Mutual fund internal loss carryovers

H.R.4337

Mutual funds are legally structured as pass-through conduits of investment income. The income can come from dividends and interest received from securities or by profits realized by selling securities. By law, the fund must distribute income and gains to shareholders or else pay tax on retained income.

While a fund must distribute or pay tax on investment gains,  similar treatment is not permitted for investment losses realized on security sales.  These losses are retained by the fund, where they can be used to offset realized gains.  Surplus losses can be “carried over” to subsequent years when they can be used to offset future gains. Prior to 2010, these carryover losses where subject to expiration dates.

The passage of the Regulated Investment Company Act Modernization Act of 2010 stipulated that mutual fund losses could be carried over indefinitely but must be used before any expiring loss carryforwards.  With expiration dates  coming due in 2016 – 2018 funds must use both sets of losses  by the applicable expiration date.

For example, assume a fund has  a loss carryforward of 3 billion dollars that is allocated as follows:

  • Losses after 2010 : 1.4 billion dollars
  • Losses expiring 12/31/2016: 1.6 billion dollars

In this instance, because post 2010 act losses must be used before any expiration losses, all 3 billion dollars of carryover losses must be used to offset 2016 gains or else some losses will expire.

Thus, if in 2016, the fund realizes 800 million dollars of gains, these gains can be offset by 800 millions dollars of the 1.4 billion dollars of non-expiring losses. The fund  would retain a  600 million dollar non-expiring loss carryforward. The 1.6 billion dollars of expiring losses would expire at year’s end.

What happens when loss carryforwards are not used and expire? All is not lost, as the expired losses are accounted for by reclassifying  the losses from accumulated net realized losses to paid-in capital. The reclassification raises the tax basis of the fund’s holdings. What is lost however, is the fund’s bank of surplus of losses to offset future gains. Assuming the fund continues to harvest losses, these losses can now carryover indefinitely according to the 2010 act provisions.

A spreadsheet documenting the loss carryforward expiration dates for Vanguard U.S. stock index funds can be accessed here.

About

Barry Barnitz, administrator of both the Bogleheads® wiki and of Financial Page, a Bogleheads® blog

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March 2016
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