Mutual funds (costs, distributions, etc.)

The return of principal payments is often called either a return of capital or a nondividend distribution. As a return of your original investment (cost), it reduces your basis. However, your return of capital is not taxed until after it reduces your basis to zero. If you cannot identify specific shares, reduce the basis of the earliest stock purchases first. This information may be reported to you on a Form 1099-DIV, Dividends and Distributions in box 3.

Once you've adjusted your basis to zero, report any additional returns or distributions (other than dividend distributions) on Schedule D (Form 1040), Capital Gains and Losses and Form 8949, Sales and Other Dispositions of Capital Assets. Any gains from stock held longer than a year should be reported as a long-term capital gain.

• Publication 550, Investment Income and Expenses (Including Capital Gains and Losses)

To figure your gain or loss using an average basis, you must have acquired the identical shares at various times and prices or you acquired the shares after 2011 in connection with a dividend reinvestment plan (DRP) and left them on deposit in an account kept by a custodian or agent.

To calculate average basis:

• Add up the cost of all the shares you own in the mutual fund.
• Divide that result by the total number of shares you own. This gives you your average per share.
• Multiply the average per share by the number of shares sold.

If you wish to use the average basis to figure the gain on the sale of identical mutual fund shares, you must elect to do so. To choose the election, there are two separate processes for making the election for average basis method for covered and noncovered securities. See "Average Basis" in Publication 550, Investment Income and Expenses (Including Capital Gains and Losses) for information on how to make these elections.

If you were using the double-category method for figuring your average basis on stock acquired before April 1, 2011, refer to Publication 550.

• Instructions for Form 8949, Sales and Other Dispositions of Capital Assets

A mutual fund is a regulated investment company that pools funds of investors allowing them to take advantage of a diversity of investments and professional asset management.

You own shares in the mutual fund but the fund owns capital assets, such as shares of stock, corporate bonds, government obligations, etc. One of the ways the fund makes money for you is to sell these assets at a gain.

If the mutual fund held the capital asset for more than one year, the nature of the income from a sale of the capital asset is capital gain, and the mutual fund passes it on to you as a capital gain distribution. These capital gain distributions are usually paid to you or credited to your mutual fund account, and are considered income to you. Form 1099-DIV, Dividends and Distributions distinguishes capital gain distributions from other types of income, such as ordinary dividends.

Consider capital gain distributions as long-term capital gains no matter how long you've owned shares in the mutual fund.

Report the amount shown in box 2a of Form 1099-DIV on line 13 of Schedule D (Form 1040), Capital Gains and Losses. If you have no requirement to use Schedule D (Form 1040), report this amount on line 7 of Form 1040, U.S. Individual Tax Return or Form 1040-SR, U.S. Tax Return for Seniors and check the box. Review the Instructions for Form 1040 (and Form 1040-SR) for more information.
 

• Publication 550, Investment Income and Expenses (Including Capital Gains and Losses)
• Tax Topic 404 - Dividends