Due to the drop in the stock market, many investors decided to sell their holdings in mutual funds. Not having enough money in cash reserves, many mutual fund managers were forced to sell some of the stocks in the funds to generate cash to pay the redeeming investors. Many of these stocks had been held for a long time with low cost basis, thus generating long-term capital gains. Those phantom long-term capital gains are now being "distributed" to the remaining mutual fund owners.
In order to avoid the income tax on these capital gain distributions, an investor will need to sell the mutual funds before the distributions are made. Investors should find out how exposed they are to the capital gains by contacting the fund companies.
For investors who hold “short” exchange traded funds (ETF’s), these funds sell short in various indexes and industries. While the performance has been great in this bear market, the ETF’s are now distributing capital gain dividends – some as high as 40% of the net asset value. And because the funds hold short positions, the capital gains are almost entirely short-term capital gain dividends that fall under the same rules as a mutual fund – the short term capital gains are taxed as ordinary income. So, not only does this tax the dividend at ordinary income rates, but the investor has no opportunity to offset the short term capital gain dividend with capital losses.