How does the return of principal payments affect my cost basis in my mutual funds?


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 basis can't be adjusted below zero. 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.

How do I calculate the average basis for the sale of mutual fund shares?


In order to figure your gain or loss using an average basis, you must have acquired the shares at various times and prices.

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.

You may no longer use the double-category method for figuring your average basis. If you were using that method for shares acquired before April 1, 2011 and you sell, exchange, or otherwise dispose of those shares on or after April 1, 2011, you must figure the average basis of those shares by averaging together all identical shares in the account on April 1, 2011, without regard for the holding period.

If you wish to use the average basis to figure the gain on the sale of 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 Publication 550, Investment Income and Expenses (Including Capital Gains and Losses), for information on how to make these elections.

I received a 1099-DIV showing a capital gain. Why do I have to report capital gains from my mutual funds if I never sold any shares?


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 is capital gain, and the mutual fund passes it on to you as a capital gain distribution. Form 1099-DIV, Dividends and Distributions, distinguishes this 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 13 of Form 1040, U.S. Individual Income Tax Return, and check the box, or on line 10 of Form 1040A, U.S. Individual Income Tax Return. Review the Instructions for Form 1040 and the Instructions for Form 1040A for more information.