Do you know what you sold? - tax accounting and mutual funds - For Your Tax File - column

Nation's Business, Jan, 1990 by Gerald W. Padwe

Do You Know What You Sold?

During periods of stock-market turmoil, many investors have given up hope of understanding the market's ups and downs, and they have turned more and more to mutual funds to take advantage of diversity within a portfolio.

One noninvestment drawback to these funds, though, is accounting for the cost of shares. With prices fluctuating daily, and with funds routinely recording purchases to the nearest thousandth of a share, keeping track of the cost of a specific share is a cumbersome process. This is particularly true for those investors who have monthly dividends reinvested in the fund at whatever price exists on the dividend date.

When the time comes to sell shares and calculate the cost of shares sold, following the rules provided by regulation can be most important to obtaining the best tax result. This was the unhappy lesson learned by a certain investor who had acquired mutual-fund shares over time in a rising stock market. Because prices were climbing, it was advantageous for him to treat sales as coming first from the most recently purchased shares, since they would have a higher cost and thus result in lower gain.

Accordingly, the investor used the last-in, first-out method of accounting for mutual-fund sales, only to be challenged by the IRS. Regulations governing sales of stock acquired at different times state that, in the absence of specific written instructions from the investor to the broker or agent, a first-in, first-out flow must be assumed.

Since the investor had bought and sold many of his shares by telephone, without any formal written instructions to the fund agent, he was not permitted to treat his later-purchased, higher-cost shares as sold first. The result was a substantially higher tax gain for the year. The U.S. Tax Court agreed with the IRS that this was proper.

But how can you avoid this kind of result? Even if the sale is made by telephone, send your broker or fund agent a confirming letter that states which shares are to be sold. In addition, the broker or agent must send you a confirmation letter saying that your instructions have been followed.

Avoid a written request that states, "Please make this sale from my highest-cost shares in XYZ fund." Instead, your letter should identify the number of shares acquired (whether through purchase or dividend reinvestment) on specific dates at specific prices, to ensure you have satisfied the regulatory rules.

Is this a triumph of form over substance? Absolutely! But it is a relatively painless exercise to follow, and your lower tax bill should more than make up for the nuisance of drafting those letters to your broker.

Gerald W. Padwe is national director-tax practice for Touche Ross & Co. Readers should see tax and legal advisers on specific cases.