By Kaye A. Thomas
Current as of January 3, 2015
If you bought shares at different times or prices, you may get a better tax result if you identify shares when selling.
When you hold multiple lots of shares and sell a portion of your holdings, the tax consequences may differ depending on which lots you sell. The amount of gain or loss as well as the category (short-term or long-term) may be affected. By default you’re treated as having sold the oldest shares first, a process known as first-in, first-out, or FIFO. Unless you’re using the average basis method for your shares, you’re allowed to identify shares to sell them in a different order, a process sometimes redundantly called specific identification or adequate identification.
- You can also identify shares for transactions other than sales, such as when you make a gift or donation of shares.
Not available when averaging
You aren’t allowed to identify shares while using the average basis method (which is optional for mutual fund shares and stocks held in dividend reinvestment plans). Note, however, that current rules permit you to terminate the average basis method at any time, and it appears that you would then be able to identify shares. If it would be advantageous to sell newer shares (to obtain a short-term loss, for example), you may want to consider changing from the average basis method.
One method, not two
FIFO and identification are sometimes misleadingly presented as alternative methods that can apply to your account. In reality they are parts of a single method. It permits you to choose for each individual transaction whether to identify shares, and provides a default rule for situations where you fail to do so. In choosing to identify shares for a particular transaction you are not changing the method of disposition for your account or locking yourself into a requirement to identify shares in all future transactions.
When a broker has custody of your shares (which is nearly always the case these days) there are two requirements for a valid identification:
- You have to tell the broker which shares you’re selling; and
- Within a reasonable time thereafter, receive written confirmation (which may be in electronic form) from the broker.
Note that the broker doesn’t have to actually transfer the shares you’ve identified. The broker merely has to provide written confirmation, which normally appears in a sale confirmation, but may also appear in an account statement or other document the broker provides periodically. If your broker provides online access to a listing of your portfolio holdings by individual lots, a listing that has been updated after your sale should meet the requirement for written confirmation.
Timing for identification. Although the broker’s confirmation can be provided “within a reasonable time” after the sale, your identification must be provided “at the time of the sale.” Normally identification is part of the sale instruction (“sell 100 shares from the lot purchased December 10,” for example), but the regulations permit identification any time until the earlier of the actual settlement date or the settlement date specified in the securities regulations. The settlement date is normally a few days after the trade date, providing a brief window of opportunity to correct an error in identification (or inadvertent failure to identify shares).
The regulations say you can use a standing order to identify shares. Perhaps the simplest approach would be to say that in the absence of other instructions you’re always selling the shares with the highest basis first. This method, sometimes called highest-in, first-out, or HIFO, produces the smallest gain or largest loss, although it is not necessarily the ideal method in all situations, particularly if it results in a short-term gain in a situation where you would otherwise have a long-term gain that is only slightly larger.
You might prefer a different method, such as one that always prefers short-term shares when selling at a loss and long-term shares when selling at a gain. The tax regulations don’t impose any restriction on these standing orders. Your broker doesn’t have to accept a standing order, however, and generally will require you to select from among methods that have been built into the broker’s software. If your preferred method doesn’t appear, you’ll have to use a different alternative or apply your method by identifying shares in each individual transaction.
A standing order is actually just one way to identify shares rather than a distinct method of disposition. You should be able to override your standing order for any particular transaction or switch to a different standing order (or use none at all) whenever you wish. Some brokers may not have software that accommodates this level of flexibility, however.
Is the broker required to permit you to identify shares? The regulations aren’t entirely clear on this point. They say that for covered shares (that is, shares that are covered by the rules requiring brokers to report cost basis) the broker has to report basis in accordance with a valid identification. Yet your identification isn’t valid without a written confirmation from the broker, and there is no clear rule making it mandatory for the broker to provide this confirmation.
- An explanation accompanying the cost basis regulations says brokers are not required to accept standing orders.
The identification rules are different when you sell shares represented by certificates that are in your custody (rather than held by your broker). You have to transfer certificates representing the lots you want to sell. If you transfer the wrong certificates, you won’t get the right tax result. The regulations say this rule applies even if you inform your broker or agent that you intend to transfer different lots, so take care in this situation.