Three Tax Traps

Last week, I wrote about funds that looked like attractive candidates for a taxable account. Those funds either carried sizeable tax loss carryforwards or at least didn't appear likely to pay out gains anytime soon.

Of course, the opposite can be true as well--many funds do have the potential for hefty capital gains payouts. So this week, I scoured our database to find types of funds and specific offerings that I wouldn't own in a taxable account, especially at the current time.

Real Estate Funds
Not surprisingly, many real estate funds made my list. These funds have enjoyed spectacular gains over the past few years, as the typical real estate fund gained about 17.89% annually for the trailing five-year period through Aug. 9, 2005. However, because many of these funds are restricted to a small subset of stocks to choose from--there are only so many REITs, after all--they tend to hang on to their positions, even as they vary them in size. So, with the rally continuing into 2006, their potential capital gains exposure has only grown. True, some of that is diluted by the heavy inflows these funds have gotten, but offerings such as  Cohen & Steers Realty Shares (CSRSX) still have potential capital gains exposure of greater than 50%.

Thus, if the sector cools--and I think it's ripe to do just that--I wouldn't be surprised to see outflows and some forced selling, which will result in capital gains payouts. Moreover, as we've pointed out in the past, regardless of these funds' capital gains situation, it doesn't make sense to own them in a taxable account. That's because dividends from REITs don't qualify for the favorable tax treatment afforded to dividends from other equities, as they are generally taxed at the same rate as income.

 Fidelity Leveraged Company Stock (FLVCX)
At 27% of assets, this fund's potential capital gains exposure is lower than that of many real estate funds, but it's substantial enough to have caught my eye. In particular I can't help but think that this fund, like real estate funds, has been a magnet for hot money because of its red-hot performance. And I simply don't think those kinds of returns--the fund is up more than 56% annually over the trailing three years--are sustainable. At some point in the near future, they will return to more reasonable levels, which may well cause some performance chasers to get out. Indeed, the kinds of companies this fund invests in--highly levered firms--have seen their stocks and bonds soar in the past few years, and that may change in the next few years if larger-cap, blue-chip firms lead the way. As such, while I think this fund is a good investment on its own merits, I wouldn't buy it for a taxable account, especially after the run it's had.

 Nations Mid Cap Value (NAMAX)
This fund, which has potential capital gains exposure in the same range as does the Fidelity fund, is set to absorb the larger  Columbia Mid Cap Value --with its larger potential capital gains exposure. And at 61% annually, this fund's turnover rate is already somewhat high, and my guess is that melding the two portfolios together will only lead to realizing more capital gains in the near term. Thus, I wouldn't be inclined to put this fund in a taxable account at least until the first payout after the merger. Moreover, as the Columbia fund complex works its way through melding its various funds into a more reasonable lineup, we think investors will do fine by watching from the sidelines.