Tax Lot Accounting:: Impact on Your Cost Basis

What Is Tax Lot Accounting?

Tax lot accounting is a record-keeping technique that traces the dates of purchase and sale, cost basis, and transaction size for each security in your portfolio, even if you make more than one trade in the same security.

Breaking Down Tax Lot Accounting

Shares purchased in a single transaction are referred to as a lot for tax purposes. When shares of the same security are purchased, the new positions create additional tax lots. The tax lots are multiple purchases made on different dates at differing prices. Each tax lot, therefore, will have a different cost basis. Tax lot accounting is the record of tax lots. It records the cost, purchase date, sale price, and sale date for each security held in a portfolio. This recordkeeping method allows an investor to track each stock sale throughout the year so that s/he can make strategic decisions about which lot to sell and when bearing in mind that the type of investment tax to be paid will depend on how long the stock was held for.

For example, assume an investor purchased 100 shares of Netflix in March 2017 for $143.25 and another 100 shares in July 2017 for $184.15. In April 2018, the value of NFLX stock has risen to $331.45. Their first tax lot has been held for more than a year, but the most recent lot has been held for less. The Internal Revenue Service (IRS) imposes a long-term capital gains tax on the profit made from the sale of a security held for more than a year. This tax is more favorable than the ordinary income tax applied to capital gains on stock held for less than a year. If the investor decides to sell, say 120 shares, how long the investments were held for must be recorded. Also, they must factor in the fact that the newer tax lot will have a smaller capital gain if sold, which may translate to lower tax than that of the older lot.

If they choose to sell shares from the March lot, they will be using the First-In First-Out (FIFO) method of tax lot accounting in which the first shares purchased are the first shares sold. In this case, the long-term capital gains tax will apply. Selling 120 shares will mean that their March acquisition will be sold, and the remaining 20 shares will come from the second lot. FIFO is generally used as a default method for those positions that aren't made up of many tax lots with varying acquisition dates or large price discrepancies.

If the shares sold are elected to come from the July lot, this choice will follow the Last-In First-Out (LIFO) method of accounting, and the realized gains will be taxed as ordinary income. If they sell 120 shares, 100 shares will be sold from the July lot and the remaining 20 shares will be sold from the March lot.

Other tax lot accounting methods include the average cost basis, highest cost, lowest cost, and tax-efficient harvester loss methods.

The goal of tax lot accounting is to minimize the net present value of current taxes by deferring the realization of capital gains and recognizing losses sooner.