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Accounting for Stock Sales: New Rules to Confuse

The IRS has made some changes to the rules for capital gains taxes on the sale of investments.  The terms FIFO and LIFO might confuse you, but luckily you have me to explain them to you.

My stock brokerage gave me the ability to adjust my accounting plan starting a few weeks ago.  I am given an option between First in-First Out (FIFO), Last in-First Out (LIFO), high cost, low cost, and a tax lot optimizer.  Each has a unique tax impact for you.

IRS 1040 Taxes
Calculating Taxes on Stock Sales Doesn’t Have to Be Confusing

First in First Out – FIFO

FIFO records your shares of stock as you buy them, and the oldest priced shares are sold first.  Think of this like the milk isle at the grocery store.  The first cartons on the shelf move to the front for you to purchase.

When the capital gain of a sale is calculated, the purchase price of the oldest shares is subtracted from the sale price.  This is the taxable income or loss from your sale.

Last in First Out – LIFO

LIFO records your shares as you buy them and uses the most recent shares purchased to calculate your capital gain.  There are several possible downsides to this method.  The most obvious is that you are favoring short term gain over long term gain.  Short term capital gains have a higher tax rate, so this is not the best way to go.

Think of the lumber isle at your local hardware store to visualize LIFO.  When the shelves are stocked, the oldest items are moved to the back.  Because lumber does not expire like groceries, you grab the first one on the shelf, which is the newest, to make your purchase.

High Cost

This one is self explanatory.  Your brokerage calculates capital gain by selling the highest cost first.  This is how my account is currently set up.  The idea is to minimize your capital gain in the short run and delay paying taxes on the lower cost shares until a later date.

Because of inflation and the time value of money, it is always best to delay taxes.  You have to pay them eventually, but you can minimize the short term impact.

Tax Optimizer

My brokerage also allows me to select a tax lot optimizer.  It sells shares in a particular order to minimize tax impact in the short run.  Schwab uses the priority below to determine the order of sales:

Short-term Losses

Lots reflecting short-term losses are sold first, from greatest short-term loss to least short-term loss.
Long-term Losses Lots reflecting long-term losses are sold, from greatest long-term loss to least long-term loss.
Short-term, no gains nor losses Short-term lots that reflect no gain nor loss
Long-term, no gains nor losses Long-term lots that reflect no gain nor loss
Long-term Gains Lots reflecting long-term gains from least long-term gain to greatest long-term gain.
Short-term Gains

Lots reflecting short-terms gains from least short-term gain to greatest short-term gain.

Only you know what your best tax situation is.  If you expect major changes in capital gains in the future, it is probably best to ask a tax professional what you should do.  For most of us, though, a highest cost or tax optimized sale process is ideal.  It keeps the money in the bank in the short run and saves us in the long run.

10 thoughts on “Accounting for Stock Sales: New Rules to Confuse”

  1. I got a 34534589340 page long email from my broker the day before these changes were rolled out. From what I understand, this roll out will extend through 2013, with new securities added each year.

    1. Eric - Narrow Bridge

      That sounds right to me. I know that this is the rule for my stocks and my mutual funds have very different tax options.

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