Quick Answer
Regulated investment companies avoid fund-level tax by passing through at least 90% of net investment income to shareholders under Subchapter M, and REITs follow the same 90% rule. Capital gains distributions are always taxed long-term based on the fund's holding period, not the investor's, and buying shares right before a distribution creates a tax bill with no economic gain.
These pass-through rules create several exam traps: distributions taxed as long-term even for a brand-new shareholder, REIT payouts taxed as ordinary income despite being called dividends, and fund exchanges within a family that trigger tax even though no cash changes hands.
How Does Conduit (Pass-Through) Treatment Work?
Under Subchapter M of the Internal Revenue Code, regulated investment companies (mutual funds, ETFs) avoid fund-level taxation by distributing at least 90% of net investment income to shareholders.
- Shareholders pay tax on distributions; the fund itself pays no corporate tax on distributed income
- REITs follow the same rule: distribute at least 90% of taxable income to maintain REIT status
What Types of Distributions Are Taxable?
- Ordinary income dividends - taxed at the shareholder's ordinary income rate
- Qualified dividends - taxed at preferential long-term capital gains rates (0%, 15%, or 20%)
- Capital gains distributions - the fund distributes net realized capital gains from selling securities
- Taxed as long-term capital gains regardless of how long the investor held fund shares
- The holding period of the underlying securities (not the investor's holding period) determines the tax rate
Exam Tip: Gotchas
Capital gains distributions from a mutual fund are taxed as long-term based on how long the fund held the securities, not how long the investor held the fund shares. Even a day-one shareholder pays long-term capital gains rates on the fund's distribution.
Why Is Buying Before a Distribution an Exam Trap?
A capital gains distribution pays out gains the fund already realized earlier in the year by selling appreciated securities, built up long before this investor bought in. Whoever is a shareholder of record on the fund's record date receives the full distribution, even if they bought shares the day before. This is sometimes called "buying a dividend."
If an investor purchases shares just before a capital gains distribution:
- The investor does receive the distribution (as cash or reinvested shares), simply because they are a shareholder of record on the record date, not because they earned the underlying gain
- The NAV drops by the distribution amount on the ex-dividend date
- The investor has no economic gain but owes tax on the distribution they just received
- This creates a phantom tax liability - effectively paying tax on gains the fund realized before the investor owned the shares
Think of it this way: The distribution is not free money. NAV drops by the distribution amount, so the investor's total value stays the same, but now they owe taxes on someone else's gains.
Exam Tip: Gotchas
Buying a fund before a distribution creates a tax liability with no economic benefit. Checking distribution dates before purchasing is a common adviser practice to avoid this outcome.
Which Vehicles Are Most Tax Efficient?
| Vehicle | Tax Efficiency | Reason |
|---|---|---|
| Index ETF | Most efficient | In-kind creation/redemption avoids realizing capital gains |
| Index mutual fund | Efficient | Low turnover, but cash redemptions can force taxable sales |
| Actively managed fund | Less efficient | Frequent trading generates capital gains distributions |
| Non-traded REIT | Least efficient | Distributions taxed as ordinary income (not qualified dividends) |
"Redemption" means something different for each vehicle, and that difference is what drives the tax gap in the table above:
- Selling ETF shares on an exchange is not a redemption. A retail investor selling ETF shares sells to another investor on the secondary market. The trade never touches the fund's portfolio, so it creates no tax consequence for other ETF shareholders. Only large institutional Authorized Participants redeem directly with the fund, and that redemption is in-kind (a basket of securities, not cash)
- Mutual fund shares have no secondary market. An investor redeeming mutual fund shares sells directly back to the fund itself for cash. If the fund does not have enough cash on hand, it must sell portfolio securities to raise it. Any capital gains realized from those sales are distributed to all remaining shareholders, not just the investor who redeemed
Exam Tip: Gotchas
A retail investor selling an ETF on the exchange is not redeeming shares with the fund at all. Only an Authorized Participant redeems directly with the fund, and that redemption is in-kind. Mutual fund investors, by contrast, always redeem directly with the fund for cash, since mutual funds have no secondary market.
How Are REIT Distributions Taxed?
- Required to distribute 90% of taxable income annually
- Distributions taxed as ordinary income (NOT capital gains)
- A frequently tested distinction: REIT dividends do not receive the preferential qualified dividend rate
Exam Tip: Gotchas
REIT distributions are ordinary income, NOT capital gains. Despite being called "dividends," they do not qualify for preferential dividend tax rates.
Are Fund Exchanges Within a Family Taxable?
Exchanging shares between funds in the same family is a taxable event. Capital gain or loss is realized on the exchanged shares, even though no cash is received.
Exam Tip: Gotchas
Fund exchanges within the same family are taxable. Many investors mistakenly believe these are tax-free.
What Should You Check on Exam Day?
- Regulated investment companies and REITs both avoid fund-level tax by distributing at least 90% of the relevant income annually.
- Capital gains distributions are always long-term, based on the fund's holding period, never the investor's.
- Buying right before a distribution's record date creates a phantom tax liability: the distribution is real, but NAV drops by the same amount, so there is no economic gain.
- Index ETFs are the most tax-efficient vehicle listed here because in-kind Authorized Participant redemptions avoid realizing capital gains; actively managed funds and non-traded REITs are the least efficient.
- REIT distributions are ordinary income, not capital gains, despite the "dividend" label. Fund exchanges within the same family are taxable even without cash changing hands.