Dear rss free blog,
Normally
at this time of year I start to worry about the tax consequences of
new-buys of closed end funds. Your earnings distribution can trigger
a short term gain. Now with so much tax-loss carryforwards from 2008
(the anno horribilis!) the odds are that there are enough losses in
your fund to sop up the gains.
So
you should only buy such funds at other times of the year, and sell
them in the latter part of the year. But not this year.
There is another new risk, pointed out by Cecilia Gondar of Thomas B.
Herzfeld & Co., the closed-end fund experts. She writes about
CEFs, but be aware that the risk applies to some open-end funds too. Essentially, if a fund has set up a steady payout (for marketing reasons), its managers often do not know what proportion of the dividends sent to shareholders is actually earned by the fund until the books are closed at the end of the year. Part of the payment may be return of capital, which normally is NOT taxed for the recipients. It is their money after all. But this year is different. Over to Cecilia:
“2009’s
strong performances combined with the prevalence of loss
carryforwards may have an unexpected negative tax consequence for
shareholders. Funds with managed and level payout policies, [and]
those that chose to make distributions in excess of their net
investment income and capital gains, may find that some or all [of]
their return of capital (ROC) distributions fall into a new category
of tax treatment. This happens when three conditions occur
simultaneously:
•
the fund has current year gains
•
the fund has accumulated losses from prior years, and
•
the fund pays out distributions that exceed distributions required by
the IRS.
“If
all of these criteria are met, any excess ROC may
be reclassified and taxed as ordinary income. ROC
distributions are usually not taxable when paid, but instead the
amount of ROC distributed is subtracted from the investor’s cost
basis.
“Funds
with managed payout policies have been monitoring this and several
disclose the possibility of ROC being reclassified as a taxable
payout. (TCW Strategic Income
Fund, TSI,
was the example.)
“The
increased odds of having to tell investors that returning their own
money to them will be taxable has been, in part, a reason funds
suspended or discontinued formal payout policies this year. [But]
ROC payments are more prevalent than most investors realize. In past
years, funds that estimated that some of their payouts included ROC
could later reclassify these distributions as capital gains if in the
course of the year offsetting capital gains were actually realized.
This year, however, loss carryforwards are likely to offset most or
all capital gains and leave the ROC source of the payment intact.
“If
you are wondering if this news will have investors up in arms, the
answer is probably no. When Zweig
Fund(ZF)
and Zweig
Total Return Fund (ZTR)
discontinued their 10% managed payouts in 2003 for this reason,
investors demanded they be reinstated, no matter what the tax
consequences. For those investors, a steady stream of predictable
distributions and potential for narrower discounts outweighed the
additional tax burden.
Along
with Cecilia, thanks for the idea
behind this story to blogger “Gwailo”. Now the IRS proposes to tax you on getting your own money back.
Having asked for help on
Passive Foreign Investment Companies from Daniel J. Pilla, I will
later ask him to address return of capital issues. Pilla, from
Stillwater MN, is a specialist in Tax Litigation and author of nearly
a dozen books. He was consulstant to the National Commission on
Restructuring the IRS. Apologies in advance to non-subscribers. Taxes
are a key to successful investing in tax-hungry America.
More
on CEFs for paid subscribers follows along with some company news and some trading details.
