STRATEGIES FOR COMBATING EMBEDDED CAPITAL GAINS FROM MUTUAL FUNDS
Capital gain distributions from mutual funds is a timely subject. It’s also one many people do not fully understand.
Mutual funds are great investment vehicles, particularly for the small investor. Every year, most mutual funds must distribute any net realized gains to its investors. Normally they are paid close to yearend, and many post the amount of gains in advance. The investor can choose between being paid cash or receiving more shares (dividend reinvested). Under either scenario, the gains are taxable. The gains can be short term, long term, or both.
However, one of the biggest problems with mutual funds is something called embedded capital gains. This problem becomes even more important during market downdrafts like we’re currently experiencing. If you are comfortable “staying the course” with your mutual fund, you have a long-term view, and you don’t want to incur any taxable events, you can reap many benefits.
But a mutual fund has many investors, and not all think like you do. Many times, when markets go down, retail investors have a history of panicking and selling. To meet the redemptions, the mutual fund must liquidate positions to raise cash. Not only is the mutual fund forced to sell when stock prices are declining, the fund is incurring capital gains or losses. Given the run up in equity markets, any sales of positions held will probably be a capital gain.
The problem is the investor who did not sell is going to be hit with a capital gain. This is called an embedded capital gain.
To explain, assume XYZ mutual fund bought Apple stock 20 years ago at $10 a share. Now, because of redemption demands, it must sell Apple at the current market price of $140, thus creating a long-term gain of $130 per share. If an investor invested in XYZ mutual fund two days ago, they’ll be hit with the $130 per share capital gain incurred by the fund – thus, the term ‘embedded capital gain’. The situation could get even worse: now at year end, the mutual fund is worth less than the investor paid for the fund. So, they’ll have been hit with a capital gain tax while also having a losing position in the fund – a double hit.
There are ways to minimize the damage if you know the rules. Even though the sale of Apple occurred in June, it does not become taxable to the mutual fund investor until the fund formally declares the capital gain, which is usually in November or December.
The smart investor will sell the mutual fund BEFORE the capital gain is declared, thus avoiding the capital gain. And if the fund is sold at a loss, the investor enjoys a capital loss that can be used against capital gains or taxable income, with some limits.
Under the Internal Revenue Code, any stock sold at a loss cannot be rebought for at least 30 days, called the Wash Rule. Long-term investors want to stay invested. Missing days when the market has big gains can dramatically reduce long-term gains.
Again, there is a solution. Assume the mutual fund sold was a U.S. large cap value fund. It is perfectly legal to merely buy another U.S. large cap fund or an ETF such as SPY. Thus, the investor stays invested in a specific asset class and can rebuy the original fund on day 31.
One last strategy that can be used in down markets is called tax-loss harvesting. This involves selling individual positions that will cause capital losses. This can include not only mutual funds, but also ETFs and individual stocks. The same holds true for any asset class: oil, gold, commodities, etc. Sell losing positions and take advantage of tax-loss harvesting, then rebuy similar investments.
In summary, creating a capital loss to offset capital gains and some taxable income while avoiding a taxable gain on an investment that is losing money, all while staying fully invested, is a great strategy for many investors and one we recommend often at Intercontinental Wealth Advisors.
As always, consult your tax accountant to make sure you are compliant tax wise, and consult with your financial advisor before making investment decisions like these. If you have any questions or would like to discuss further, please don’t hesitate to reach out.
Bear markets are never pleasant, and trying to time markets is a fool’s game – but there are actions than can be taken by the intelligent investor.
CEO at Intercontinental Wealth Advisors