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Capital gains distributions are capital gains that are passed on to investment company shareholders.
Let's assume that XYZ Company mutual fund invested well during the year and realized $1,000,000 in net capital gains (that is, capital gains after subtracting capital losses). The fund has 10,000,000 shares outstanding, and you own 1,000 of those shares. Thus, because you own 0.01% of the fund's shares, you are entitled to 0.01% of the net capital gains, or $100.
XYZ Company (and most mutual funds) will probably allow you to collect your $100 either via check (this is called a capital gain dividend) or to reinvest it in additional shares of the fund (this is called a capital gain allocation).
Mutual funds and other investment companies must meet the Internal Revenue Code's "regulated investment company" qualifications in order to pass through income and gains directly to shareholders without having to pay taxes at the fund level. One of these requirements is that an investment fund must pay out a minimum of 90% of its income and gains each year.
When a fund company makes a distribution, that distribution is deducted from the fund's assets. This is why capital gains distributions decrease the net asset value of an investment fund. Unrealized capital gains, however, increase the net asset value of the investment company's fund.
Stock funds typically make capital gains distributions in December. This means that investors who purchase shares of a mutual fund near the end of the year might receive a taxable capital gains distribution for that year. Bond funds usually make capital gains distributions every month.
Distributions make some investments desirable to hold. The income generated from them creates a solid base for some income investors. Capital gains distributions are taxable, and shareholders who receive them also receive an IRS Form 1099 from the investment fund that generated the gain.
As with individuals, investment funds may incur short-term capital gains and long-term capital gains, depending on how long they hold the underlying securities. Funds in turn distribute both of types of gains to shareholders, who then are responsible for the corresponding tax liability. The IRS taxes long-term capital gains distributions as long-term capital gains income even if the shareholder reinvests the distributions or even if the investor held the fund shares for less than a year. A fund distributes its short-term capital gains distributions as part of its dividend distributions, and the IRS generally taxes these as ordinary income.
Some investment funds, such as municipal bond funds have different tax circumstances, and investors should seek professional tax advice when reporting distributions.
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