Publication 564 Mutual Fund Distributions

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Introduction

This publication provides federal income tax information for individual shareholders of mutual funds or other regulated investment companies, including money market funds. It explains:

In this publication, the term "mutual fund" means a mutual fund or other regulated investment company.

Mutual fund. A mutual fund is a regulated investment company generally created by "pooling" funds of investors to allow them to take advantage of a diversity of investments and professional management.

Money market fund. A money market fund is a mutual fund that tries to increase current income available to shareholders by buying short-term market investments.

Money market funds pay dividends and should not be confused with bank money market accounts that pay interest.

Qualified retirement plans and IRAs. The rules in this publication do not apply to mutual fund shares held in individual retirement arrangements (IRAs), section 401(k) plans, and other qualified retirement plans. The value of the mutual fund shares and earnings allocated to you are included in your retirement plan assets and stay tax free generally until the plan distributes them to you. The tax rules that apply to retirement plan distributions are explained in the following publications.

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Tax questions. If you have a tax question, check the information available on http://www.irs.gov or call 1-800-829-1040. We cannot answer tax questions sent to either of the above addresses.

Useful Items

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Publication

Tax Treatment of Distributions

A distribution you receive from a mutual fund may be an ordinary dividend, a qualified dividend, a capital gain distribution, an exempt-interest dividend, or a nondividend distribution. The fund will send you a Form 1099-DIV or similar statement telling you the kind of distribution you received. This section discusses the tax treatment of each kind of distribution, describes how to treat reinvested distributions, and explains how to report distributions on your return.

CAUTION: You may be treated as having received a distribution of capital gains even if the fund does not distribute them to you. See Undistributed capital gains under Capital Gain Distributions.

Community property states. If you are married and receive a distribution that is community income, one-half of the distribution is generally considered to be received by each spouse. If you file separate returns, you must each report one-half of any taxable distribution. See Publication 555, Community Property, for more information on community income.

If the distribution is not considered community income under state law and you and your spouse file separate returns, each of you must report your separate taxable distributions.

Share certificate in two or more names. If two or more persons, such as you and your spouse, hold shares as joint tenants, tenants by the entirety, or tenants in common, distributions on those shares are considered received by each of you to the extent provided by local law.

Certain year-end dividends received in January. Dividends declared and made payable by mutual funds in October, November, or December are considered received by shareholders on December 31 of the same year even if the dividends are actually paid during January of the following year.

Tax-exempt mutual fund. Distributions from a tax-exempt mutual fund (one that invests primarily in tax-exempt securities) may consist of ordinary dividends, capital gain distributions, nondividend distributions, or undistributed capital gains like any other mutual fund. These distributions generally are treated the same as distributions from a regular mutual fund.

Distributions designated as exempt-interest dividends are not taxable. (See Exempt-Interest Dividends, later.)

Ordinary Dividends

An ordinary dividend is a distribution by a mutual fund out of its earnings and profits. Include ordinary dividends that you receive from a mutual fund as dividend income on your individual income tax return.

Ordinary dividends are the most common type of dividends. They will be reported in box 1a of Form 1099-DIV or on a similar statement you receive from the mutual fund.

Qualified dividends. Many ordinary dividends you received are also classified as qualified dividends. The amount of your qualified dividends will be shown in box 1b of Form 1099-DIV or on a similar statement you get from the mutual fund.

Qualified dividends are taxed at the same maximum tax rates that apply to a net capital gain. They are taxed at 15% if the regular tax rate that would apply is 25% or higher. They are taxed at 0% (zero%) if the regular tax rate that would apply is lower than 25%.

To be a qualified dividend subject to the 0% or 15% rate, all of the following requirements must be met.

More information. See chapter 1 of Publication 550 for more information about qualified dividends.

Capital Gain Distributions

These distributions are paid by mutual funds from their net realized long-term capital gains. The Form 1099-DIV (box 2a) you receive or the fund's statement will tell you the amount you are to report as a capital gain distribution. Capital gain distributions are taxed as long-term capital gains regardless of how long you have owned the shares in the mutual fund.

Undistributed capital gains. Mutual funds may keep some of their long-term capital gains and pay taxes on those undistributed amounts. You must report your share of these amounts as long-term capital gains, even though you did not actually receive a distribution. You can take a credit for your share of any tax paid because you are considered to have paid it.

Form 2439. The fund will send you Form 2439, instead of Form 1099-DIV, showing your share of the undistributed long-term capital gains in box 1a and any tax paid by the mutual fund in box 2. Attach Copy B of Form 2439 to your return.

Increase to basis. When you report undistributed capital gains from a mutual fund, you must increase your basis in the shares. You must keep Copy C of Form 2439 to show this increase. See Adjusted Basis, later.

Exempt-Interest Dividends

A mutual fund may pay exempt-interest dividends to its shareholders if it meets certain requirements. These dividends are paid from tax-exempt interest earned by the fund. Since the exempt-interest dividends keep their tax-exempt character, do not include them in income. However, you may need to report them on your return. See Information reporting requirement, next. The mutual fund should send you a Form 1099-INT showing your exempt-interest dividends. Exempt-interest dividends should be shown on Form 1099-INT, box 8.

