Michael on October 24th, 2008
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You: Pay taxes on losing investments?  That sounds counterintuitive.

It is counterintuitive.

You: Okay.

But it is what can happen and is likely to happen to many mutual fund holders this year as reported by The Wall Street Journal earlier this week.

You: What? I own some mutual funds. I’m going to owe taxes on them even though they’re down?  That’s crazy.

It’s counterintuitive.

You: It was counterintuitive before I knew you were talking about me. Now it’s just crazy!

But it can happen. Let me explain how.

You: Yes, do that.

Remember, I’m only the messenger.

You: Yeah, whatever.

Here’s the deal.  Whether your mutual fund goes up or down in value has no bearing on the income tax you pay.  This fluctuation in mutual fund value is known as an unrealized gain or loss. You don’t report unrealized gains or losses, so you don’t have to pay taxes on the gains and you don’t get to deduct the losses.

You: Okay. I am with you so far.

However, if you sold the mutual fund at a gain, then that unrealized gain becomes a realized gain and, presto, you’d pay taxes.  Likewise, if you sold a mutual fund at a loss, the unrealized loss becomes a realized loss and you can deduct that loss (subject to certain limits, of course).

You: Of course.  But still, I didn’t sell any of my mutual funds this year and those I have went down in value, so how is it that I might owe tax from that?  You know, the crazy talk from before?

Each year, mutual funds must distribute substantially all of their investment gains and income. If you own your mutual fund in a taxable account (not, for example in an IRA or 401(k)), then your pro-rata share of this distribution is taxable income to you.

You: Okay, even that seems fair.  After all, my mutual funds lost money this year so they won’t be distributing income so I don’t have anything to worry about from what you just said.


You: Wrong?

Okay, probably wrong.

You: Why “probably wrong?”

Just because your mutual fund lost value doesn’t mean that it didn’t have any gains.

You: There’s that crazy talk again.

I agree, but again, I’m just reporting the news here.  Let’s say that during February your mutual fund sold some stocks it had purchased a few years earlier and did so at a substantial gain.  With this cash, your mutual fund purchased other investments which have since plummeted.  The mutual fund believes, however, that in the long-term these investments will bounce back.

You: Okay, that sounds plausible.

Not only is it plausible, it’s taxable.

You: Seems like anything plausible is taxable.

Good one.  That gain your mutual fund obtained in February is a taxable gain because it has been realized. But the loss on the replacement investments is not deductible because it has yet to be realized. It is an unrealized loss. Net impact to you: a taxable distribution despite the fact that your investment has gone down in value.

You: Would this be true even if I bought the mutual fund last October, before most of the gain was earned by the mutual fund?

Yes.  In fact, it would be true even if you bought the investment in March of this year, after the underlying stocks sold at a gain were sold.

You: More crazy talk.

Hey, it’s plausible.

You: So it’s taxable.

Indeed, so buyer beware.  Make sure to double-check with the mutual fund company before buying any mutual fund in a taxable account before the end of the year. If they intend to make a sizable distribution, it may be a good idea to consider waiting to invest in that fund until after the distribution is made.

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Has this ever happened to you?  Can you think of more “crazy” examples of taxes being assessed against “unreal” gains?  I can.

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