Understanding capital gains distributions

Imagine you’re part of a group of 10 friends at a restaurant to celebrate the holidays. Everyone else arrives on time and enjoys cocktails, appetizers and a main course, while you get stuck in traffic and barely make it in time for dessert. At the end of the meal, the server brings 10 separate bills, each for the same amount. “But I only had a slice of pie!” you complain. “Why am I paying for a full meal?”

If you’re an ETF or mutual fund investor who makes a large purchase in December, you may end up feeling the same way. That’s because some funds distribute capital gains at the end of the year, and you’re on the hook for the taxes whether you’ve held the fund for a couple of weeks or the full 12 months. (Note this only applies to non-registered accounts: you don’t need to worry if you’re using only RRSPs and TFSAs.)

Giving them the slip

Let’s back up and review why this happens. Mutual funds and ETFs occasionally sell investments that have increased in value, resulting in capital gains. Over the course of the year, a fund may also do some tax-loss harvesting to realize losses that can offset some or all of those gains. Then, at the end of the year, the fund declares any net capital gains and, if you hold the fund in a taxable account, you’ll receive a T3 slip with this amount indicated in Box 21.

• Capital gains explained »

So here’s the issue: funds make a single capital gains distribution in December, regardless of when the gains happened to have been realized. That’s not the case with dividends or interest. If a fund pays a quarterly dividend of $0.25 cents per share and you buy 1,000 shares in December, your T3 slip will only include the $250 you received for the fourth quarter, not the amounts paid in March, June and September. But if the fund realized a large taxable gain any time during the year, your tax slip will include it if you held units of the fund on the date of the distribution. It doesn’t matter whether you were around to benefit: you’re like a restaurant patron who gets handed the same bill as everyone else, even though you missed the drinks, appetizers and main course.

What big gains you have

That’s why it’s not a good idea to make a large purchase of an ETF or mutual fund in a taxable account in December—unless you can be reasonably sure the fund won’t be distributing any gains for the year. The good news is traditional broad-market index funds distribute little or nothing in capital gains, especially if they have been around a while. However, there are exceptions, so always check: fund providers typically send out a press release with an estimate late in the year.

To give you an idea of how large capital gains distributions can occasionally be, consider the estimates recently announced by BlackRock. The iShares US Fundamental Index ETF (CLU) leads the pack with an estimated distribution of $3.47 per share, equal to roughly 10% of the ETF’s current price. The iShares US Dividend Growers (CUD) and iShares U.S. High Dividend Equity (XHD) also estimated distributions of $2.12 and $1 per share, respectively.

The press release from iShares explains these gains are largely the result of stocks being sold after being deleted from the funds’ benchmark index following an increase in price. This highlights a potential problem with alternative indexes that screen for value stocks and dividend growers. If stock enjoys a run-up in price, it may no longer qualify as “cheap,” so it gets assigned less weight in the index, or even gets booted out altogether, resulting in a taxable gain. For all their faults, one of the many benefits of broad-market index funds is they never remove companies for this reason: indeed, they typically have extremely low turnover and many have not distributed gains for many years.

• Slash capital gains with cost deductions »

What you need to know

Even if you’re not planning to make new purchases this late in the year, you should still understand the implications of capital gains distributions if you hold ETFs in a taxable account.

First, you should be aware that the term “capital gains distribution” is confusing, because it implies you received a payout of some kind. After all, most distributions consist of dividends, interest or return of capital, all of which are paid in cash. Or, if you have a dividend reinvestment plan (DRIP) in place, you’ll receive new units of the fund. But neither is the case with capital gains distributions: when a fund sells a holding you don’t usually receive any income or new shares. The manager just reinvests the proceeds, which won’t affect the fund’s market price or the number of units you own.

Finally, if your ETF issues a reinvested capital gains distribution, you need adjust the book value of your holding to reflect it. For example, if your ETF has a book value of $25 per share and it distributes a reinvested capital gain of $0.10 per share, you should adjust the book value to $25.10. Otherwise you’ll pay tax on this gain twice: once when it appears on your T-slip and again when you eventually sell the shares. For more information, see our white paper, As Easy As ACB.

This article was originally published on CanadianCouchPotato.com