Information reporting requirement. Although exempt-interest dividends are not taxable, you must report them on your tax return if you are required to file. This is an information reporting requirement and does not convert tax-exempt interest to taxable interest. Also, this income is generally a "tax preference item" and may be subject to the alternative minimum tax. Form 1099-INT, box 9, should show the tax-exempt interest subject to the alternative minimum tax. If you receive exempt-interest dividends, you should see Form 6251, Alternative Minimum Tax--Individuals, for more information.

Nondividend Distributions

A nondividend distribution is a distribution that is not out of earnings and profits and is a return of your investment, or capital, in the mutual fund and is shown on Form 1099-DIV, box 3.

A nondividend distribution reduces your basis in the shares. Basis is explained under Keeping Track of Your Basis, later. Your basis cannot be reduced below zero. If your basis is zero, you must report the nondividend distribution on your tax return as a capital gain. Report this capital gain on Schedule D (Form 1040). Whether it is a long-term or short-term capital gain depends on how long you held the shares.

Example. You bought shares in a mutual fund in 2005 for $12 a share. In 2006, you received a nondividend distribution of $5 a share. You reduced your basis in each share by $5 to an adjusted basis of $7. In 2007, you received a nondividend distribution of $1 per share and further reduced your basis in each share to $6. In 2008, you received a nondividend distribution of $2 per share. Your basis was reduced to $4. In 2009, the nondividend distribution from the mutual fund was $5 a share. You reduce your basis in each share to zero and report the excess ($1 per share) as a long-term capital gain on Schedule D (Form 1040).

Reinvestment of Distributions

Most mutual funds permit shareholders to automatically reinvest distributions in more shares in the fund, instead of receiving cash. You must report the reinvested amounts the same way as you would report them if you received them in cash. This means that reinvested ordinary dividends and capital gain distributions generally must be reported as income. Reinvested exempt-interest dividends generally are not reported as income. Reinvested return of capital distributions are reported as explained under Nondividend Distributions, earlier. See Keeping Track of Your Basis, later, to determine the basis of the additional shares.

How To Report

You must report mutual fund distributions on Form 1040 or Form 1040A. You cannot report mutual fund distributions on Form 1040EZ.

You cannot use Form 1040A and must use Form 1040 in either of the following situations.

If you reported qualified dividends on Form 1040A, line 9b, use the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040A instructions.

CAUTION: Do not include capital gain distributions as dividend income on Form 1040A or Schedule B (Form 1040A or 1040).

Capital gain distributions. If you received capital gain distributions, you may have to file Form 1040. But you can report capital gain distributions on Form 1040A, line 10, instead of on Form 1040, if both of the following are true.

Form 1040. If you file Form 1040, report your exempt-interest dividends on line 8b. Report your ordinary dividend distributions on line 9a and your qualified dividend distributions on line 9b. If the total of the ordinary dividends you received is more than $1,500 or you received ordinary dividends as a nominee, first report the ordinary dividends on Schedule B (Form 1040A or 1040), Part II, line 5. Report the total from line 6 of that schedule on Form 1040, line 9a. Attach Schedule B (Form 1040A or 1040) to your return.

If you reported qualified dividends on line 9b, use the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040 instructions or the Schedule D Tax Worksheet in the Schedule D instructions, whichever applies, to figure your tax.

CAUTION: Do not include capital gain distributions as dividend income on Form 1040 or Schedule B (Form 1040A or 1040).

Capital gain distributions. If you received capital gain distributions, you report them either directly on Form 1040, line 13, or on Schedule D (Form 1040), line 13, depending on your situation. Report them on Schedule D (Form 1040), line 13, unless both of the following are true.

Undistributed capital gains. To report undistributed capital gains, you must complete Schedule D (Form 1040) and attach it to your return. Report these gains on Schedule D (Form 1040), line 11, and attach Copy B of Form 2439 to your return. Report the tax paid by the mutual fund on these gains on Form 1040, line 70, and check box a on that line.

Table 1. See Table 1 for more information on where to report your mutual fund distributions on Form 1040 or Form 1040A.

Table 1. Reporting Mutual Fund Distributions on Form 1040 or 1040A

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If you received an ordinary dividend distribution as a nominee, report it on Schedule B (Form 1040A or 1040), line 5. Under your last entry on line 5, enter a subtotal of all ordinary dividends listed. Below this subtotal, enter "Nominee Distribution" and show the total ordinary dividends you received as a nominee. Subtract this amount from the subtotal and enter the result on line 6.

If you received a capital gain distribution or were allocated an undistributed capital gain as a nominee, report only the amount that belongs to you on Form 1040A, line 10, Form 1040, line 13, or Schedule D (Form 1040), line 13, whichever is appropriate. Attach a statement to your return showing the full amount you received or were allocated and the amount you received or were allocated as a nominee.

Foreign tax deduction or credit. Some mutual funds invest in foreign securities or other foreign instruments. Your mutual fund may choose to allow you to claim a deduction or credit for the taxes it paid to a foreign country or U.S. possession. The fund will notify you if this applies to you. The notice will include your share of the foreign taxes paid and the part of the dividend derived from sources in foreign countries or U.S. possessions.

You may be able to claim a credit for income tax paid to a foreign country. However, it may be to your benefit to treat the tax as an itemized deduction on Schedule A (Form 1040). For more information on claiming a foreign tax deduction or credit, see Publication 514, Foreign Tax Credit for Individuals.

