Tax-Free Bond Funds

[bicker]

I'm a dummy. Could someone please explain Tax-Free Bond Funds to me? Specifically, I'm wondering what I am supposed to put on my tax forms when I "cash-out" of a fund for which the "interest is free of state and federal income taxes".

 

[Bob Slydell]

As far as a sale of a bon fund, you should treat it like any other sale of a security, e.g. report the gross proceeds and any capital gain from the increase in bond value. The interest is tax-free, but any principal gain in the bond's value is not.

http://personal.fidelity.com/global/search/inquira/resultsindex.shtml?question=bond fund

 

[bicker]

I'm not sure I understand what it means to "report the gross proceeds". I mean, 95% of this money I put in post-tax, so it's mine, right? I shouldn't be taxed on the money I invested, right? (Can you tell I'm a dummy about investing? )

 

[Bob Slydell]

No, you're not being taxed on the money you put in (your basis in the fund), simply on the increase in the value of the fund (if any). I haven't sold a fund in a few years, but IIRC, on the form for the sale of securities, there's separate boxes for proceeds (how much cash you're getting for the sale) and for fund basis (how much you initially paid for the fund). Any net gain is taxable.

 

[bicker]

Okay, so I'm just guessing here. I have to treat the original investment and each reinvestment of dividends separately, since I paid a different amount each time there was a reinvestment. Is that right?

 

[Bob Slydell]

Yes, that would be correct. Each purchase would have a different basis amount. I think (emphasis on think, since I haven't researched it yet) you might be able to do an average cost basis instead of having to detail each and every reinvestment. But don't quote me on that.

Did you get a statement from your fund company detailing the sale? That should help guide you as far as how to handle the sale.

 

[Bob Slydell]

Here you go (I did the research quickly):

http://www.irs.gov/faqs/faq10-3.html

How do I calculate the average basis for the sale of mutual fund shares?

In order to figure your gain or loss using an average basis, you must have acquired the shares at various times and prices and have left them on deposit in a managed account.

There are two average basis methods:

Single-category method, and
Double-category method.

Single-category method. First, add up the cost of all the shares you own in the mutual fund. Divide that result by the total number of shares you own. This gives you your average per share. Multiply that number by the number of shares sold.

Double-category method. First, divide your shares into two categories, long-term and short-term. Then use the steps above to get an average basis for each category. The average basis for that category is then the basis of each share in the sale from that category.

Once you elect to use an average basis method, you must continue to use it for all accounts in the same fund. You must clearly identify on your tax return the average basis method that you have elected to use. You do this identification by including "AVGB" in column (a) of Form 1040, Schedule D (PDF) .

 

[bicker]

Thanks! I'll try to decrypt those glyphs from the IRS and apply them to our appeal.

 

[Bob Slydell]

No problem.

In plain English -- take the total value of your fund and divide by the total number of shares you own. That's your per share average basis (or cost). Do the same with your proceeds and you can get your per share gain (or loss) on the sale of the fund.