(Dow Jones) At a time when the government can't seem to make a decision about any key tax issue, U.S. lawmakers are on the verge of long-awaited mutual-fund tax overhaul that could be a real help to individual investors.

The House of Representatives recently passed a bill that would make landmark changes in the way funds' capital gains distributions are taxed.

While getting the bill-the Regulated Investment Company Modernization Act-through the Senate is no sure thing, this is as close to substantive change as investors have ever gotten on this front. Moreover, even if the changes aren't adopted now, the odds of real change in the near future have dramatically improved.

The issue is as old as the fund business itself. Mutual funds are "pass-through" investments, meaning that the tax obligations of the fund are passed to shareholders, who are on the hook for them. So if a fund accrues capital gains by trading stocks, shareholders must pay the tax for their share of the gains.

Funds are trading in and out of stocks all the time, and shareholders who hold the fund in a taxable account are responsible for the taxes, even if they don't trade. This is how a fund can post a loss during the year and still leave an investor with a bill for any capital gains paid out.

By comparison, investors in individual stocks only owe taxes when they sell shares at a profit. Exchange-traded funds-which are basically index mutual funds built to trade like stocks-also have the edge of being treated like stocks when it comes to taxable distributions. A buy-and-hold investor won't pay taxes on gains until the ETF shares are sold.

There are worse things than receiving taxable distributions. Losing money, for example. Or paying taxes twice, which sometimes happens with the current system. Investors pay taxes due on distributions they get during the calendar year, but fail to adjust their cost basis when they roll those dividends back into the fund.

Say an investor has $10,000 in a fund, which then has a 10% distribution. The investor owes tax on the $1,000 distribution, but reinvests that money into the fund. That leaves the account with a value of $10,000, but the shareholder has actually put $11,000 into the fund, between the initial investment and the reinvested distribution.

Failing to properly account for the distribution could result in paying taxes on it twice.

Tax Relief, And More 

The new bill ends the confusion by allowing shareholders to put off taxes on gains until they sell their shares, putting funds on an equal footing with stocks and ETFs. From a government standpoint, the move is revenue neutral over time. It is just that investors get some short-term relief and the confusing system gets smart.

The proposed legislation addresses other key concerns about funds. It removes some legal strictures that make it difficult for traditional funds to invest in commodities, which would result in a new wave of commodity funds, something that already has happened with ETFs, which again have a beneficial tax structure.

The new bill also would allow tax losses accrued by funds to carry-over indefinitely; currently, if a fund that racks up losses is closed or merged out of business, many of the tax benefits of those accrued losses-which can be used to offset taxable gains-are wiped out or expire.

While this is all good news for fund investors, it's hardly a sure thing to get through the Senate. Congress is staring down huge tax issues now, from where it will set the capital gains tax rate to the treatment of estate taxes. Mutual fund tax reform hasn't even been able to be a rider on that kind of key legislation in the past, and it may get pushed to the back-burner yet again.

The bill is too lightweight to get through on its own, but if it can be attached to the right bill, or if the Treasury Department could be convinced to change the rules without a legislative shove, then fund investors may finally get the change they need.

"It's definitely the farthest any real fund tax reform has gone," said Geoff Bobroff, an industry consultant in East Greenwich, R.I. "It needs to be done and it's long overdue...You would not have expected Congress to finally do this right now, with everything else on its plate, but any steps that move in that direction are good for shareholders."

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