Keeping Track of Your Basis

You should keep track of your basis in mutual fund shares because you need the basis to figure any gain or loss on the shares when you sell, exchange, or redeem them.

Original basis. As explained in the following paragraphs, original basis depends on how you acquired your shares.

Adjusted basis. As described later under Adjusted Basis, your original basis is adjusted (increased or decreased) by certain events. You must keep accurate records of all events that affect basis so you can figure the proper amount of gain or loss.

Shares Acquired by Purchase

The original basis of mutual fund shares you bought is usually their cost or purchase price. The purchase price usually includes any commissions or load charges paid for the purchase.

Example. You bought 100 shares of Fund A for $10 a share. You paid a $50 commission to the broker for the purchase. Your cost basis for each share is $10.50 ($1,050 ÷ 100).

RECORDS: When you buy or sell shares in a fund, keep the confirmation statements you receive. The statements show the price you paid for the shares when you bought them and the price you received for the shares when you disposed of them. The information from the confirmation statement when you purchased the shares will help you figure your basis in the fund.

Commissions and load charges. The fees and charges you pay to acquire or redeem shares of a mutual fund are not deductible. You can usually add acquisition fees and charges to your cost of the shares and thereby increase your basis. A fee paid to redeem the shares is usually a reduction in the redemption price (sales price).

You cannot add your entire acquisition fee or load charge to the cost of the mutual fund shares acquired if all of the following conditions apply.

Reinvestment right. This is the right to acquire mutual fund shares in the same or another mutual fund without paying a fee or load charge, or by paying a reduced fee or load charge.

Shares Acquired by Reinvestment

The original cost basis of mutual fund shares you acquire by reinvesting your distributions is the amount of the distributions used to purchase each full or fractional share. This rule applies even if the distribution is an exempt-interest dividend that you do not report as income.

RECORDS: When you acquire shares through reinvestment, keep the statements that show each date, amount, and number of full or fractional shares purchased. Keep track of any adjustments to basis of the shares as they occur.

TIP: Generally, you must know the basis per share to compute gain or loss when you dispose of the shares. This is explained under Identifying the Shares Sold, later.

Shares Acquired by Gift

To determine your original basis of mutual fund shares you acquired by gift, you must know:

Example. You are given mutual fund shares with an adjusted basis of $10,000 at the time of the gift. The FMV of the shares at the time of the gift is $9,000. You later sell the shares for $9,500. The basis for figuring a gain is $10,000, so there is no gain. There also is no loss, since the basis for figuring a loss is $9,000. In this situation, you have neither a gain nor a loss.

Fair market value equal to or more than donor's adjusted basis. If the FMV of the shares at the time of the gift was equal to or more than the donor's adjusted basis at the time of the gift, your basis is the donor's adjusted basis at the time of the gift, plus all or part of any gift tax paid on the gift, depending on the date of the gift.

For information on figuring the amount of gift tax to add to your basis, see Property Received as a Gift in Publication 551, Basis of Assets.

Shares Acquired by Inheritance

If you inherited shares in a mutual fund, your original basis is generally the fair market value (FMV) (the last quoted public redemption price) on the date of the decedent's death, or the alternate valuation date if chosen for estate tax purposes.

Community property states. In community property states, you and your spouse generally are considered to each own half the estate (excluding separate property). If one spouse dies and at least half of the community interest is includible in the decedent's gross estate (whether or not the estate is required to file a return), the FMV of the community property at the date of death becomes the basis of both halves of the property.

For example, if the FMV of the entire community interest in a mutual fund is $100,000, the basis of the surviving spouse's half of the shares is $50,000. The basis of the heirs' half of the shares also is $50,000.

In determining the basis of assets acquired from a decedent, property held in joint tenancy is community property if its status was community property under state law.

Shares you gave the decedent. A different basis rule applies to inherited shares that you or your spouse gave the decedent within the 1-year period ending on the date of the decedent's death if, on the date of the gift, the shares were appreciated property. In this situation, the basis of the inherited shares is the decedent's adjusted basis in them immediately before his or her death, rather than their FMV.

This basis rule also applies if the decedent's estate (or a trust of which the decedent was the grantor) sells the shares instead of distributing them to you, and you are entitled to the proceeds.

Appreciated property. Appreciated property is any property (including mutual fund shares) whose FMV is more than its adjusted basis.

Exceptions. This basis rule does not apply if the decedent died before 1982 or you gave the shares to the decedent before August 14, 1981.

Adjusted Basis

After you acquire mutual fund shares, you may need to make adjustments to your basis. The adjusted basis of your shares is your original basis (defined earlier), increased or reduced as described here.

Addition to basis. Increase the basis in your shares by the difference between the amount of undistributed capital gain you include in income and the tax considered paid by you on that income.

The mutual fund reports the amount of your undistributed capital gain on Form 2439, box 1a, and any tax paid by the mutual fund in box 2. You should keep Copy C of all Forms 2439 to show increases in the basis of your shares.

Reduction of basis. You must reduce your basis in your shares by any nondividend distributions that you receive from the fund.

The mutual fund reports the amount of any nondividend distributions on Form 1099-DIV, box 3. You should keep the form to show the decrease in the basis of your shares.

