Mutual funds are required to distribute realized capital gains to shareholders at least once a year. Most funds will make the distributions near the end of the year. If the capital gain distributions are reinvested into more fund shares, the investor's cost basis in the fund changes. It is important to adjust the basis of a fund account to avoid double taxation on the capital gain distributions.
Add together the dollar amounts of your investment in the fund. If you have just purchased shares one time, this is your amount. If you have made additional purchases since the initial purchase, add in the additional purchase amounts.
Add together the dollar amounts of all capital gains distributions since you have first purchased shares in the fund. Capital gains distributions can be long term and/or short term gains each year. Total all of the distributions.
Add together your investment amount and the capital gains distributions from steps one and two above. This total is your dollar cost basis in the mutual fund.
Divide your total dollar cost basis by the number of shares you have in your account. The result is the average cost basis per share. If you sell shares, this number will be used to calculate the capital gain or loss resulting from the sale of the shares.
Reinvested capital gains distributions increase your cost basis in a fund. Reinvested dividend distributions will also increase the basis in the same manner as capital gains. Capital gains distributions are taxed in the year they are paid. Reinvesting the distributions is the same as adding your own money to the fund account.
If you do not add reinvested capital gains to your cost basis in the fund, you may end up paying income taxes twice on the value of the distributions when you sell your fund shares.