How would you like to buy a stock fund, have it earn a profit and not pay income taxes on those gains, even if you held it in a taxable account? By taking advantage of a fund\'s past losses, you might be able to do just that. Read on, as we go over how you can use a fund\'s capital losses to your advantage to end up with a higher after-tax return on your investment.

Values Go Down, Taxes Go Up
Let\'s begin with a review of what happened to various funds\' shareholders during the bear market of 2008. Shareholders tend to panic when their mutual funds start falling - in other words, they sell. Once the herd mentality sets in, even more people sell. This puts fund managers in the position of not having enough cash to cover all of the sell orders, forcing them to liquidate long-term holdings to come up with additional money to pay the abnormal number of sellers. In 2008, this phenomenon became a reality for scores of fund shareholders, especially those who owned funds holding large-cap, growth-oriented stocks. (For further reading, check out When To Sell A Mutual Fund.)

When long-term holdings are sold, a capital gain may result, and this taxable gain is passed on to all shareholders - including those who did not sell any of their shares - regardless of whether those payments are reinvested in the fund. As was the case in 2008, this situation can cause shareholders to see their fund\'s value drop over the course of a year, while also receiving a higher-than-expected taxable amount on their 1099-DIV form when their fund distributes the net profit from securities sold that year. (To read more, see A Long-Term Mindset Meets Dreaded Capital Gains Tax.)

Stockpiled Losses
However, not all mutual funds sold securities for a profit during the bear market. Some got hit with so many shareholder redemptions that they had to dump holdings for a loss. And when funds realize capital losses, they carry forward those losses to future years.

The good news is that the taxable gains these funds might realize when they sell securities in the future could be offset for several years by the stockpiled losses from past holdings that were sold for less than the purchase price. If this is the case, you can use the fund\'s losses to your benefit.

Capital Gains Exposure
A fund\'s capital gains exposure (CGE) is an estimate of the amount of a fund\'s assets that are made up of capital gains or losses (realized or unrealized). It measures the extent to which the fund\'s holdings have appreciated and whether they have been distributed or taxed. Another way of looking at it is to think about what percentage of a fund\'s portfolio would be taxable if every holding was sold. The CGE can give you an idea of any possible future capital gains distributions that might result in tax consequences for investors. (To learn more, check out What are unrealized gains and losses? and Selling Losing Securities For A Tax Advantage.)

A positive CGE number could indicate that fund managers have done a good job of selecting investments. However, because the capital gains have not been distributed yet, shareholders will be hit with a taxable distribution at some time in the future, when the managers sell the profitable securities. New shareholders, therefore, will have to pay tax on profits they never actually received because those profits will have been built into the fund\'s share price.

For example, suppose it\'s November 28 and you\'re looking to buy a growth fund that is selling for $25 per share. You see that it has gone up from $20 since January 1. This could mean that there is a 20% CGE ($5/$25) that will get passed on to you if the fund manager sells all the securities that have appreciated. You\'ll have to pay tax on that $5 distribution, and the share price will drop by $5. Assuming that the $5 payout is derived from capital gains, you will be required to pay tax on the distribution.

On the other hand, a negative CGE number means that the fund has a capital loss carry-forward and might be able to use past losses to offset future capital gains distributions. Therefore, investors could receive an untaxed capital gain.

Now suppose that the $25-per-share fund holds $200 million in assets and has a $100 million loss carry-forward. This provides a CGE of -50% (-$100 million/$200 million). In this case, it may take several profitable years before investors will have to worry about taxable capital gains distributions.

Where To Find This Information
Fund losses can be carried forward for eight years, and some companies will provide information on their websites about the amount that expires each year. When you\'re looking for information on a fund\'s capital gains and losses, don\'t be afraid to call the fund company if you need to or browse its website - there may be a link for end-of-year distributions or capital gains. You could also check out the fund\'s annual or semiannual report and look under "notes to financial statements". (To learn more, see Footnotes: Start Reading The Fine Print and How To Read Footnotes: Part 1 and Part 2.)

Keep in mind that tax loss carry-forwards are only one of many factors that you should consider before investing in a particular fund. Also understand that accumulated losses could be eaten up quickly if the market takes off, especially if the fund manager isn\'t particularly concerned about minimizing shareholders\' tax liability.

Of course, eventually you will have to pay tax if your fund continues to earn a profit. But by using past losses to offset future gains, you may be able to delay the inevitable and end up with a higher after-tax return.

For further insight, see Advantages Of Mutual Funds and Disadvantages Of Mutual Funds.

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