Basis cannot go below zero. Your basis cannot be reduced below zero. If your basis is zero, you must report the nondividend distribution on your tax return as a capital gain. Report this capital gain on Schedule D (Form 1040). Whether it is a long-term or short-term capital gain depends on how long you held the shares.

No reduction of basis. You do not reduce your basis for distributions from the fund that are exempt-interest dividends.

RECORDS: Table 2. This is a worksheet you can use to keep track of the adjusted basis of your mutual fund shares. Enter the cost per share when you acquire new shares and any adjustments to their basis when the adjustment occurs. This worksheet will help you figure the adjusted basis when you sell or redeem shares.

Table 2. Mutual Fund Record

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When you sell or exchange your mutual fund shares, or if they are redeemed (a redemption), you will generally have a taxable gain or a deductible loss. This also applies to shares of a tax-exempt mutual fund. Sales, exchanges, and redemptions are all treated as sales of capital assets. The amount of the gain or loss is the difference between your adjusted basis (defined earlier) in the shares and the amount you realize from the sale, exchange, or redemption. This is explained further under Gains and Losses, later.

Sale. In general, a sale is a transfer of shares for money only.

Exchange. An exchange is a transfer of shares in return for other shares.

Redemption. A redemption occurs when a fund reacquires its shares from you in exchange for money or other property.

RECORDS: Recordkeeping. When there is a sale, exchange, or redemption of your shares in a fund, keep the confirmation statement you receive. The statement shows the price you received for the shares and other information you need to report gain or loss on your return.

Exchange of shares in one mutual fund for shares in another mutual fund. Any exchange of shares in one fund for shares in another fund is a taxable exchange. This is true even if you exchange shares in one fund for shares in another fund within the same family of funds. Report any gain or loss on the shares you gave up as a capital gain or loss in the year in which the exchange occurs. Usually, you can add any service charge or fee paid in connection with an exchange to the cost of the shares acquired. For an exception, see Commissions and load charges under Shares Acquired by Purchase, earlier.

Information returns. Mutual funds and brokers must report proceeds from sales, exchanges, or redemptions to the Internal Revenue Service. They must provide or send each customer a written statement with that information by February 15 of the year following the calendar year the transaction occurred. Form 1099-B, or a substitute, may be used for this purpose. If it is mailed, you should allow adequate time to receive it before contacting the payer. If you still do not get the form by February 28, call the IRS for help.

Report your sales shown on Form(s) 1099-B (or substitute) on Schedule D (Form 1040) along with your other gains and losses. If the total of the sales price amounts reported on Form(s) 1099-B in box 2 is more than the total you report on Schedule D (Form 1040), lines 3 and 10, attach a statement to your return explaining the difference.

Taxpayer identification number. You must give the broker your correct taxpayer identification number (TIN). Generally, an individual will use his or her social security number as the TIN.

If you do not provide your TIN, your broker is required to withhold tax on the gross proceeds of a transaction. For 2010, the withholding rate is 28%. In addition, you may be penalized.

Identifying the Shares Sold

To figure your gain or loss when you dispose of mutual fund shares, you need to determine which shares were sold and the basis of those shares. If your shares in a mutual fund were acquired all on the same day and for the same price, figuring their basis is not difficult. However, shares are generally acquired at various times, in various quantities, and at various prices. Therefore, figuring your basis can be more difficult. You can choose to use either a cost basis or an average basis to figure your gain or loss.

Cost Basis

You can figure your gain or loss using a cost basis only if you did not previously use an average basis for a sale, exchange, or redemption of other shares in the same mutual fund.

To figure cost basis, you can choose one of the following methods.

You will adequately identify your mutual fund shares, even if you bought the shares in different lots at various prices and times, if you:

First-in first-out (FIFO). If your shares were acquired at different times or at different prices and you cannot identify which shares you sold, use the basis of the shares you acquired first as the basis of the shares sold. In other words, the oldest shares you own are considered sold first. You should keep a separate record of each purchase and any dispositions of the shares until all shares purchased at the same time have been disposed of completely.

Table 3 (on the next page) illustrates the use of the FIFO method to figure the cost basis of shares sold, compared with the use of the single-category method to figure average basis (discussed next).

Average Basis

You can figure your gain or loss using an average basis only if you acquired the shares at various times and prices, and you left the shares on deposit in an account handled by a custodian or agent who acquires or redeems those shares.

To figure average basis, you can use one of the following methods.

Example. You own two accounts that hold shares of the income fund issued by Company A. You also own 100 shares of the growth fund issued by Company A. If you elect to use average basis for the first account of the income fund, you must use average basis for the second account. However, you may use cost basis for the growth fund.

TIP: You may be able to find the average basis of your shares from information provided by the fund.

Single-category method. Under the single-category method, you find the average basis of all shares owned at the time of each disposition, regardless of how long you owned them. Include shares acquired with reinvested dividends or capital gain distributions.

Table 3 illustrates the use of the single-category method to figure the average basis of shares sold, compared with the use of the FIFO method to figure cost basis (discussed earlier).

