With everyone arguing about whether expiring tax cuts should be extended, huge parts of the tax law are still in limbo. But it appears that Congress may be preparing to change a long-hated tax law that has plagued mutual fund investors for decades.

How to get taxed for doing nothing
There's a huge difference in the way buy-and-hold investors get taxed on the appreciated gains on their investments, depending on whether they own individual stocks or shares of mutual funds and exchange-traded funds. With individual stocks, you're in complete control of when you pay taxes on any share price appreciation. As soon as you sell, you'll incur capital gains taxes; but if you keep holding your shares, you don't have to pay any tax. That voluntary deferral is the biggest advantage that investors have outside tax-favored retirement accounts.

With mutual fund and ETF shares, however, there's a trap that often snares shareholders. In order to qualify for favorable Internal Revenue Service treatment, mutual funds and ETFs are required to distribute all of the dividends and capital gains they receive each year. Because many funds buy and sell their holdings fairly actively, the amount of capital gains they realize can be extremely high, especially in years when the financial markets have strong returns. Shareholders are then required to include those distributions as taxable income.

The net result is that long-term investors who own individual stocks get a huge tax break simply by doing nothing but sitting on their appreciating shares. Meanwhile, mutual fund shareholders often get a big year-end tax bill even when they don't deserve it.

According to Dow Jones, lawmakers are close to a deal to change the rules. Under the proposal, fund shareholders wouldn't owe capital gains taxes on distributions that they reinvested into additional fund shares until they sold them.

Taxation without profit
The way funds get taxed currently is unfair for two reasons. First, if you're a new investor, you're on the hook for taxes related to gains the fund realizes -- even if those gains came about long before you owned the fund. This was particularly painful in 2008, when many funds declared capital gains distributions for gains from past years even though the S&P 500 had lost 37%.

Second, in many cases, investors never actually get any cash from their funds' distributions. Especially with traditional mutual funds, reinvesting those distributions into additional fund shares is a very common and smart thing for investors to do. And even with ETFs, an increasing number of brokers allow direct reinvestment of distributions to acquire more ETF shares.

In fact, because of the particular investments that some ETFs hold, especially leveraged and inverse ETFs, capital gains distributions can sometimes represent a huge percentage of the ETF's value. Look at how much these funds had to pay out two years ago:


2008 Distribution Amount per Share

% of Pre-Distribution Share Price

ProShares UltraShort S&P 500 (NYSE: SDS) $11.49 13.1%
Rydex Inverse 2x S&P Select Sector Energy (NYSE: REC) $86.85 86.6%
ProShares UltraShort Dow30 (NYSE: DXD) $16.06 22.0%
ProShares UltraShort QQQ (NYSE: QID) $9.51 13.8%
ProShares Short S&P 500 (NYSE: SH) $11.98 13.8%
ProShares UltraShort Russell 2000 (NYSE: TWM) $25.07 26.6%
ProShares UltraShort Oil & Gas (NYSE: DUG) $6.08 17.5%
ProShares Short Dow30 (NYSE: DOG) $8.74 11.0%

Source: Yahoo! Finance.

Admittedly, these and other inverse and leveraged ETFs are particularly susceptible to this problem, and few investors would seek to hold these ETFs as a long-term investment, given their daily focus. In contrast, most standard ETFs use techniques that help them minimize the tax impact of their trading activity on shareholders.

But even with small distributions, the point remains the same for ETFs as with mutual funds: If investors could simply reinvest distributions into additional shares and avoid capital gains, it would be beneficial to long-term investors.

Wait and see
Unfortunately, this isn't the first time that proposals to remedy mutual fund capital gains taxation have surfaced. So far, none of them have gotten past this stage. But with experts noting that this is the furthest any such proposal has gotten through Congress, optimists can hope that this will finally be the year that mutual fund investors are freed from having to dread capital gains distributions.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.