Moving mutual funds

[forummm]

I have a Vanguard mutual fund (VFIAX) position that has a fair amount of capital gains. I am interested in moving it to a different broker (IB) to meet some minimum balance requirements. I know that Vanguard can convert the funds into ETFs as a nontaxable conversion. But since the ETF shares have a different dollar value per share than the VFIAX shares, would it make the taxes pretty complicated when I sell them? What's the easiest way to do this and how do I keep track of the tax basis, etc? In case it matters, I already sold a few shares of VFIAX in this Vanguard account for TLH using specific ID.

[Cathy]

If you want to do so, you should be able to transfer the mutual fund shares to Interactive Brokers ("IB") using ACAT without having to exchange them for ETF shares. IB accepts VFIAX, although it does charge a pretty hefty transaction fee of $14.95 for selling shares of it, so I can see why you would rather deal with the ETF, where the transaction fees are negligible or negative (if you enroll in securities lending).

Turning to your actual question, "[t]he basis of property shall be the cost of such property", subject to certain exceptions that are not relevant here. 26 USC § 1012(a); 26 CFR 1.1012-1(a). If you purchase 100 shares of Q for $100 and then exchange them for 500 shares of X, your basis in the shares of X is still $100 (or $0.20 per share of X). In other words, there is no special rule for this situation; "the sum of the basis of all of the stock and securities received in the transaction shall be the same as the basis of all the stock and securities ... surrendered in the transaction". 26 CFR 1.358-1(a).

In the specific case of VFIAX, at the time of writing, the price of the mutual fund is $184.14 per share and the NAV of the ETF (VOO) is $182.74 per share. That means that if you executed the exchange right now, then for every share of VFIAX that you own, you will receive slightly more than one share of VOO. For the purpose of allocating the basis among the shares received, each set of shares "acquired on different dates or at different prices" is treated as its own "segment". 26 CFR 1.358-2(a)(2)(vi). Within each segment, the following language from 26 CFR 1.358-2(a)(2)(i) governs the allocation of basis:

If more than one share of stock or security is received in exchange for one share of stock or one security, the basis of the share of stock or security surrendered shall be allocated to the shares of stock or securities received in the exchange in proportion to the fair market value of the shares of stock or securities received.

To put it in arguably simpler language: First, every tax lot ("segment") is treated separately. Within each separate lot ("segment"), calculate the total basis in the original lot and then divide it equally between each identical share received in the exchange in respect of that lot.

In conclusion, the basis rules do not prejudice you in any way for exchanging your VFIAX shares for VOO.

[forummm]

To put it in arguably simpler language: First, every tax lot is treated separately. Within each separate lot, calculate the total basis in the original lot and then divide it equally between each identical share received in the exchange in respect of that lot.

What does "tax lot" mean in this context? I purchased the shares over time so there are many transactions. Do I need to keep each transaction separate or can I just merge them all into average cost for the purchases overall?

So even though I previously used specific ID to sell a few shares, I can switch to average cost basis for the remainder, and do my own calculation of what the basis is for each individual ETF after conversion (total cost for the original mutual fund shares divided by the number of ETF shares)? And then I just report that number I calculated to the IRS whenever I do sell them?

[Cathy]

To put it in arguably simpler language: First, every tax lot is treated separately. Within each separate lot, calculate the total basis in the original lot and then divide it equally between each identical share received in the exchange in respect of that lot.

What does "tax lot" mean in this context?

As mentioned earlier in the post, the exchange basis rules apply separately to each set of shares "acquired on different dates or at different prices". 26 CFR 1.358-2(a)(2)(vi). This is true regardless of what method you are using to track basis (although, of course, it is a simpler calculation if you happened to be using the average cost method, but that was not assumed in my post; see below).

So even though I previously used specific ID to sell a few shares, I can switch to average cost basis for the remainder, and do my own calculation of what the basis is for each individual ETF after conversion (total cost for the original mutual fund shares divided by the number of ETF shares)?

This was not addressed in my post because it is a separate topic. My post intentionally did not say anything about changing to or from an average cost basis method of tracking basis, which is a different issue. In particular, (1) I made no assumption about what method you were using to track basis, (2) the information in my post above applies regardless of which method you are using and (3) if you apply that information, it will not change what method you are using to track basis.

If you want to change what method you are using to track basis, the regulations contain separate (and very complicated) rules for that. I don't really want to get into this topic because it's really complicated and attempting to summarise it is almost guaranteed to contain at least one subtle error. I just suggest you read 26 CFR 1.1012-1 very carefully. However, please understand that this is a totally separate issue. The transaction of exchanging VFIAX shares for VOO itself has no effect on what method you are using to track basis, it just forces you to do some simple math that maintains whatever method you were using before, as explained in detail in my post above. If you want to change the method used for tracking basis, that is a separate question and is not specifically related to the exchange transaction.

I can only provide general information and if you need help applying this information to your own situation, you will have to retain counsel to assist you.

[forummm]

Thanks for pointing to the legal text. It looks like I can do what I was asking about. There are several places that say you can change basis as desired, even if the shares were purchased at different times or different dollar amounts. They just have to be for the same stock/fund/etc ("identical stock" is the term of art). It actually doesn't seem that complicated unless you have some outlier case (like certain gift shares).

https://www.law.cornell.edu/cfr/text/26/1.1012-1

It appears I can change basis methods and Vanguard will take care of the initial math for me. I wonder if they will even update the basis from MF to ETF once the conversion has taken place as well.

https://investor.vanguard.com/taxes/cost-basis/methods

Even if you've already selected—and even used—one of these cost basis calculation methods, you can change it for future sales whenever you want. And you can apply those changes to just one fund or to all the funds within an account.

[Cathy]

...It looks like I can do what I was asking about. There are several places that say you can change basis as desired, even if the shares were purchased at different times or different dollar amounts....

I suspect you may be confusing two unrelated issues. Your OP asked about the tax consequences of exchanging or converting shares of VFIAX for VOO. I answered that question in detail in my initial reply. As mentioned several times, for the purpose of that transaction, it does not matter what method you are using to track basis because in any case, each set of shares "acquired on different dates or at different prices" is treated as a distinct "segment" for the application of the basis allocation rules. 26 CFR 1.358-2(a)(2)(vi).


In your follow up post, you then asked about the rules for changing the method you use to track basis. That is wholly unrelated to your initial question. The rules are quite tricky with tons of pitfalls but luckily, as you mention, you probably don't need to worry about any of this if all your shares were purchased relatively recently as the broker-dealer will keep track of it for you.

[forummm]

For all of you sitting on the edge of your seat about this issue:
1) Vanguard converted the MFs to ETFs and did the basis calculation for me.
2) I used ACAT to transfer the position over. I had to transfer the "full" account over in order for it to work. But I only had VOO in it so that was what I wanted to do anyway.
3) The transfer also included the ETF cost basis info from Vanguard. So it's available in the IB system if I eventually sell.