The new tax lot accounting rules for 2011 has changed the way we track taxes on stock sales. No longer will you be able to number crunch your way to lower taxes on your stock sales at year’s end. Instead you’ll need to calculate cost basis throughout the year. When you track your profits/losses, you can use the tax lot accounting method that gives you the best tax savings at the time of sale.
Tax Lot ID Refresher Course
Which accounting method you choose will depend on your capital gains tax (which we covered in part 1) and how many tax lots you have of a particular stock. Every time you buy a stock, whether it’s one share or 1,000 shares, that stock purchase is given a tax lot ID. You can have multiple tax lots in the same stock.
If you buy 100 shares of stock XYZ, those 100 shares are given a unique tax lot ID. If you buy another 150 shares of stock XYZ, those 150 shares will be given a new tax lot ID. It doesn’t matter if you bought the 100 and 150 shares 1 minute apart or 4 months apart, each purchase gets a unique tax lot ID.
When you choose to sell stock XYZ, whether its 1 share or 249 shares, the tax lot ID method you choose could have a significant impact on the amount of taxes you pay. If you choose to sell all 250 shares of stock XYZ, the tax lot ID method of choice won’t matter because your selling all your tax lots in that stock.
FIFO (First-in, First-out) is the default tax lot ID method used by most brokerages if you don’t specify which method to use, thanks to the IRS. Though the IRS uses FIFO, it’s not always the best method to use all the time.
FIFO sells the oldest tax lots you bought first. Because of this it tends toward selling the longer-term tax lots. Currently long-term (over 1 year) tax lot sales are generally taxed at a lower rate than short-term tax lots. In this respect, FIFO will tend toward a lower year-end tax, but over time by consistently selling off your longer-term holdings, will eventually leave you with a handful of the higher taxed short-term tax lots.
Using FIFO is best suited for those who tend to not buy many multiple tax lots of the same stock with large differences in price and purchase date.
LIFO (Last-in, Last-out) is the exact opposite of FIFO. LIFO sells the newest tax lot you bought first. Short-term tax lot sales are taxed at ordinary income tax rates. If you find yourself in the higher tax brackets, LIFO may not be the best option.
Using LIFO over time can have an effect of leaving you with more long-term tax lots. Longer-term tax lots generally have a lower tax rate than short-term tax lots.
The highest cost method selects the tax lot with the highest price to be sold first. This tax lot method is specifically designed to limit your total gains.
One thing to keep in mind, the highest cost method doesn’t consider the length of time you held your shares. Though it generates the lowest gains, it may not always give you the lowest tax rate.
On the loss side of things, using the highest cost method when you have two similarly priced tax lots, one long-term (priced at $25.00) and one short-term (priced at $24), won’t take time into account. In this case selling the short-term tax lot first may be best. If the stock price rises over time to a potential profit, holding the long-term tax lot will lead to the lower long-term capital gains tax when you sell at that time.
The highest cost tax lot method tends to be most used with a portfolio of short-term holdings.
The lowest cost method selects the tax lot with the lowest price to be sold first. This tax lot method is specifically designed to maximize gains, and is most often used to take advantage of realized losses that can be offset by larger gains.
Like highest cost, lowest cost does not take length of time into consideration when choosing which tax lot to sell. Holding on to longer-term tax lots will always be more favorable when using the lowest cost method.
When using the lowest cost method your specific tax needs should always be used as a determining factor. If you use lowest cost as your default method, you should keep a close eye on your tax situation.
Instead of using FIFO, LIFO, highest cost or lowest cost as a default, you do have the option to choose a specific lot to sell at the time of your trade. By selling a specific lot, it allows you to precisely determine your gains or losses on a trade and whether it’s a long-term or short-term tax lot being sold.
Specific lot ID method can potentially give the best financial outcome since if forces you to be actively aware of your investments and tax liability.
Things To Keep In Mind
Whichever tax lot accounting method you choose to use, remember that the tax code constantly changes. The current capital gains tax code is in effect until the end of 2012. What happens after that will most likely trend toward higher taxes but what really happens is anyone’s guess.
If you see any upcoming changes in the next years tax code, either good or bad, could be beneficial to you. We know that after 2012, tax codes might change. If the long-term capital gains tax is eliminated it may be a good idea to lock in the lower tax rate by the end of 2012. You can always buy the stock again after the wash sale period ends.
Regardless of which method you choose as your default tax lot accounting method, keeping track of your gains and losses throughout the year are highly recommended. It will give you a better sense of your financial situation as well as your investments. If that’s not a good enough reason, you could always do it just to make sure you’re paying as little as possible in taxes.