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Return of Capital from ETF -- Tax Treatment?


Last year I bought a closed-end, exchange traded fund that invests in emerging market debt. (Morgan's Stanley's EDD.) The fund pays a quarterly dividend.
My year end statement indicates the dividends for the second and third quarters of 2009 were "return of capital."
I understand how return of capital works, I understand it's not taxable, and I'm familiar with the concept of "managed distributions" from fixed income funds.
But I'm hazy on how the return of capital affects my basis. I realize that return of capital reduces my basis. But I reinvest dividends and that has my scratching my head.
I use the average share price method of tracking my basis, as opposed to figuring a basis for each individual block of shares. So it seems to me it works this way:
The fund returns $X of my capital.
This reduces my basis by $X.
I chose to reinvest $X in Y shares.
My total cost for all the shares I own stays the same, but the number of shares increases by Y. Therefore, my average cost per share decreases.
On my spread sheet, I list the price of the shares I purchased when reinvesting the returns of capital as $0.
Am I doing this correctly?
Thanks in advance for any guidance from the group.
Paul Michael Brown Washington, D.C.
Reply to
Paul Michael Brown

Dunno the answer, but here is my perhaps too timid preventative approach which maybe someone can critique. Put everything with tax complications into retirement accounts. This includes closed end funds, gold/silver funds, and commodity futures funds.
The gold/silver is to avoid your gains being taxed at a high "collectibles" rate (ticker CEF is supposed to be a safe exception because it is a company that warehouses the metal). I'm a little fuzzy on the problem with commod future etf's, but I think they tend to be structured as partnerships with horrendous K-1 form tax treatment incl return of capital (can check the prospectus).
Reply to
dumbstruck

Paul Michael Brown writes:
nitpick: it's a closed-end (mutual) fund. "exchange traded fund" has a specific meaning and it doesn't apply to this fund.
CEFs (like this one) have a fixed number of shares which trade on the secondary market. CEFs may also use leverage by doing things like issuing corresponding preferred shares. ETF shares are both traded on the secondary market but also constantly created or destroyed.
Return of capital is a tax-free distribution to you which reduces your basis. It can lead to a larger cap-gain when you sell the shares from which that return of capital was distributed.
They offset each other in the aggregate: The return of capital reduces your basis on the existing shares, but the reinvestment increases your basis on the combination of the existing shares and the new shares by exactly that same amount (assuming the entirety of the return of capital was reinvested).
That's correct.
That's one way to do it, but it only works as long as you are using the average share price method, which you said you're using. It's a little messy. And if you were using the specific shares identification for sales, your spreadsheet is now entirely wrong because the reduction in basis is attached to the older shares, not the new ones you've just purchased.
Moreover, if you are using the double-category method when the time comes to sell, and you've distributed the reduction in basis to the newer rather than the older shares, you may be mis-reporting the breakdown of long-term versus short-term gains.
For more details, see IRS pub 564.
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Reply to
BreadWithSpam

dumbstruck writes:
Do *not* do that with some things - like MLPs and other publicly traded partnerships. They could generate "UBTI" - unrelated business taxable income - and cause serious problems with the IRA.
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Reply to
BreadWithSpam

Unfortunately c.e.f's are widely lumped into the category of etf's in informational web sites and directories. I hate that because it's a pitfall in me avoiding c.e.f's. Also one can confuse c.e.f. with ticker "CEF" which is not a fund, but a company structured to avoid the tax issues of precious metal etf's and c.e.f's.
Which reminds me of my other tax simplifying strategy... NEVER reinvest dividends of any taxable (non retirement) fund unless it has a fixed share price. It can appear to be automatically accounted for, but exceptions are too painful. Spare me arguments against leaving them as cash and failing to "compounding"; just do that manually. But not mindlessly... use it as a rebalance opportunity in periodic dispersion of pooled dividends into the asset class you need to shift into.
Reply to
dumbstruck

snipped-for-privacy@fractious.net explained:
Thanks for the tutorial. In the future I will endeavour to use the correct nomenclature.
Understood. I'm of the mind that the proper holding period for income producing assets is forever. So I don't worry about having a large unrealized capital gain.
That is exactly what happend in my case. Thanks for confirming my understanding.
Which is how I'm doing it for this particular fund. It's a tiny fraction of my fixed income portfolio and it's just not worth the hassle of calculating a basis for each individual block of shares.
Thanks for the citation to authority. I'll check it out.
Reply to
Paul Michael Brown

Oh rats, a commodity etf (as a publicly traded partnership) has sent me a K-1 form against my traditional IRA declaring "adjustments to basis". I assume this is not normally of relevance because you typically will treat the whole shebang with basis of zero. Hopefully it is only for folks doing fancy transactions - this IRA of mine is in a decades long frozen state with no external deposits, withdrawals, or conversions.
Reply to
dumbstruck

dumbstruck writes:
Normally - ie. if it represents return of capital.
But again, beware - certain extrange trade securities (in particular some of the commodity ETNs) do have potential for UBTI. If you have more than $1000 of it across your whole set of IRA and Roth accounts, you may have a serious problem.
Look carefully at that K-1. UBTI will be in line 20-V. (iShares has posted a sample K-1 for their GSCI Commodity-indexed trust. Most of us who don't actually have shares in any of these things won't have any K-1s handy to look at to see what they are like. For the curious, here:
It's really not too big a deal, but certainly for a small position, it's not likely to be worth the headache in a taxable account. In an IRA, the tax headache almost all goes away -- unless it doesn't...
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