Table 3. Example of How To Figure Basis of Shares Sold

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Example. You bought 400 shares in the LJO Mutual Fund: 200 shares on May 15, 2008, and 200 shares on May 14, 2009. On November 10, 2009, you sold 300 shares. The basis of all 300 shares sold is the same, but you held 200 shares for more than 1 year, so your gain or loss on those shares is long term. You held 100 shares for 1 year or less, so your gain or loss on those shares is short term.

How to figure the basis of shares sold. To figure the basis of shares you sell, use the steps in the following worksheet.

 1) Enter the total adjusted basis of all

 1) Enter the total adjusted basis of all

Example 2. The facts are the same as in Example 1, except that you sold an additional 50 shares on December 17, 2009. You do not need to recompute the average basis of the 150 shares you owned at that time because you acquired or sold no shares, and had no other adjustments to basis, since the last sale. Your basis is the $16 per share figured earlier.

Example 3. The facts are the same as in Example 1, except that you bought an additional 150 shares at $14 a share on September 17, 2009, and then sold 50 shares on December 18, 2009. The total adjusted basis of all the shares you owned just before the sale is $4,500, figured as follows.

 1) Basis of remaining shares ($16 ×

 1) Enter the total adjusted basis of all

The basis of each share in a category is the average basis for that category. This is the total remaining basis of all shares in that category at the time of disposition divided by the total shares in the category at that time. To use this method, you specify, to the custodian or agent handling your account, from which category the shares are to be sold or transferred. The custodian or agent must confirm in writing your specification. If you do not specify or receive confirmation, you must first charge the shares sold against the long-term category and then charge any remaining shares sold against the short-term category.

Changing categories. After you have held a mutual fund share for more than 1 year, you must transfer that share from the short-term category to the long-term category. The basis of a transferred share is its actual cost or other basis to you unless some of the shares in the short-term category have been disposed of. In that case, the basis of a transferred share is the average basis of the undisposed shares at the time of the most recent disposition from this category.

Making the choice. You choose to use the average basis of mutual fund shares by clearly showing on your income tax return, for each year the choice applies, that you used an average basis in reporting gain or loss from the sale or transfer of the shares. You must specify whether you used the single-category method or the double-category method in determining average basis. This choice is effective until you get permission from the IRS to revoke it.

Shares received as gift. If your account includes shares that you received by gift, and the fair market value of the shares at the time of the gift was not more than the donor's basis, special rules apply. You cannot choose to use the average basis for the account unless you submit a statement with your initial choice. It must state that the basis used in figuring the average basis of the gift shares will be the FMV at the time of the gift. This statement applies to gift shares received before and after making the choice, as long as the choice to use the average basis is in effect.

Gains and Losses

You figure gain or loss on the disposition of your shares by comparing the amount you realize with the adjusted basis of your shares. If the amount you realize is more than the adjusted basis of the shares, you have a gain. If the amount you realize is less than the adjusted basis of the shares, you have a loss.

Amount you realize. The amount you realize from a disposition of your shares is the money and value of any property you receive for the shares disposed of, minus your expenses of sale (such as redemption fees, sales commissions, sales charges, or exit fees).

Adjusted basis. Adjusted basis is explained under Keeping Track of Your Basis, earlier. Also see the explanations of cost basis and average basis under Identifying the Shares Sold, earlier.

Wash sales. If you sell mutual fund shares at a loss and within 30 days before or after the sale you buy, acquire in a taxable exchange, or acquire a contract or option to buy substantially identical shares, you have a wash sale. You cannot deduct losses from wash sales.

Substantially identical. In determining whether the shares are substantially identical, you must consider all the facts and circumstances. Ordinarily, shares issued by one mutual fund are not considered to be substantially identical to shares issued by another mutual fund.

For more information on wash sales, see Publication 550.

Reporting information from Form 1099-B. Mutual funds and brokers report dispositions of mutual fund shares on Form 1099-B, or a substitute form containing substantially the same language. The form shows the amount of the sales price and indicates whether the amount reported is the gross amount or the net amount (gross amount minus commissions).

If your Form 1099-B or similar statement from the payer shows the gross sales price, do not subtract the expenses of sale from it when reporting your sales price in column (d) on Schedule D (Form 1040). Instead, report the gross amount in column (d) and increase your cost or other basis, column (e), by any expense of the sale. If your Form 1099-B shows that the gross sales price less commissions was reported to IRS, enter the net amount in column (d) of Schedule D (Form 1040) and do not increase your basis in column (e) by the sales commission.

Example 1. You sold 100 shares of Fund HIJ for $2,500. You paid a $75 commission to the broker for handling the sale. Your Form 1099-B shows that the net sales proceeds, $2,425 ($2,500 - $75), were reported to the IRS. Report $2,425 in column (d) of Schedule D (Form 1040).

Example 2. You sold 200 shares of Fund KLM for $10,000. You paid a $100 commission at the time of the sale. You bought the shares for $5,000. The broker reported the gross proceeds to IRS on Form 1099-B, so you enter $10,000 in column (d) of Schedule D (Form 1040) and increase your basis in column (e) to $5,100.

Note. Whether you use line 1 (for a short-term gain or loss) or line 8 (for a long-term gain or loss) of Schedule D (Form 1040) depends on how long you held the shares, discussed next.

Holding Period

When you dispose of your mutual fund shares, you must determine your holding period. Your holding period determines whether the gain or loss is a short-term capital gain or loss or a long-term capital gain or loss.

