Thank you for an interesting article on Oct. 17, but it was my impression that when a mutual fund makes a distribution, the net asset value falls by the amount of the distribution. If one adjusts the basis on the original shares by adding on the distribution, then aren't you double-counting?

-- Gene Garfield

Gene,

Don't you worry. The

Internal Revenue Service

would never allow us to double-count anything.

When a mutual fund makes a distribution, its net asset value falls by the amount of the distribution. The net asset value of a traditional open-ended fund is like a company's stock price, except that it is calculated at the end of every day. The fund takes all its assets (including cash) subtracts out any liabilities (i.e., any financial obligations of the fund like bank overdrafts or transfer agent and trustees' fees) and then divides by the total number of shares outstanding to get the day's net asset value.

But even when the net asset value falls because of a distribution, the number of shares you hold does not change, nor does the total value of your investment. Each share is just worth less because you received some of your investment back as a distribution.

We definitely need an example here.

Let's say you bought 100 mutual fund shares at $10 per share. You have a $1,000 investment and your cost basis in each share is $10.

Now let's also assume your mutual fund had a great year and the share price appreciates to $20. Your shares now are valued at $2,000 (100 x $20). If you sold today you would have a $1,000 capital gain.

But at this point, you're sticking with the fund. And it rewards you with a $4 capital gain distribution. Remember, when a fund sells securities at a profit it must pass those profits on to shareholders. You receive them in the form of a capital gains distribution and, yes, you will owe tax on it. So while you haven't sold anything yet, you do have a tax liability.

You'll receive a

Form 1099:

Dividends and Distributions

showing the current fair value of that distribution only, says Ravi Singh, mutual fund tax partner at

Ernst & Young

. That taxable amount is reported to the IRS as well. Your cost basis is not reported on Form 1099.

In our example, $4 per share, or $400, is being distributed to you. As a result, the net asset value of the fund falls to $16 because a portion of the fund is actually being returned to you. So you still have an investment currently worth $2,000 -- you have 100 shares at $16 per share ($1,600) and a $4 per-share distribution ($400).

So far, so good.

Now you decide to reinvest that $400 back into the fund. "When you reinvest distributions, the number of shares increase but total value of your investment stays the same," says Joel Dickson, a tax-efficiency expert in

Vanguard's

portfolio review group.

With the fund's net asset value currently at $16, your $400 can buy an extra 25 shares. So now you have 125 shares, all currently valued at $16 each. Your total investment is still $2,000. So no double-counting there.

At this point, you decide to sell everything with the share price at $16.

You need to determine your cost basis in the shares. There are many different methods of calculating your basis, and we've written about them

before. Many fund companies, like Vanguard and

Fidelity

, use the average cost method. So we'll walk you through that now.

In simplest terms, calculate the average cost per share by dividing the total cost of all the shares you own by the total number of shares. It looks like this:

100 shares at $10 = $1,000

25 shares at $16 = $400

Total = $1,400

Divide $1,400 by your 125 shares. Your cost basis in each share is $11.20.

If you sold 125 shares at $16, you'll receive $2,000 in proceeds. But since your cost basis is $11.20 per share, or $1,400, your taxable gain only will be $600.

Remember, your initial investment in the fund was $1,000, but you already paid tax on the $400 distribution.

As we've said before, it is not easy to keep track of your cost basis in a mutual fund. Many of the big fund companies will do it for you using the average cost method. But that does not mean you're stuck with that method.

If you believe, say, that the first-in-first-out method, where the first shares you sell are the first ones you purchased, is a more beneficial choice for you, then you need to keep track of that basis calculation yourself.

Remember, you are the only one who reports your original basis to the IRS. The fund companies or brokerage houses are not required to do so. So your records count in the end.

Calling Covered Callers -- Again!

In last Saturday's

Tax Forum, we discussed the tax implications of what happens when you sell a covered call on the

QQQ

and the option is exercised.

Our reader bought 1,000 shares of the

Nasdaq 100

tracking stock

(QQQ) - Get Report

for $95 and sold a covered call, with a $90 strike price, for $7. (For a thorough explanation of this trade, check out that column.)

While we correctly reported that there is no definitive answer to the question of what happens when an option is called on the QQQ since the IRS has not ruled on it, our rationale for why you would sell a covered call in the first place was, well, a bit mixed up.

We said, "No doubt you were hoping QQQ shares would rise and the calls you sold would expire worthless, allowing you to pocket the premium free and clear."

Duh!

Obviously, the seller wants the price of the QQQ to

fall

to $90; that way the buyer has no desire to exercise the call. Then the calls become worthless, and the seller can pocket the premium.

On the flip side, the call buyer wants the QQQ to jump above $90 so he can exercise his call.

A special thanks to our readers for waking me up!

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TSC Investor Forum aims to provide general investment information. It cannot and does not attempt to provide individual advice. All readers are urged to consult with a professional as needed about their individual circumstances.