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What Causes a Capital Gain?

Peter K. HooverJanuary 17, 2019

Investments

A client called our office and asked why do I have to pay tax on capital gains when my investments lost value this year?  The answer lies in understanding what causes a capital gain. 

Basically, there are two different ways to generate a capital gain.  The first is when you own a capital asset such as a stock, bond or mutual fund and the asset increases in value from the original purchase.  When that asset is sold, the difference in value or profit between the original purchase price (tax cost basis) and selling price represents a capital gain that is taxed according to your capital gains tax rate.  It is important to note that the investor controls when this capital gain is realized by when the capital asset is sold.

The second method to generate a capital gain is primarily out of the investor’s control.  Each year, generally in the last month or two, a mutual fund may pay a capital gain distribution to shareholders of record on the date the capital gain was declared.  This capital gain is the result of transactions the mutual fund manager made throughout the entire year.  When the manager determines a security within the fund should be sold either due to market outlook, stock indicators, economic fundamentals or simply a need to raise cash for shareholder redemptions, a capital gain may occur if a profit is realized.  Shareholders in mutual funds do not see these capital gains being realized throughout the year, but they are accumulated and reflected in an increased share price or Net Asset Value on a day by day basis.  By prospectus requirements, the mutual fund is required to distribute at least 95% of these capital gains to shareholders each year in the form of a capital gain distribution.

It does not matter if the investor chooses to reinvest the capital gain and buy more shares or elects to take the capital gain distribution in cash, the capital gain is still taxed in the current year.  These capital gains, along with any interest or dividends, are reported on IRS Form 1099 at the end of each year. 

It is important to note, that a mutual fund can lose value due to a decline in share price, but the fund could still pay a capital gain at year end.  How does this happen?  If you consider 2018 as an example, investors experienced a tremendous amount of volatility in their portfolios due to many different factors.  Mutual fund managers may have made sales throughout the year to capture profits from investments made several years ago in order to rebalance their portfolio or raise cash for redemptions.  As a result of these sales the mutual fund generated capital gains.  In the fourth quarter of 2018, most investments experienced a decline in share price due to adverse market conditions, and the value of such investments decreased.  However, if capital gains were realized in the year by the mutual fund, it is required to distribute that gain and the investor has to pay the corresponding capital gains tax even though the fund declined in value.

There are passive mutual funds, such as index funds, that generally do not distribute capital gains at year end because none of the securities were sold during the year.  Generally, this would cause little or no capital gain distributions at year end and defers the gain until the investor chooses to sell the fund. 

Most people look at capital gain distributions as a bad thing because they must pay taxes.  However, the purpose of investing is to make money, thus creating capital gains. Therefore taxes must be paid someday.  As financial planners, our goal is to help clients to maintain and/or grow wealth.  In our opinion, capital gains should be considered a positive experience. An experience that has realized profits. Taxes go along with the benefit.

The optimal solution for capital gains tax assessment is to monitor your taxes throughout the year. Make asset sales when appropriate, yet be careful to purchase funds that are not expected to pay capital gains you cannot control.  If capital gains have been realized, your planner may also consider a tax loss harvesting program to help offset a capital gain.

Please consult your financial advisor to learn more about capital gains and how to best manage your tax liability.