Short-term gain or loss. If you hold the shares for 1 year or less, your gain or loss will be a short-term gain or loss.

Long-term gain or loss. If you hold the shares for more than 1 year, your gain or loss will be a long-term gain or loss.

Determining period held. Determine your holding period by using the trade dates of your purchases and your sales. The trade date is the date on which you contract to buy or sell shares. Most mutual funds will show the trade dates on confirmation statements showing your purchases and sales.

CAUTION: Do not confuse the trade date with the settlement date, which is the date by which the mutual fund shares must be delivered and payment must be made.

To find out how long you have held your shares, begin counting on the day after the trade date on which you bought the shares. (Do not count the trade date itself.) The trade date on which you dispose of the shares is counted as part of your holding period.

Example. If you bought shares on January 7, 2008 (trade date), and sold them on January 7, 2009 (trade date), your holding period would not be more than 1 year. If you sold them on January 8, 2009, your holding period would be more than 1 year (12 months plus 1 day).

Mutual fund shares received as a gift. If you receive a gift of mutual fund shares and your basis is determined by the donor's basis, your holding period is considered to have started on the same day that the donor's holding period started.

Inherited mutual fund shares. If you inherit mutual fund shares, you are considered to have held the shares for more than 1 year, regardless of how long you actually held them. Report the sale of inherited mutual fund shares on Schedule D (Form 1040), line 8, and enter "Inherited" in column (b) instead of the date you acquired the shares.

Reinvested distributions. If your dividends and capital gain distributions are reinvested in new shares, the holding period of each new share begins the day after that share was purchased. Therefore, if you sell both the new shares and the original shares, you might have both short-term and long-term gains and losses.

Certain short-term losses. Special rules may apply if you have a short-term loss on the sale of shares on which you received an exempt-interest dividend or a capital gain distribution.

Exempt-interest dividends before short-term loss. If you received exempt-interest dividends on mutual fund shares that you held for 6 months or less and sold at a loss, you may claim only the part of the loss that is more than the exempt-interest dividends. On Schedule D (Form 1040), column (d), increase the sales price by the amount of exempt-interest dividends, but do not increase it to more than the cost or other basis shown in column (e). Report the loss as a short-term capital loss.

Example. On January 7, 2009, you bought a mutual fund share for $40. On February 4, 2009, the mutual fund paid a $5 dividend from tax-exempt interest, which is not taxable to you. On February 11, 2009, you sold the share for $34. If it were not for the tax-exempt dividend, your loss would be $6 ($40 - $34). However, you must increase the sales price from $34 to $39 (to account for the $5 portion of the loss that is not deductible). You can deduct only $1 as a short-term capital loss.

Capital gain distribution before short-term loss. Generally, if you received capital gain distributions (or had to report undistributed capital gains) on mutual fund shares that you held for 6 months or less and sold at a loss, report only the part of the loss that is more than the capital gain distribution (or undistributed capital gain) as a short-term capital loss. The rest of the loss is reported as a long-term capital loss.

Example. On April 10, 2009, you bought a mutual fund share for $20. On June 26, 2009, the mutual fund paid a capital gain distribution of $2 a share, which is taxed as a long-term capital gain. On July 14, 2009, you sold the share for $17.50. If it were not for the capital gain distribution, your loss would be a short-term loss of $2.50 ($20 - $17.50). However, the part of the loss that is not more than the capital gain distribution ($2) must be reported as a long-term capital loss. The remaining $0.50 of the loss can be reported as a short-term capital loss.

Loss on share that paid qualified dividends. Any loss on the sale or exchange of a mutual fund share must be treated as a long-term capital loss to the extent you received, from that share, qualified dividends (defined earlier) that are extraordinary dividends. This is true regardless of how long you actually held the share. Generally, an extraordinary dividend is a dividend that equals or exceeds 10% (5% in the case of preferred stock) of your adjusted basis in the mutual fund share.

How To Figure Net Gain or Loss

Separate your short-term gains and losses from your long-term gains and losses on all the mutual fund shares and other capital assets you disposed of during the year. Then determine your net short-term gain or loss and your net long-term gain or loss.

Net short-term capital gain or loss. Net short-term capital gain or loss is determined by adding the gains and losses shown on Schedule D (Form 1040), Part I, column (f), lines 1 through 6. Line 7 is the net short-term capital gain or loss.

Net long-term capital gain or loss. Net long-term capital gain or loss is determined by adding the gains and losses shown on Schedule D (Form 1040), Part II, column (f), lines 8 through 14. Line 15 is the net long-term capital gain or loss.

Your net long-term capital gain or loss includes any undistributed capital gains you reported on Schedule D (Form 1040), line 11, and any capital gain distributions you reported on Schedule D (Form 1040), line 13.

Total net gain or loss. The total net gain or loss is determined by combining the net short-term capital gain or loss on line 7 with the net long-term capital gain or loss on line 15. Enter the result on Schedule D (Form 1040), Part III, line 16. If line 16 shows a gain, enter the amount on Form 1040, line 13. If line 16 shows a loss, see Limit on Capital Loss Deduction, later.

Figuring Your Tax

If you are reporting capital gain distributions on Form 1040A, use the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040A instructions to figure your tax. See How To Report, earlier, to see whether you can report your capital gain distributions on Form 1040A.

