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Why Do I Pay Taxes When My Fund’s NAV Falls?

It may feel counterintuitive to pay tax on a fund whose net asset value has dropped, but if you’re paying taxes, it’s because despite a lower NAV, the fund is still making you money.

Taxes are often seen as the downside of successful investing, but while most people will endure taxation on gains, it can be wearisome to have to pay up when the value of an investment goes down.

Yet it’s entirely possible for fund unitholders to pay taxes even when the fund’s net asset value, or NAV, is down. That’s because despite the drop in value, the fund may very well have earned income and/or realized capital gains.

To understand this apparent disconnect, it’s important to think about how funds are typically structured, and what they’re designed to do.

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According to Raj Vijh, chief operating officer and chief financial officer with Lysander Funds Limited, it helps to understand the inner workings of any pooled product investors may be putting their money into, such as a mutual fund.

For tax purposes, these funds are designed as “flow-through” products, which means all their earnings are distributed to investors.

For earnings to be generated by a fund, two things have to happen: income has to be earned and (or) capital gains have to be realized.

Any security that is held within the fund may generate income such as interest or dividends. Regardless of whether the fund’s NAV is up or down, as a unitholder, you’re going to get your share of that income because the company whose securities the fund holds is paying income on the shares. Since the fund is a flow-through product, it must distribute this realized income to unitholders each year. When investors receive their share of the fund’s earnings, they will be taxed on that return based on their own tax rates and circumstances.

“The other thing that’s happening in the fund is that the shares are being bought and sold by the fund’s portfolio manager,” Vijh said. These may be bought or sold for a profit or a loss. If they’re sold at a profit, the fund has a capital gain; if they’re sold at a loss, it has a capital loss. As with income mentioned above, the fund must also distribute any overall realized capital gains to unitholders each year. If there are overall capital losses, then these will be carried forward to be offset against future capital gains.

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The NAV of a fund can go up and down because it also includes unrealized capital gains or losses. This is where the fund’s securities have not been sold, but their value has changed because of their market value has changed. So the NAV tells you what the fund is worth right now, but not necessarily what its realized earnings have been.

“Realized capital gains or losses generally only happen when the fund actually sells a security,” Vijh said.

“These three things – realized income, realized capital gains and unrealized capital gains – happen sort of independently, so a fund may have realized income and/or capital gains, but if that year, the market value falls, and it has unrealized capital losses, your NAV will go down,” Vijh said.

“But you’ve still got that income (so) you’ve still got to pay taxes.”

While the NAV itself is an important measure for understanding a fund’s value, it shouldn’t be a daily focus for investors, he added.

Given that most people invest in these types of funds for the long term, the NAV is a useful tool from which to calculate the performance of the fund over any given time period.

“NAVs can be very fluid and dynamic,” said Vijh. “Generally, mutual funds are priced once a day, at the end of the day, and usually each day’s price will be different, depending on what the markets did that day.”

There are also certain things fund managers can do to try to manage taxes.

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On the income side, for example, the fund can offset the expenses of running the fund against income earned to reduce the amount of net income that gets paid out.

From a capital gains perspective, if the fund manager sold securities at a capital gain during the year, he or she could also sell some of the losers closer to year-end to realize capital losses and offset those realized gains. This would, again, reduce the amount distributed. Capital gains tax is also lower than taxes on interest income.

Unitholders themselves may also try to offset gains by selling underperforming mutual funds near the end of the year to offset capital gains they expect from other funds.

But it’s important to keep in mind that tax management, while important, is not the main goal of this kind of investment.

“At the end of the day, the portfolio manager has to do the right thing for the long term and for the investors … (even if it means) realizing that capital gain,” Vijh said.

“The main thing the fund is trying to do is provide long-term returns, while keeping an eye on the taxes. If it makes sense, the fund manager can reduce the gain by harvesting capital losses.”

“(But) paying taxes is not necessarily a bad thing – it means that your fund earned income that year. And these distributions of income and capital gains in some cases can also be used to reduce capital gains taxes in future when you eventually sell the mutual fund units.”

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