Turn Lemons Into Lemonade

After an extended bear market, most stock funds now have unrealized losses, not gains. Thus, you can buy such funds at a discount to their after-tax value and avoid paying tax on capital gains distributions, perhaps for many years. Mutual funds may have two kinds of net losses:

• Realized losses. Each year, most funds will engage in many trades. In recent years, these trades have resulted in more losses than gains.
• Unrealized losses. Funds also may be holding onto stocks that have fallen in value since their purchase by the fund. Such holdings may be converted into realized losses at any time.

Unlike realized gains, funds can’t pass realized losses through to shareholders. However, realized losses can be “banked” by funds and carried forward for up to eight years. During this time, realized gains may be sheltered from tax.

Suppose, for example, Great Growth Mutual Fund had realized losses totaling $6 per share in 2001 and 2002. In 2003, as the market recovers, Great Growth realizes $2 per share in gains.

In 2003, Great Growth won’t have to make any capital gains distributions (so shareholders won’t have to pay unwanted taxes). The $6 per share loss it has carried forward will offset the $2 per share realized gains, and the fund still will have $4 per share in banked losses to offset future realized gains.

Thus, even if you own shares of Great Growth that appreciate in 2003, through profitable trades, you’ll owe no tax on the gains. It’s true that stock dividends will be passed through to you, and taxed. However, most stock funds pay meager dividends these days and the federal income tax on those dividends will be no higher than 15 percent, under the 2003 tax law. When you buy into a fund with unrealized capital losses, you’re buying at a discount, after-tax. To get this tax advantage, you do not have to have been a shareholder of the fund when it actually suffered those losses. Instead, you can invest in a fund today and receive the full tax benefit of previous losses.

Suppose that Great Growth Fund now holds $2 billion in assets. Those assets, stocks bought in prior years at higher prices, have a basis of $4 billion.

Therefore, you’re buying into $2 billion of unrealized tax losses: 100 percent of the fund’s current assets. At the new 15 percent tax rate on capital gains, that’s a 15 percent bonus: you’re buying $115 worth of after-tax assets for every dollar you invest in Great Growth Fund, in this example. To enjoy this tax benefit, you must hold a fund in a taxable account. Funds held in a tax-deferred retirement plan won’t owe current taxes on capital gains distributions but will generate fully-taxed income as money is withdrawn from the plan.