Mutual funds investors face double blow of low returns and capital gains tax

This year has been one that most every investor would love to forget. In the US, the benchmark Dow Jones Industrial Average is down more than 40 per cent from its October 2007 peak and 99.7 per cent of American. equity mutual funds are in the red this year.

That their portfolios are down double-digits is no surprise by now. What may shock - and infuriate - investors is that, despite a brutal year for stocks, some will owe hefty capital gains taxes on their losing funds come April.

For example, investors in the $4 billion Templeton Foreign Fund who have already lost more than 50 per cent of their money this year, will forced to pay taxes on as much as $1 billion of gains from the sales of investments. These investors are not the only ones facing a double blow. Fidelity Investments, the world's largest mutual-fund manager, expects 135 of its 212 funds to have to pay capital gains tax, based on data as of 15 November.

Money managers have had to sell profitable holdings this year as customer redemptions increased, resulting in short- and long-term capital gains. The result means tax bills for investors in the worst year for financial markets since the 1930s.

The last time investors were hit with capital gains during a losing year was in 2001, when they paid $9.9 billion in taxes on fund distributions after the collapse of the Internet bubble, according to Lipper & Co., a Denver-based financial-research firm. In 2001, the Standard & Poor's 500 Index declined 13 per cent, compared with 40 per cent this year.

The massive redemptions seen in recent times forced some mutual fund managers to sell positions in order to hand investors their cash. Some of those positions may have been held for years, performed well and earned major profits during that period. The tax authorities require taxes to be paid on the income generated from a sale, whether a fund is having an off year or not.

Some asset classes are more likely to trigger gains than others this year. For instance, investors in international and commodities funds - high-flying categories in 2007 that fell back to Earth this year - tend to have a lot of unrealized capital gains.

There are strategies that can be employed to minimise or avoid a big gains-related tax bill, but investors must act quickly; most funds make their capital gains distributions in December, but others will distribute any day now.

One way for most individuals to offset capital gains would be by selling losing investments by the end of this year. Tax law allows individuals to write off their capital gains with losses. Capital losses can be written off against capital gains. If losses exceed gains, as much as $3,000 can offset other income.

Unused losses can be carried over from year to year. Another possible escape clause is to get out of the fund before it makes its distribution. Only shareholders of record on the day of distribution owe capital gains, even if you've been holding the fund for years.