If you are reporting capital gain distributions on Form 1040, but are not required to file Schedule D (Form 1040), use the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040 instructions to figure your tax. See How To Report, earlier, to see whether you must file Schedule D (Form 1040).

If you are required to file Schedule D (Form 1040), use the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040 instructions to figure your tax if both of the following are true.

Capital Gain Tax Rates

The tax rates that apply to a net capital gain are generally lower than the tax rates that apply to other income. These lower rates are called the maximum capital gain rates.

The term "net capital gain" means the amount by which your net long-term capital gain for the year is more than any net short-term capital loss.

The maximum capital gain rate can be 0%, 15%, 25%, or 28%. See Table 4.

Table 4. What Is Your Maximum Capital Gain Rate?

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Example. You have a capital gain distribution that is a section 1202 gain, so the maximum capital gain rate on the distribution would be 28%. Because you are single and your taxable income is $25,000, none of your taxable income will be taxed above the 15% rate. The 28% rate does not apply.

Limit on Capital Loss Deduction

If Schedule D (Form 1040), Part III, line 16, shows a loss, your allowable capital loss deduction is the smaller of:

Example. Bob and Gloria sold all of their shares in a mutual fund. The sale resulted in a capital loss of $7,000. They had no other capital transactions. Their taxable income was $26,000. On their joint 2009 return, they can deduct $3,000. The unused part of the loss, $4,000 ($7,000 - $3,000), can be carried over to 2010.

If Bob and Gloria's capital loss had been $2,000, their capital loss deduction would have been $2,000. They would have no carryover.

Capital loss carryover. If you have a total net loss on Schedule D (Form 1040), line 16, that is more than the yearly limit on capital loss deductions, you can carry over the unused part to next year and treat it as if you had incurred it in that next year. To determine your capital loss carryover, subtract from your total net loss the lesser of:

Use the Capital Loss Carryover Worksheet in Publication 550 to figure your capital loss carryover.

When carried over, the loss will keep its original character as long term or short term. Therefore, a long-term capital loss carried over from a previous year will offset long-term gains of the current year before it offsets short-term gains of the current year. For more information on figuring capital loss carryovers, see Publication 550.

Separate returns. Capital loss carryovers from separate returns are combined if you now file a joint return. However, if you once filed jointly and are now filing separately, a capital loss carryover from the joint return can be deducted only on the separate return of the spouse who actually had the loss.

Investment Expenses

You can generally deduct the expenses of producing taxable investment income. These include expenses for investment counseling and advice, legal and accounting fees, and investment newsletters. These expenses are deductible as miscellaneous itemized deductions to the extent that they exceed 2% of your adjusted gross income. See chapter 3 in Publication 550 for more information.

Interest paid on money to buy or carry investment property is also deductible, but the deduction may be limited. See Limit on Investment Interest Expense, later.

Publicly offered mutual funds. Most mutual funds are publicly offered. Expenses of publicly offered mutual funds are not treated as miscellaneous itemized deductions. This is because these mutual funds report only the net amount of investment income after your share of the investment expenses has been deducted.

Nonpublicly offered mutual funds. If you own shares in a nonpublicly offered mutual fund during the year, you can deduct your share of the investment expenses on your Schedule A (Form 1040). Claim them as a miscellaneous itemized deduction to the extent your miscellaneous itemized deductions exceed 2% of your adjusted gross income. Your share of the expenses will be shown in box 5 of Form 1099-DIV. A nonpublicly offered mutual fund is one that:

Expenses allocable to exempt-interest dividends. You cannot deduct expenses that are for the collection or production of exempt-interest dividends. Expenses must be allocated if they were for both taxable and tax-exempt income. One accepted method for allocating expenses is to divide them in the same proportion that each type of income from the mutual fund is to your total income from the fund. To find the part of the expenses that relates to the tax-exempt income, you must first divide your tax-exempt income by your total income. Then multiply your expenses by the result. You cannot deduct this part.

Example. William received $600 in dividends from his mutual fund: exempt-interest dividends of $480 and taxable dividends of $120. In earning this income, he had a $50 expense for a newsletter on mutual funds. William divides the exempt-interest dividends by the total dividends to figure the part of the expense that is not deductible. Therefore, 80% ($480 ÷ $600) of William's expense is for exempt-interest income. He cannot deduct $40 (80% of $50) of the expense. William may claim the balance of the expense, $10, as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income limit. That is the part of the expense allocable to the taxable dividends.

Limit on Investment Interest Expense

The amount you can deduct as investment interest expense may be limited in two different ways. First, you may not deduct the interest on money you borrow to buy or carry shares in a mutual fund that distributes only exempt-interest dividends. If the fund also distributes taxable dividends, you must allocate the interest between the taxable and nontaxable income. Allocate the interest as explained under Expenses allocable to exempt-interest dividends, earlier.

Second, your deduction for investment interest expense is limited to the amount of your net investment income.

Net investment income. This is figured by subtracting your investment expenses other than interest from your investment income. For this purpose, do not include any income or expenses taken into account to figure gain or loss from passive activities. For more information on passive activity losses, see Publication 925, Passive Activity and At-Risk Rules.

