When Funds Collide: Combining Capital Gains May Be Your Loss

When Funds Collide, Survivors Often Suffer
Mergers Cause Sleepless Nights at SEC
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Mutual fund companies portray mergers as win-win situations for shareholders of both funds, but in truth, there's potential for everyone to get burned.

Mergers can have tax consequences, whether you own the fund that's doing the acquiring or the target fund that's being dissolved.

A merger can trigger a big taxable distribution for the target fund's shareholders. And it can saddle the acquiring fund's shareholders with unrealized gains that someday could turn into taxable distributions.

Either way, it pays to look closely at the terms of a fund merger. And if you decide you want to bail out, there are tax-efficient ways to do it. But first, some background.

Inherited Gains and Losses

There are two kinds of gains on your mutual fund's books: realized and unrealized.

Shareholder Checklist
Be aware of realized and unrealized gains in both funds' portfolios. You can find these figures in the "financial highlights" section of the funds' semiannual reports or prospectuses.
Make sure the acquiring fund will be able to use these carry-forward losses. In many cases, the target funds are dogs with lots of capital losses, but if a poorly performing fund "is merging into another dog, that's silly," says Singh. Then neither fund can take advantage of the built-up losses. Check the tax footnote of the financials for details on carry-forward losses.
Read up on what the acquiring fund is going to do with the target fund's portfolio. The acquiring fund's intentions should be spelled out clearly in the merger documents. Invariably, the acquiring fund sells the target fund's assets. Tax law allows the acquirer to sell up to two-thirds of the target fund's portfolio. That translates into more taxable realized gains that will be passed on to the shareholder. It also means higher transaction costs, which are deducted from a fund's returns.

In simplest terms, a mutual fund generates realized gains when it sells a holding for more than it bought it for. By law, a mutual fund must pass net realized gains on to its shareholders by the end of its fiscal year. Those gains are taxable to you. In the case of a merger, realized gains of the target fund must be distributed before the day the funds merge, says Ravi Singh, mutual-fund tax partner at Ernst & Young.

On the flip side, unrealized gains are the difference between what your fund initially paid for the securities still in its portfolio and what they're worth now. Let's say your fund manager bought shares of IBM (IBM) at 18 in January 1995. On July 23, the stock closed around 125. That means there's an unrealized gain of 107 per share on the books.

Even though these are just "paper" gains, be wary. One day the fund's manager may decide to sell those IBM shares. Selling would turn that 107 unrealized gain into a realized gain, which then would be passed on to you and other shareholders in the fund.

If two funds merge, unrealized gains of both funds are combined. If the target fund has a big unrealized gain on its books, the surviving fund will inherit that potential distribution, says Jim Calvin, an investment management tax partner at Deloitte & Touche in Boston and editor-in-chief of the Journal of Taxation of Investments.

On the plus side, a surviving fund also absorbs a target fund's unused, or carry-forward, losses. Excess losses can be "banked" and used to offset gains for up to eight years. So an acquiring fund with lots of realized gains could benefit from teaming up with a fund that has carry-forward losses.

Should You Sell?

• Target-fund shareholders:

  You can avoid a big realized-gains distribution by selling your shares before the merger. If you plan to take this course, don't dawdle. If you're going to sell, then sell. You may not get notice that the distribution is coming. And once you get it, you're stuck with it.

  If your fund is a poor performer and you would like to own shares in the acquiring fund, instead of simply waiting for the merger to go through, here's a better way.

  Sell your shares in the target fund before the merger, then buy shares in the acquiring fund. That way, you avoid the capital-gains distribution. And if you've suffered a loss on your investment in the target fund, you can use it to offset capital gains from other investments. (Don't sweat the wash-sale rule; it probably won't apply here.)

• Target-fund and acquiring-fund shareholders:

  If you think most of the target fund's portfolio will be sold off after the merger, that could mean additional capital-gains distributions. If you're nervous about this, you'll have to weigh the tax consequences of selling a fund you may have owned for a long time before you decide whether to sell.

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