This Great News Has Been a Long Time Coming

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Ordinarily, the end of the year is a dangerous time for mutual fund investors. This year, though, most fund shareholders will enjoy something they haven't seen in a while: freedom from capital gains taxes.

It's payback time
Last year, fund investors couldn't seem to catch a break. Not only did they see their portfolio's value plummet in light of the financial crisis, but they also got hit with taxable distributions from their funds. Even if you chose to reinvest those distributions in exchange for additional fund shares, you still had to pay income tax on them.

The reason this happens has to do with the way that mutual funds are taxed. Unlike most corporations, which have to pay their own taxes at the corporate level, mutual funds that qualify as regulated investment companies don't have to pay any taxes themselves. Instead, they pass through any taxable liability directly to their shareholders, who include that income on their own individual tax returns as though they had earned it themselves.

So when fund managers sold stocks back in 2008, they generated capital gains that their shareholders had to pay taxes on. Even though the value of those funds fell sharply, many stocks were still worth more than they had been in years past. For instance, McDonald's (NYSE: MCD) more than doubled between October 2004 and October 2008, while shares of Google (Nasdaq: GOOG) clung to 150% gains over the same period, despite having lost over 40% of their value in the previous year. Fund managers who chose to sell some of their holdings at a profit forced their investors to incur tax liability.

Reaping the rewards
This year, however, the tables have turned. After another painful downturn at the beginning of the year, stocks have recovered all of their losses, and the S&P is currently up around 20% for the year. Many mutual funds have turned in even better performances.

In light of those gains, you might expect to see another big tax hit coming for funds with high returns. Yet preliminary estimates from some fund companies suggest that you won't have to worry about big taxes from fund distributions in 2009. Even some strong-performing funds count themselves among the tax-savvy:

• Vanguard Capital Value (VCVLX) has risen over 75% so far in 2009, thanks in part to spectacular performance from stocks like Teck Resources (NYSE: TCK) and Ford Motor (NYSE: F). Yet despite those gains, the fund still had accumulated capital losses equal to a staggering 34% of the fund's net asset value as of August.
• Mining and precious metals stocks like BHP Billiton (NYSE: BHP) and Harry Winston Diamond have pushed the Vanguard Precious Metals & Mining (VGPMX) fund to gains of 73% so far this year. Yet the fund doesn't just have some realized losses banked; it also has a net unrealized loss on its current positions, despite its recent gains.
• Many international stocks, such as like CNOOC (NYSE: CEO) and Petroleo Brasileiro (NYSE: PBR) have risen even more than U.S. stocks in the recent rally. The Vanguard Emerging Markets Stock Index (VEIEX), however, still has a 10% loss cushion against future realized gains despite being up 72% this year.

What it means
This unusual situation puts investors in a position where they don't have to be as careful as usual in buying fund shares. Ordinarily, investing in a fund right before a big distribution forces you to pay tax on gains that you didn't actually earn -- as a newcomer, you still inherit the tax liabilities the fund incurred before you came on board.

With no capital gains distributions likely, however, that's less of a concern. Still, even though most funds won't have capital gains this year, many will still have to make dividend distributions, which would also be taxable. So some caution is still warranted if you're buying shares in a taxable account.

Last year's double-hit of losses and capital gains taxes wasn't any fun. This year, though, the reverse double-benefit of gains without tax will make shareholders very happy indeed.

Not all funds are good investments right now. Find out why Foolish fund expert Amanda Kish thinks you should stay away from these funds.