Net loss not distributed by mutual funds to their shareholders?
From Wikipedia
Mutual funds pass taxable income on to their investors annually. The
type of income they earn is unchanged as it passes through to the
shareholders. For example, mutual fund distributions of dividend
income are reported as dividend income by the investor. There is an
exception: net losses incurred by a mutual fund are not distributed or
passed through to fund investors.
I was wondering how to understand the last paragraph?
For example, after an investor purchases some shares of a mutual fund, he has
a net capital loss X (>0) in the first year,
a net capital gain Y (>0) in the second year,
a net capital gain Z (>0) in the third year, and then he sells all of his shares at the end of the third year.
According to the last sentence in the quote, is it correct that
for tax report of the first year, the net capital loss x is not reported for tax purpose,
for tax report of the second year, he has to pay the tax on the net capital gain Y,
for tax report of the third year, since he sells all his shares at the end of the third year, he has a net capital gain Y+Z-X and has to pay the tax on Y+Z-X.
If it is correct, I think it is not fair, because in the ideally fair case, he should have a net capital loss X reported for the first year and does not have to pay tax for the first year, and then he can use this loss to offset the net capital gains Y and Z in the second year and the third one. So he only has to pay the tax on Y+Z-X, the capital gain offset by the the capital loss.
So I wonder if my understanding is correct? If not, how shall I understand it?
Thanks and regards!
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I'll try to answer using your original example. First, let me restate your assumptions, slightly modified:
The mutual fund has:
a net realized capital loss of X in year 1
a net realized capital gain of Y in year 2
a net realized capital gain of Z in year 3
Note that I say the "mutual fund has" those gains and losses. That's because they occur inside the mutual fund and not directly to you as a shareholder. I use "realized" gains and losses because the only gains and losses handled this way are those causes by actual asset (stock) sales within the fund (as directed by fund management). Changes in the value of fund holdings that are not sold are not included in this.
As a holder of the fund, you learn the values of X, Y, and Z after the end of the year when the fund management reports the values. For gains, you will also typically see the values reported on your 1099-DIV under "capital gains distributions". For example, your 1099-DIV for year 3 will have the value Z for capital gains (besides reporting any ordinary dividends in another box).
Your year 1 1099 will have [CO] "capital gains distributions" shown because of the rule you highlighted in bold: net realized losses are not distributed.
This capital loss however can later be used to the mutual fund holder's tax advantage. The fund's internal accounting carries forward the loss, and uses it to offset later realized gains. Thus your year 2 1099 will have a capital gain distribution of (Y-X), not Y, thus recognizing the loss which occurred.
Thus the loss is taken into account. Note that for capital gains you, the holder, pay no tax in year 1, pay tax in year 2 on Y-X, and pay tax in year 3 on Z.
All the above is the way it works whether or not you sell the shares immediately after the end of year 3 or you hold the shares for many more years. Whenever you do sell the shares, you will have a gain or loss, but that is different from the fund's realized losses we have been talking about (X, Y, and Z).
When you invest (say 00) in (say 100 shares) of a mutual fund
at per share, and the price of the shares changes,
you do not have a capital gain or loss, and you do not have to
declare anything to the IRS or make any entry on any line on
Form 1040 or tell anyone else about it either. You can brag about
it at parties if the share price has gone up, or weep bitter tears
into your cocktail if the price has gone down, but the IRS not only
does not care, but it will not let you deduct the paper loss or
pay taxes on the paper gain.
What you put down on Form 1040 Schedules B
and D is precisely what the mutual fund will tell you on
Form 1099-DIV (and Form 1099-B), no more, no less.
If you did not report any of these amounts on your previous
tax returns, you need to file amended tax returns, both
Federal as well as State,
A stock mutual fund invests in stocks and the fund manager
may buy and sell some stocks during the course of the year.
If he makes a profit, that money will be distributed to the
share holders of the mutual fund. That money can be re-invested
in more shares of the same mutual fund or taken as cash
(and possibly invested in some other fund). This
capital gain distribution
is reported to you on Form 1099-DIV and you have to report
sit on your tax return even if you re-invested in more share
of the same mutual fund, and the amount of the distribution
is taxable income to you. Similarly, if
the stocks owned by the mutual fund pay dividends, those will
be passed on to you as a dividend distribution and all the
above still applies. You can choose to reinvest, etc, the
amount will be reported to you on Form 1099-DIV, and you need
to report it to the IRS and include it in your taxable income.
If the mutual fund manager loses money in the buying and selling
he will not tell you that he lost money but
it will be visible as a reduction in the price of the shares.
The loss will not be reported to you on Form 1099-DIV and you
cannot do anything about it. Especially important, you cannot
declare to the IRS that you have a loss and you cannot
deduct the loss on your income tax returns that year.
When you finally sell your shares in the mutual fund,
you will have a gain or loss that you can pay taxes on
or deduct. Say the mutual fund paid a dividend of one
year and you re-invested the money into the mutual fund,
buying 3 shares at the then cost of per share. You
declare the on your tax return that year and pay taxes on it.
Two years later, you sell all 103 shares that you own
for .50 per share. Your total investment was
00 + = 33. You get 81.50 from the fund,
and you will owe taxes on 81.50 - 33 = .50. You
have a profit of on the 100 shares originally bought
and a loss of .50 on the 3 shares bought for : the
net result is a gain of .50.
You do not pay taxes on .50 as the profit from your
original 00 investment; you pay taxes only on .50
(remember that you already paid taxes on the ).
The mutual fund will report on Form 1099-B
that you sold 103 shares
for 81.50 and that you bought the 103 shares for
an average price of 33/103 = .029 per share.
The difference is taxable income to you.
If you sell the 103 shares for per share (say),
then you get 7 out of an investment of 33 for
a capital loss of 6. This will be reported to you
on Form 1099-B and you will enter the amounts on
Schedule D of Form 1040 as a capital loss.
What you actually pay taxes on is the net capital
gain, if any, after combining all your capital gains
and losses for the year. If the net is a loss, you can
deduct up to 00 in a year, and carry the rest
forward to later years to offset capital gains in later years.
But, your unrealized capital gains or losses (those
that occur because the mutual fund share price goes
up and down like a yoyo while you grin or grit your
teeth and hang on to your shares) are not reported
or deducted or taxed anywhere.
It is more complicated when you don't sell all the
shares you own in the mutual fund or if you sell
shares within one year of buying them, but let's stick
to simple cases.
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