Investment income. Investment income generally includes gross income derived from property held for investment (such as interest, dividends, annuities, and royalties). It generally does not include net capital gain derived from disposing of investment property. Nor does it include qualified dividends or capital gain distributions from mutual fund shares. However, you can choose to include part or all of these amounts in investment income. For information on this choice, see chapter 3 of Publication 550.

Investment expenses. Investment expenses are your allowed deductions (other than interest expense) directly connected with the production of investment income. Investment expenses that are included as a miscellaneous itemized deduction on Schedule A (Form 1040) are allowable deductions after subtracting 2% of adjusted gross income. In figuring the amount over the 2% limit, miscellaneous expenses that are not investment expenses are disallowed before any investment expenses are disallowed.

For information on the 2% limit, see Publication 529, Miscellaneous Deductions.

Example. Jane, a single taxpayer, has investment income for the year of $12,000. Jane's investment expenses (other than interest expense) directly connected with the production of income were $980 after subtracting the 2% limit on miscellaneous itemized deductions. Jane incurred $12,500 of investment interest expense during the year. She had no passive activity losses. Jane figures net investment income and the limit on her investment interest expense deduction as follows:

 Total investment income          $12,000

Carryover. You can carry forward to the next tax year the investment interest that you cannot deduct because of the limit. You can deduct the interest carried forward to the extent that your net investment income exceeds your investment interest in that later year.

Form 4952. Use Form 4952 to figure your investment interest expense deduction. For more information about investment interest expense, see Publication 550.

Comprehensive Example

Robert and Janice Martin have the following four sources of investment income to report on their 2009 tax return. Page 1 of their Schedule D (Form 1040) is shown later. Page 2 is not illustrated.

The Martins keep this record with their mutual fund documents, and they use it to report their 2009 sale of Mutual Fund S.

Preparing Schedule D (Form 1040). The Martins use their Form 1099-B and their Mutual Fund Record to figure the gain from the sale of Mutual Fund S to report on Schedule D (Form 1040).

Robert and Janice enter the $61 capital gain distribution from Mutual Fund R (from Form 1099-DIV, box 2a) on line 13, column (f).

They report the sale of their shares in Mutual Fund S on line 8 because they owned the shares for more than 1 year. They use the information from their Mutual Fund Record to complete columns (a), (b), and (e). After adjustment for their nondividend distributions and their undistributed capital gains, their basis is $1,996 ($9.98 per share). They use their Form 1099-B to complete columns (c) and (d). Their sales price in column (d) (the gross proceeds from Form 1099-B, box 2) is $3,200 ($16 per share). They enter their gain of $1,204 in column (f).

Robert and Janice add the amounts in column (f) of lines 8 and 13 and enter their net long-term capital gain of $1,265 on line 15. They also enter that amount on line 16. They check the "Yes" box for line 17, leave lines 18 and 19 blank, and check the "Yes" box for line 20. They follow the line 20 instructions and they compute their tax on Form 1040 using the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040 instructions. They enter their taxable income of $36,505 (from Form 1040, line 43) on line 1 of the worksheet and their qualified dividends of $470 ($250 from Mutual Fund R and $220 from Green Publishing Co.) (from Form 1040, line 9b) on line 2.

Table 5. Mutual Fund Record for Robert and Janice Martin

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 Keep for Your Records

You can get help with unresolved tax issues, order free publications and forms, ask tax questions, and get information from the IRS in several ways. By selecting the method that is best for you, you will have quick and easy access to tax help.

Contacting your Taxpayer Advocate. The Taxpayer Advocate Service (TAS) is an independent organization within the IRS whose employees assist taxpayers who are experiencing economic harm, who are seeking help in resolving tax problems that have not been resolved through normal channels, or who believe that an IRS system or procedure is not working as it should. Here are seven things every taxpayer should know about TAS:

Free tax services. To find out what services are available, get Publication 910, IRS Guide to Free Tax Services. It contains lists of free tax information sources, including publications, services, and free tax education and assistance programs. It also has an index of over 100 TeleTax topics (recorded tax information) you can listen to on your telephone.

Accessible versions of IRS published products are available on request in a variety of alternative formats for people with disabilities.

Free help with your return. Free help in preparing your return is available nationwide from IRS-trained volunteers. The Volunteer Income Tax Assistance (VITA) program is designed to help low-income taxpayers and the Tax Counseling for the Elderly (TCE) program is designed to assist taxpayers age 60 and older with their tax returns. Many VITA sites offer free electronic filing and all volunteers will let you know about credits and deductions you may be entitled to claim. To find the nearest VITA or TCE site, call 1-800-829-1040.

As part of the TCE program, AARP offers the Tax-Aide counseling program. To find the nearest AARP Tax-Aide site, call 1-888-227-7669 or visit AARP's website at http://www.aarp.org/money/taxaide.

For more information on these programs, go to http://www.irs.gov and enter keyword "VITA" in the upper right-hand corner.

Internet. You can access the IRS website at http://www.irs.gov 24 hours a day, 7 days a week to:

Walk-in. Many products and services are available on a walk-in basis.

Internal Revenue Service 1201 N. Mitsubishi Motorway Bloomington, IL 61705-6613

DVD for tax products. You can order Publication 1796, IRS Tax Products DVD, and obtain: