It can be important for investors to keep track of what they paid for which stock certificate when they buy shares of one company at different times and at different prices. Usually, there is no problem in determining your cost basis when you sell all the shares in one transaction. But there can be some complications when you dispose of only part of your holdings.
The hitch is that the tax laws do not permit you to use an average price per share to calculate gain or loss on a sale. What counts is which certificate you unload.
You get the most favorable gain or loss only if you are able to identify which certificate you sold. If the shares you want to sell do not match the certificates you deliver, the Internal Revenue Service treats the first shares bought as the first shares sold -- in tax lingo, "the first-in, first-out" (FIFO) rule. That requirement affects the basis used in determining the gain or loss.
EXAMPLE: Your portfolio includes 600 shares of JKL stock, 200 of which were acquired two years ago at $10 a share, a second block of 200 last year at $30 a share and a third block of 200 this year at $45 a share. Now, JKL is trading at $20 and you want to sell 200 shares. