Portfolios hit hard in the bear market can have tax advantages for new investors

Journal Report

When gains exceed losses from the sale of securities in their portfolios, mutual funds distribute capital gains to their shareholders, who then must pay taxes on them. This is true even if you reinvest your distributions in additional fund shares, as most investors do. It’s also true even if you are in the hole because your fund’s share price has fallen below your purchase price.

If a fund has net capital losses, however, alas: Mutual funds are prohibited from passing their losses through to investors, who might otherwise use them to offset capital gains or other income.

But take heart: You can turn this unfortunate rule to your advantage, with a little legwork on your part and some help from a new law that prolongs the life of funds’ losses. What follows is a Q and A that will help investors understand how they can benefit from this rule change:

Q. What are the standard rules for investment gains and losses?

A. If you own individual stocks and bonds in a taxable account, you don’t owe capital-gains tax unless you actually sell securities at a profit.

If you sell at a loss, you can use the capital losses to offset capital gains dollar for dollar on your federal tax return. Plus, up to $3,000 in additional losses can be deducted against ordinary income.

If you still have losses above that, Uncle Sam permits you to carry those net capital losses forward indefinitely to help offset capital gains and income in future years. This process continues every year until you’ve used up all of your losses.

Q. How are the capital-gains rules different for mutual funds?

ENLARGE

Alison Seiffer

A. You don’t have as much control over the timing of capital-gains tax bills. Besides the gains you realize by deciding to sell fund shares, you may have taxable gains imposed upon you by the manager’s trading and subsequent distributions. Note, though: Taxes you pay now on gains distributions can reduce the tax you’ll owe down the road when you sell your position in a fund.

Although mutual funds are not permitted to pass along their net capital losses to shareholders, they can carry the losses forward on their books, just as individual investors can for regular investments.

In fact, a new law updates the tax-loss carry-forward rules for mutual funds so that they now more closely resemble the rules for individuals. In the past, funds could only carry forward capital losses for a maximum of eight years.

Now funds will have unlimited use of their capital-loss carry-forwards, just as individuals do. Specifically, net capital losses incurred in fund tax years that begin after Dec. 22, 2010, can be carried forward indefinitely. Older losses will expire according to their original schedules, but the new losses must be used before the older losses can be tapped.

Q. How might I benefit from a fund’s tax-loss carry-forwards?

A. A mutual fund’s tax-loss carry-forwards, along with any unrealized losses on securities it still holds, act like built-in tax shelters. Funds with a large amount of embedded capital losses—both realized and unrealized—can potentially minimize their taxable distributions for years to come. That means more of your investment in the fund can continue to compound tax-deferred.

This is a boon for investors holding funds in taxable accounts, especially since today’s historically low capital-gains rates aren’t likely to last forever, and investors everywhere are scaling back expectations for the market’s long-term performance.

In this environment, investors need to be especially vigilant about their after-tax returns, says Stephen Fusi, an investment adviser at New Wealth Advisors, a registered investment-advisory firm in Tewksbury, Mass.

Q. How prevalent are funds with large embedded losses?

A. After the market meltdown of 2008, the mutual-fund industry was awash in tax losses, resulting in a tax holiday for investors, says Tom Roseen, a senior analyst at Lipper, a unit of Thomson Reuters Corp. Indeed, despite the market’s strong performance in 2009 and 2010, mutual funds paid out only $15.6 billion in capital gains in 2009 and $3.4 billion in the first nine months of 2010, compared with $414 billion in 2007, according to the Investment Company Institute trade group.

Going forward, however, Mr. Roseen and others expect capital-gains distributions to pick up. One indicator: funds’ potential capital-gains exposures, or PCGEs, as calculated by Morningstar Inc.

This is basically an estimate of a fund’s realized and unrealized gains as a percentage of its assets. A negative PCGE means a fund has realized and unrealized losses, or a tax-loss overhang. A fund with a 50% tax-loss overhang, for example, could appreciate about 50% before it had to start distributing capital gains to investors.

According to Morningstar, about 37% of all mutual funds currently have negative PCGEs, down from 60% a year ago. Further, the median PCGE for all stock funds has been inching up, to 7% from negative 6% over the same time period.

Q. What are some good funds with large embedded losses?

A. Of course, a large tax-loss overhang shouldn’t be your only criterion for investing in a fund. Once you’re satisfied with a fund’s fees, management, track record and the like, however, take a look at its tax position. Morningstar updates fund PCGEs on its website monthly. Or you can go hunting in a fund’s annual report for its realized and unrealized losses. You just might uncover a diamond in the rough—a good fund sitting atop a pile of losses.

Take Old Mutual Focused. A five-star, large-blend fund, it has a PCGE of minus 167%, meaning it could appreciate more than 1½ times before paying out a dime of capital gains. Its $1.2 billion capital-loss carry-forward—a monster, says Mr. Roseen—is mostly inherited from two funds merged into it in 2009.

Morningstar fund analyst Kathryn Young calls Focused fund manager Jerome Heppelmann a true stock picker with a very solid record. The fund’s performance ranks in the top 10% of its category over the past five years.

Then there’s Putnam Voyager. Manager Nick Thakore took over this lagging large-growth fund in 2008, and has made it the No. 1 fund in its category for the three-year period ended Dec. 31, 2010, according to the latest rankings from Lipper. The fund has $2.3 billion in capital-loss carry-overs—due mostly to its dismal performance through much of the ’00s—amounting to a negative 30% PCGE.

The bulk of the carry-overs expire in July of this year. But Mr. Thakore is keeping mum about his plans.

Ms. Geer is a writer in Fairfield, Conn. Email her at reports@wsj.com .