Buying the dividend and wash sales

One of the advantages of investing in a mutual fund is the ability to purchase and redeem shares at any given time. Potential shareowners indicate the amount they wish to invest and the share price is determined after the next closing of the financial markets.

However, there are times when it may not be in your best interest to purchase shares because the fund is about to declare a dividend. This may not only affect the price you pay for shares but also generate income, upon which you may have a tax liability. When this occurs, it is called buying the dividend.

Take for example two investors that are interested in shares of a stock fund investing primarily in large companies:

Investor A invests $10,000 in the fund on June 24th. Because the Net Asset Value of the shares is $50, Investor A is able to purchase 200 shares. On June 25th, the fund declares a dividend of $1.50 per share, reducing the NAV to $48.50 per share. Investor A receives $300 in dividend income that is reinvested in the fund. Investor A's original shares are now worth $9,700 ($48.50 x 200) and the reinvested dividends purchase 6.186 additional shares ($300 ÷ 48.50). Investor A now has 206.186 shares and taxable income of $300.

Investor B waited until the day after the dividend is declared. Her $10,000 purchased 206.186 shares (10,000 ÷ 48.50) but she has not received any dividend income, so there are no taxes assessed.

Of course, this example does not take into account any sales loads or expenses that may be required. The dividend example is hypothetical and is not based on any mutual fund investment currently available. It merely shows what can happen when a purchase is made immediately prior to declaring a dividend. You should consult a tax advisor for additional information.

Another transaction that may carry tax consequences is a wash sale. This occurs when shares of a mutual fund or individual securities are sold at a loss and replacement shares are purchased within 30 calendar days either before or after the sale. Rules set by the Internal Revenue Service prohibit shareowners from declaring a capital loss when a wash sale occurs.

The initial sale may have been made in order to declare a short- or long-term capital loss for tax purposes. A loss of this kind can be used to offset a capital gain on your personal income taxes, lowering the amount you may owe for the year. However, purchasing substantially similar shares within either 30 calendar days before or after the sale will prevent you from declaring a loss on your return.

In addition, the disallowed loss is added to the cost basis of the replacement shares. In other words, if you had originally paid $20 for the individual shares, sold them for $10 (a loss of $10 per share), and purchased replacement shares for $11, your cost basis for the new shares is now $21 (the $11 purchase price plus the $10 loss).

Your holding period for those shares is also changed to include the amount of time you held the original shares. While that may not seem like such a problem, it can make a difference in determining a long- or short-term capital loss or gain when you decide to sell the shares.

State Farm VP Management Corp. Risk/Important Disclosures and Prospectus (PDF 648 KB).

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AP2007/08/9008