How Does a Capital Gain Dividend Affect Adjusted Cost Basis?

Every time you buy shares from a particular mutual fund, you increase your total “cost basis,” which is the amount of money you've sunk into the fund. “Adjusted” cost basis includes commissions. Your cost basis declines when you sell some of your shares. Each purchase creates an open “tax lot,” which records the date, number of shares and price. You can select which tax lots to sell, have the mutual fund apply them in a first-in, first-out sequence, or have the fund use your average cost basis. The difference between the cost basis and sale proceeds of the tax lots you sell creates a capital gain or loss. You also earn capital gains and losses when the fund manager sells part of the fund portfolio.

A mutual fund doesn’t pay income taxes -- that responsibility falls upon shareholders. To qualify for this arrangement, the mutual fund must distribute at least 95 percent of its capital gains to investors each year. A capital gains dividend represents the net gains earned by the fund manager on the portfolio investments sold throughout the year. The fund issues Internal Revenue Service Form 1099-DIV each year detailing your capital gains distributions for the previous year.

Your capital gains distribution is in the form of cash, which has no effect on the cost basis of your investment in the fund. The net asset value, or price, of your shares declines in proportion to the size of the total capital gain distribution made by the fund. This reduces your gain when you sell shares. You can ask the fund to reinvest you capital gains distributions automatically. This will increase your cost basis, because you are buying additional shares. The decision to reinvest capital gains distributions or leave them as cash in no way affects the amount of capital gains tax you must fork over because of the distribution.

The IRS instructs taxpayers to treat all capital gains distributions from mutual funds as long-term gains, no matter how long you’ve held the shares. This contrasts to shares you sell, in which long-term gains apply to shares you’ve held for more than one year. In 2013, the tax rate on short-term gains is your marginal tax rate -- the tax on your “last dollar” of income. Long-term rates vary from 20 percent to zero, depending on your income level. If you choose to sell all your fund shares, your total capital gain or loss will reflect the shares you bought through reinvested capital gain distributions and thus might be higher or lower than your results would be had you chosen not to reinvest.