued to purchase or carry” certain other property (see, for example, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8044">8044</a>).<a href="#_ftn4" name="_ftnref4">4</a> For purposes of determining whether interest is investment interest, temporary regulations provide complex rules under which interest expense is allocated on the basis of the use of the proceeds of the underlying debt (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8043">8043</a>). <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC §§ 163(d), 265(a)(4). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 265(a)(4); Treas. Reg. § 1.265-3. <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.265-3(b)(2). <a href="#_ftnref4" name="_ftn4">4</a>. Rev. Rul. 95-53, 1995 CB 30; Rev. Rul. 82-163, 1982 CB 57. </div></div>

March 13, 2024

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

<div class="Section1"> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="692">692</a> 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.<a href="#_ftn1" name="_ftnref1">1</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="700">700</a>) 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.<a href="#_ftn2" name="_ftnref2">2</a> 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.<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> 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.<a href="#_ftn5" name="_ftnref5">5</a> 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).<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> 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.<a href="#_ftn8" name="_ftnref8">8</a> 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.<a href="#_ftn9" name="_ftnref9">9</a> A unit trust unit holder (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7973">7973</a>) 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.<a href="#_ftn10" name="_ftnref10">10</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 852(f). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. §§ 1.1012-1(c), 1.1012-1(e). See IRS Pub. 550 (formerly IRS Pub. 564). <a href="#_ftnref3" name="_ftn3">3</a>. See IRC § 6045(g). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.1012-1(e). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.1012-1(e)(3). <a href="#_ftnref6" name="_ftn6">6</a>. Treas. Reg. § 1.1012-1(e)(3)(iii). <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. § 1.1012-1(e)(4). <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. § 1.1012-1(e)(6). <a href="#_ftnref9" name="_ftn9">9</a>. Treas. Reg. § 1.1012-1(e)(1)(ii). <a href="#_ftnref10" name="_ftn10">10</a>. Treas. Reg. § 1.1012-1(e)(5)(ii). </div></div>

March 13, 2024

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

<div class="Section1"> 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.<a href="#_ftn1" name="_ftnref1">1</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="699">699</a> for an explanation of the holding period calculation, and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> 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).<a href="#_ftn2" name="_ftnref2">2</a> For the taxation of a wash sale of mutual fund shares, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7951">7951</a>. For the treatment of mutual fund shares that were held as part of a conversion transaction, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a>. 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.<a href="#_ftn3" name="_ftnref3">3</a> 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,<a href="#_ftn4" name="_ftnref4">4</a> 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.<a href="#_ftn5" name="_ftnref5">5</a> 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.<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> 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).<a href="#_ftn8" name="_ftnref8">8</a> 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.<a href="#_ftn9" name="_ftnref9">9</a> 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).<a href="#_ftn10" name="_ftnref10">10</a> 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.<a href="#_ftn11" name="_ftnref11">11</a> Regulations will provide a limited exception to these rules for shares sold pursuant to a periodic redemption plan.<a href="#_ftn12" name="_ftnref12">12</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. See IRC §§ 1222, 1223. <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 1001. <a href="#_ftnref3" name="_ftn3">3</a>. Rev. Rul. 54-65, 1954-1 CB 101. See IRS Pub. 550 (formerly IRS Pub. 564). <a href="#_ftnref4" name="_ftn4">4</a>. TC Memo 2005-187. <a href="#_ftnref5" name="_ftn5">5</a>. Let. Rul. 200025046. <a href="#_ftnref6" name="_ftn6">6</a>. Let. Rul. 199941016. <a href="#_ftnref7" name="_ftn7">7</a>. Let. Rul. 9807026. <a href="#_ftnref8" name="_ftn8">8</a>. IRC § 852(b)(4). <a href="#_ftnref9" name="_ftn9">9</a>. IRC § 852(b)(4)(B). <a href="#_ftnref10" name="_ftn10">10</a>. IRC § 852(b)(4)(E). <a href="#_ftnref11" name="_ftn11">11</a>. IRC §§ 852(b)(4)(C), 246(c). <a href="#_ftnref12" name="_ftn12">12</a>. IRC § 852(b)(4)(D). </div></div>

March 13, 2024

7941 / How is the shareholder taxed if the mutual fund pays a dividend in its portfolio stock or securities rather than in cash?

<div class="Section1"> The taxability of a dividend distribution is the same whether the distribution is in cash or portfolio stock or securities; thus, the distribution will be treated as an ordinary income dividend, exempt-interest dividend, or capital gains dividend, as the case may be (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7938">7938</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7940">7940</a>). The amount (if any) that the shareholder reports on the income tax return is the fair market value of the stocks or securities received as of the date of distribution.<a href="#_ftn1" name="_ftnref1">1</a> For temporary guidance regarding certain distributions declared on or after January 1, 2008, and on or before December 31, 2012, by publicly traded mutual funds when shareholders have the ability to elect to receive stock instead of cash, see the discussion of Revenue Procedure 2010-12 in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7977">7977</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 301(b); see Rev. Rul. 57-421, 1957 CB 367. </div></div>