The primary goal of investing is to earn money. The reasons for the need to earn and the pace at which earnings need to happen vary from one investor to another. Everyone’s in it for the money! While earning money is great, it’s important to understand the tax liability associated with doing so in different ways, especially when it comes to capital investments.
The Internal Revenue Service, or IRS, tracks quite a bit of information on securities trades through data sets known as tax lots.
Shares purchased on the same day, at the same price, are all lumped into the same tax lot, while shares purchased at different prices or on different days constitute new tax lots. But what exactly are these lots, and how can you use them to lessen your tax burden on investment returns?
What Are Tax Lots?
Tax lots are records of data pertaining to your acquisition of securities like stock, bonds, and options. These lots record data important to the determination of capital gains taxes, including:
Dates of Purchase & Sale
Both the sale and purchase dates are recorded in these lots. This is important data, because the length of ownership before realized capital gains or capital losses occurred will play a role in the tax rate you’ll pay on your returns.
The cost basis of most investments are the costs you pay to enter the investments. For example, say you purchased 100 shares of ABC stock at a purchase price of $10 per share for a total of $1,000. You also paid a commission to your broker of $5.99, bringing your total cost of ownership, or cost basis, to $1,005.99.
Cost basis is important in determining the profits you earn on your investments. The IRS will only charge taxes on the money earned through your investing activities.
Finally, the tax lot includes the sale price of the securities in the lot. By comparing the sale price to the cost basis, you and the IRS make an accurate determination on the profits, or taxable capital gains, generated in the transaction.
For example, if you sold the investment that cost you $1,005.99 in the example above for $1,200, you’ll owe taxes on the $194.01 of profits above your cost basis, not the entire $1,200 sale price.
How to Access Your Tax Lot Data
Most brokers have sophisticated tools for tracking and presenting tax lot information. Getting your tax lot data is likely as easy as logging into your brokerage account and accessing it there.
However, a smart investor is also a great record keeper.
In the future, every time you make a securities transaction, log the data yourself using a spreadsheet or simple pen and pad. This way, if the sophisticated tech used by your brokerage ever has a hiccup, you have a backup of data you know to be accurate.
Tax Lot ID Methods
Tax lot identification methods are offered by brokers when investors want to sell a percentage of a position that was purchased at different times and prices. These ID methods stipulate which tax lots are to be sold first in an effort to provide the most tax relief possible.
For example, say you buy 100 shares of a stock at $25 per share, 100 more at $30 per share, and another 100 at $40 per share. Then you sell 100 shares when the stock is at $30 per share. Tax lot ID methods instruct your broker which 100 shares you would like to sell in what order.
The most common lot ID methods include:
First-In, First-Out (FIFO)
Using the FIFO method, the first lots of securities acquired in a position are the first to be sold when you sell a percentage of the total position. This is a very basic strategy aiming to sell the lots that have the longest holding period to increase your chances of qualifying for long-term capital gains.
According to tax law, if you don’t stipulate a specific lot method to be used by your broker, they must use the FIFO method by default when you place orders to sell a percentage of a position.
Last-In, First-Out (LIFO)
The LIFO method is the exact opposite of FIFO, in that the last lots purchased will be the first to be sold. This method is best if you’re selling part of a position you’ve held for less than one year. In this case, the last securities purchased are likely closest to the current price, yielding the lowest taxable profits.
The average-cost method averages the overall cost per share every time new shares for a position are acquired. When shares are sold, that average cost becomes the cost basis.
When the average-cost method is used, it is coupled with the FIFO method, offloading the oldest shares in the position first when you sell.
The specific-shares method gives you the ability to choose the specific lots you want to sell out of your position. With each lot being purchased on a different day, or at a different price, you’ll have ultimate control over the amount of profit and time period held when selling specific lots.
How Tax Lots Affect Your Capital Gains Tax Determination
The amount of capital gains you’ll be taxed on is determined by the data found in tax lots. There are a few components to consider when it comes to your tax determination:
Amount of Capital Gains Realized
The amount of capital gains you realize when you sell is determined by tax lots. The difference between the purchase price plus commissions and the sale price equals the amount of your realized profits (or losses). Thoughtfully choosing which lots to sell could have a great impact on the total profits you’re charged taxes on.
Capital Gains Tax Rates
Short-term capital gains are any profits earned from investing activities in which the asset was held for under one year. Short-term capital gains are taxed at your ordinary income tax rate, which can be as high as 37% for high earners.
To avoid being taxed at these high rates, investors tend to sell older tax lots they’ve held for at least one year. In doing so, the investor pays a long-term capital gains tax rate, which tops out at only 20%, offering significant tax savings.
How to Use Tax Lots to Save On Taxes
When determining which lot to sell for tax purposes, each ID method listed above can benefit you. However, the specific shares method is best because it gives you the most control over how you’re taxed.
With this control, when it’s time to sell a number of shares, you can comb through all lots you’ve held for longer than one year for those with the highest cost basis. Selling these results in the smallest realized gains taxed as long-term capital gains.
The benefits are often dramatic. Not only will you pay the lower rate on long-term capital gains, you’ll pay it on the smallest amount of profits possible, while retaining your lowest cost shares for future moves.
Example of How Tax Lots Help Save Money On Taxes
Say you have a position of 10,000 shares of ABC composed of five tax lots, each consisting of 2,000 shares:
- Lot A was purchased five years ago at $1 per share.
- Lot B was purchased four years ago at $1.50 per share.
- Lot C was purchased two years ago at $1.75 per share.
- Lot D was purchased one year ago at $2.20 per share.
- Lot E was purchased six months ago at $2.25 per share.
Say you’re interested in selling 2,000 shares, or one entire lot, at the current price of $2.45 per share. Which tax lot should you sell?
Lots A, B, C, and D all qualify for the lower, long-term capital gains rate, whereas profits on lot E would be charged at your ordinary income tax rate because you haven’t yet held them for one year.
The highest cost basis among the long-term holdings is lot D, with a cost of $2.20 per share. So, in most cases, this would be the best lot to sell.
In selling lot D, you would only pay taxes on $0.25 in profit per share, working out to $500 in capital gains.
On the other hand, there are some cases when selling the most recently purchased shares is your better option.
Say the current price per share is down to $2.21, and you’ve determined it’s time to sell. While Lot E could expose you to higher short-term capital gains taxes, that’s only the case if you earn a profit. When you lose money, those losses help to offset capital gains in other holdings.
In this case, lots A, B, C, and D, would all result in taxable profits. However, selling Lot E would result in a loss of $0.04 per share, or $80. Because this loss would actually help to lower your tax burden, you might sell this lot, even if it was only held for six months.
Tax planning is an important consideration any time you do anything to earn money, whether it be working or investing. Understanding tax lots puts the power to reduce your tax bill on your capital gains in your hands.
Please keep in mind that when it comes to taxes, it’s best to speak with a tax professional. This article does not constitute individual tax advice.