Is it true that someone could owe tax on Mutual Fund for 2006 even if they did not sell it and it is worth les

worth less in 2007. How does that work, taxes and mutual funds.

It is true.

Income tax is based on the income generated by the fund, not the value of the fund. If the fund generates capital gains or dividends, those amounts are taxable even if the fund itself has lost value.

When you sell the fund, your gain on the sale is added to your income, and your loss on the sale is deducted from your income.

In managing a fund's portfolio, securities are being bought and sold. Anytime a security is sold, it is a potentially taxable event. It is entirely possible that a fund can lose value over a calendar year, and still generate capital gains. We saw this often in 2000-2002 after the ridiculous market boom in the previous few years.

This is one reason why I typically don't recommend mutual funds for my clients outside of a tax qualified plan.

If the mutual fund paid taxable dividends, that's income that you must claim even if you left the money in the fund. Some mutual funds trade quite heavily in the market and that can generate capital gains that you must claim as well.

You don't get a deduction for loss of value until you sell your shares in the fund. When you do, you can claim a capital loss. That will offset any capital gains first. Any excess loss can be used to offset ordinary income but only up to $3,000 per tax year. Any excess loss must be carried forward to the next tax year where the whole process starts over again.

You'll get statements that list all transactions with potential tax consequences. HANG ON TO THOSE! You will need them for this year's tax return, as well as in future years when you sell shared in the fund.

If this all gets too much to deal with, hire a CPA to help you out. Don't go to the tax prep mills with that; they screw up the simple things badly enough as it is and you don't need the aggravation of an audit for their incompetence.

Definitely possible, not even all that unusual.

If you own shares in a mutual fund, you will usually get a 1099 showing your share of the dividends that the fund received that year, and your share of the capital gains (or losses) they made on items they sold (called capital gains distribution) - you'll have to claim these on your tax return.

Assuming that you leave these in the fund, then when you sell, these amounts will be added as part of your basis, since you'll have already paid tax on that much.