Mutual fund sales and cost basis

Dear Tax Talk,

I'm in an index mutual fund held at Vanguard that hasn't been performing for quite some time now. I'd like to sell it and use the money as part of a down payment on a house. Two questions:

1) How is my cost basis determined since I'm investing monthly? That is, how is my tax rate calculated? Do I pay a certain percentage for those shares held less than a year and another for those held over a year?
2) I have lost money in this fund over the course of several years. Is it better to sell your losers later in the year to use as a capital loss deduction, or earlier?

Thanks for your help here. -- Matt

Dear Matt,
When figuring their cost, a lot of folks overlook the cost associated with the additional shares they acquired through a dividend reinvestment plan. This type of plan (called "DRIP" for short) enables you to acquire additional shares with your periodic dividend distributions rather than take the earnings in cash. It's kind of a forced savings plan.

For example, assume you acquire 1,000 shares of ACME fund for $10,000 in 2000. Each year the fund pays $1,000 in dividends, which allows you to buy additional shares at the current market price per share. Let's say that adds 200 additional shares at the cost of $4,000. Therefore, your total cost in the mutual fund is $14,000.

If the fund is worth $12,000 when you sell it, you have a loss and your tax rate, of course, is zero since you don't have a gain. If the last shares were acquired in the DRIP within one year of the sale, then you need to allocate the sale between long-term and short-term on a per-share basis.

For example, if the last 50 shares were acquired within the last year, then you would break out their cost against the sale price of 50 shares. The remaining 1,150 shares would be long-term. It could be possible to have a gain on the short-term position if the acquisition price per share was less than the sale price. However, since you would have an overall loss, you wouldn't owe any tax.

The timing of the sale is irrelevant once you decide to sell the fund. Some folks sell losers at the end of the year to offset gains realized during the year. This type of selling isn't so much motivated by the decision to dump the investment, but is more motivated by the tax benefit of offsetting the earlier gains. In fact, the sale is usually accompanied by a reacquisition, because the investor may still believe in the company (or fund, as the case may be). Just remember that the reacquisition has to take place more than 30 days after the shares are sold at a loss to avoid the wash sale rules.