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Funds owners face a capital gains bite

After years, shields expiring

Many people who own mutual funds will get an unpleasant surprise soon: They will get hit with big capital gains taxes even though the stock market has been flat.

When the stock market crashed early this decade, a silver lining was that many funds were able to use their losses as a shield against future taxes. The Dow Jones industrial average, the most widely quoted barometer of stock market performance, fell for three straight years at the beginning of the decade, dropping 27 percent from the end of 1999 to 2002, and has yet to regain all those losses.

But now these shields, or ''carryforwards," are running out, a problem even for funds that aren't performing well overall. Some funds have already put investors on notice they can expect a bite at tax time.

For instance, someone who owns 1,000 shares of Fidelity Investments' Value Strategies fund will have to report $7,550 in capital gains income on the April tax return, up from the $150 reported in 2004. That's even though the fund has lost 2.4 percent of its value so far in this year's tepid market.

A typical shareholder in the 28 percent tax bracket will owe taxes of $1,158.50 for 2005 as a result.

''We believe that more Fidelity funds will pay distributions of capital gains this year than last year," said company spokeswoman Anne Crowley. The reasons, she said, are rising stock values overall and that ''an increasing number of funds have exhausted the tax-loss carryforwards that they accumulated during the bear market."

At Vanguard Group, meanwhile, figures from the company's Explorer fund show that someone with 1,000 shares will have to report a $6,940 capital gain for 2005, up from $73 in 2004. The fund is up 5.4 percent this year.

Not all the increases in capital gains posted by mutual funds are caused by shrinking tax-loss carryforwards. Some funds are just performing well, and have no prior losses to balance the gains. Other funds that could post big increases in capital gains this year are those that bet big on the energy and utilities sectors. The Dow Jones utilities average, for example, is up 19 percent so far this year, driven by higher prices for crude oil, natural gas, heating oil, and gasoline.

And not all mutual fund holders are subject to capital gains taxes. Investors who hold the funds in tax-free accounts such as 401(k) retirement plans or individual retirement accounts aren't subject to the same taxation.

Still, specialists are starting to note the dramatic numbers that are coming in this season. ''You have a wider swath of funds that are distributing gains this year," said Russ Kinnel, research director at Morningstar Inc., a Chicago company that tracks mutual funds.

Overall, estimates Brian Reid, chief economist for the Investment Company Institute, a trade association of mutual fund companies, capital gains distributions will be stronger than last year's $22 billion for taxable holdings; those were up from $6 billion in 2003.

Tom Roseen, senior analyst at Lipper Inc. says he wouldn't be surprised to see the figure increase 50 percent this year, up to $33 billion -- or to $82.5 billion if the capital gains of 401(k) plans and other investments are included.

Capital gains are calculated as the net value of the increase in value of the stocks a fund has sold in a given year.

For instance, a fund manager who in one year sold 10 stocks that have gained $5 million in value since the time they were purchased, and five stocks that have lost $1 million in value, would have to split, or ''distribute," the $4 million capital gain among the shareholders of the fund.

When the net value of all sales is less than zero, the losses can be applied to profits in later years as a ''tax loss carryforward" to offset future capital gains until the amount of the losses from the earlier years have been exhausted.

Tax specialist Joel Dickson of the Vanguard Group said that investors should be happy their funds are reporting larger capital gains, because it's a sign that fund managers are making money for shareholders.

A larger capital-gains tax hit, he said, ''is more like the teddy bear in the closet than a real bogeyman."

Ross Kerber can be reached at kerber@globe.com.

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