Tax planning and mutual funds
This is the time of year when mutual fund companies begin releasing estimates of expected distributions on their funds. There are some broad fund categories to watch out for and some specific funds. Whether you're sitting on a small paper gain or a paper loss, taking steps to avoid distributions could be a smart tax move this fall.
To get a very broad idea of which funds might be expecting a sizeable distribution next month, we did some basic screens, using Morningstar Canada's Paltrak software. In an attempt to screen out funds with lots of tax losses to carry forward, we first looked for funds with a positive five year return through October 2005.
We then looked for both strong three year and year-to-date returns to try to identify those funds that might have had the opportunity to realize big gains. Canadian funds - Canadian balanced, Canadian (small- and large- cap) equity, dividend, natural resource, and income trust funds - make up more than 85% of the short list of funds that passed those quick screens.
With Canadian markets firing on all cylinders, this should not come as a surprise.
Mackenzie Universal Canadian Resource fund, for instance, is expecting an estimated distribution equal to about 12% of its recent unit price. Mackenzie Growth fund is expecting a similar level of distributions.
Expect the unexpected
However, this screen isn't perfect - nor is mutual fund accounting. There are funds that haven't done well this year that indeed are expecting significant payouts this year.
Brandes U.S. Small Cap Equity fund is expecting to pay a distribution of more than $0.82 per unit - nearly 8% of its recent unit price. But the fund is slightly in the red over the past year and down more than 15% in the last three months. So, it appears to have sold stocks earlier in the year - before the more recent decline - to trigger this expected capital gains distribution.
Among global funds, it's worth checking into expected distributions for small cap funds. They've had a tremendous six year run and many are bound to given investors an unwelcome, taxable holiday gift.
Investors sitting on paper losses, or on paper gains that are less than the expected distributions, it pays to consider skirting the distribution.
Avoiding distributions and superficial losses
Investors should only consider taking action if the cost of selling is less than the tax avoided by escaping the distribution. Costs of selling come in two forms - direct and indirect.
Direct costs are more obvious: realized gains and potential sales charges or other transaction costs. Indirect costs refer to opportunity costs. That's the cost of sitting out of a fund for any length of time - potentially missing out on any rise in price while on the sidelines.
Investors sitting on paper gains that are smaller than the expected distribution can simply sell out of the fund prior to the payout; then immediately buy back in after the distribution has been paid. You're out of a fund for the better part of a week but avoid the distribution.
For those in a loss position looking to avoid a distribution, more care must be taken. There is a 61-day period of which to be aware - 30 days before the sale date and 30 days after the sale date. During that period, neither the investor, the investor's spouse, nor a corporation controlled by either:
- can make purchases in the security in question at any time during the period; or
- own the security (or a right to buy such security) at the end of the period.
A superficial loss will also be triggered by switching into what tax laws consider 'identical property', but there are ways to avoid distributions while maintaining similar portfolio exposure. Switching to other funds within a family can achieve the twofold objective of covering the opportunity cost of being out of a fund and avoiding the tax hit resulting from a distribution.
For instance, those wanting to avoid the distribution on Mackenzie Universal Canadian Resource fund may consider simply switching into Mackenzie Universal World Resource Capital Class (because Mackenzie does not expect a distribution in this fund). Much of the same (though not identical) exposure is maintained, with the same investment style and portfolio manager - all while allowing the investor to make a tax-friendly move.
Recall that a disposition occurs on a trade's settlement date (not trade date) because that's the day that investors are entitled to receive the proceeds. Hence, switching within the same family is ideal since the switch settles on the same day - so you're never completely out of the market and less time is required to implement the strategy.
To demonstrate the identical property rule, Trimark Fund SC and Trimark Fund DSC would be considered 'identical' for tax purposes because they are merely two classes of the very same mutual fund trust. Even though its sibling - Trimark Select Growth - has the same mandate and very similar holdings, it is run by a different team. More importantly, it is an entirely different mutual fund trust. And that's different enough to avoid getting caught by the superficial loss rules.
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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