by Jay D. Franklin Monday, February 11, 2013
Quite frequently, an IFA advisor or I will speak to a client who thinks he has lost money because of what he sees on an unrealized gains report. Specifically, a
position may show an unrealized loss even though the investor has experienced an investment gain. It is important to understand that the unrealized gains
report merely shows the gain that would have to be reported to the IRS if the position were liquidated, and this is not the same as the gain (or loss) that
resulted from the change in value since the time of purchase. We will explore this in further detail below with a specific example.
Suppose we have a REIT index fund that has a dividend yield of 4% and the 4% is distributed at the end of each year with the proceeds being reinvested into
the fund. Let’s assume that we buy 1,000 shares at the beginning of the year at a price of $10.00 per share for a total investment of $10,000. Let us also
assume that the only source of appreciation in these shares is the dividend. This means that at the end of the year, before the distribution, we will have 1,000
shares valued at $10.40 per share for a value of $10,400. Here is the key point: When the distribution occurs, our investment will still be worth $10,400, but
now we will have 1,040 shares valued at $10.00 per share. The $400 dividend that was distributed goes into our cost basis, so here is what we would see on an
unrealized gain report:
| Market Value | $10,400 |
| Cost Basis | $10,400 |
| Unrealized Gain | $0 |
It is essential to understand that in a taxable account, taxes must be paid on the $400 regardless of whether it is taken in cash or reinvested back into the fund.
If it is reinvested, then fairness demands that it be included in the cost basis—otherwise, we would be taxed again on the $400 as a capital gain if we were to
sell the position. While the unrealized gain report gives the impression that we have simply broken even, here is what we would see on an investment
performance report:
| Initial Investment | $10,000 |
| Deposits/Withdrawals | $0 |
| Market Value | $10,400 |
| Investment Gain | $400 |
| Total Return | 4.00% |
Note that the reinvested dividend does not count as a deposit into the fund. To see how we could show a loss on the unrealized gains report, suppose that we
bought our 1,000 shares in the middle of the year when they were valued at $10.20 per share for a total purchase price of $10,200. Again, at the end of the
year, the investment is valued at $10,400, and a distribution of $400 occurs that is reinvested. Here is what we would see on the unrealized gain report
showing a $200 unrealized loss.
| Market Value | $10,400 |
| Cost Basis | $10,600 |
| Unrealized Gain/(Loss) | ($200) |
And here is the investment performance report showing a $200 investment gain.
| Initial Investment | $10,200 |
| Deposits/Withdrawals | $0 |
| Market Value | $10,400 |
| Investment Gain | $200 |
| Total Return | 1.96% |
A common complaint about mutual funds for taxable investors is the possibility of receiving a taxable distribution shortly after purchasing the fund, meaning
that the investor is taxed on a gain that she did not truly experience. While technically this is correct, it is mitigated by the fact that the distribution could go
back into the cost basis (if reinvested) or the market value of the remaining shares would be lower (if taken in cash). Either way, the investor can recoup the
tax liability by simply selling the shares and realizing a loss. Nevertheless, IFA makes an effort to minimize the impact of distributions on taxable investors.
Specifically, as the December distribution date approaches, IFA estimates the break-even date for each fund—i.e., the date at which the expected return is the
same as the tax liability from the distribution, and IFA will avoid large purchases in taxable accounts until the distribution date passes.
The key point to remember is that the unrealized gain only tells you the gain (or loss) you would report to the IRS if you sold a position. It does not tell you the
investment gain or loss. It goes without saying that for a non-taxable account, there is absolutely zero reason to ever look at an unrealized gain report. If you
have any questions or concerns on this topic, please feel free to write us at info@ifa.com.