When the stock market was going gangbusters and virtually every fund was posting impressive returns, the tax man nicked investors each year for capital gains (assuming the funds weren't held inside tax-deferred retirement accounts). You might never have sold a share or seen a penny of profit, but the funds "passed through" their capital gains to you at tax time. The fund managers bought and sold stocks during the year, even if you didn't. Whatever capital gains the stocks generated were divvied up among the shareholders at year's end, and you paid the freight.
Now that virtually every fund is losing money, they should pass through their capital losses so you can write them off on your taxes, right? Think again. This is the IRS we're talking about, so of course it isn't that simple. Thanks to a quirk in the tax code, investment losses stay within the funds even if investment gains don't. As a shareholder, you get nada for internally generated capital losses when it comes to tax time.
Compounding the problem even further for individual investors, funds are allowed to write off their capital losses over a maximum of eight years before they become worthless. If the losses passed through to the individual, you would be able to carry forward investment losses (at $3,000 per year) indefinitely.
The capital losses stored within the funds aren't completely worthless, of course. Investors in those funds can expect to see far fewer capital gains in the years ahead as money managers offset their winning stock sales against losses they carried forward.
Does that mean you should hold on to the dog funds that have lost so much of your money over the past two or three years? Not necessarily. It does mean, however, you should be aware of the capital losses a fund is currently carrying as you make investment decisions.
Understandably, fund companies are reluctant to advertise the capital losses they have generated in recent years. They do, however, offer convenient toll-free phone numbers, so you can call to ask both current and prospective fund companies about their embedded capital losses.
In addition, you can get the information from Morningstar Mutual Funds or other tracking services. And, of course, you can always do your research the old-fashioned way by combing through the fine print of a fund's prospectus and its statement of additional information.
All other things being equal, it's a good idea to keep or put your money in a fund that has capital losses held in reserve. But remember, things are rarely ever equal. In several cases, there's a reason why individual funds built up those oversized losses in the first place.
Scott Bernard Nelson is a financial writer at The Boston Globe.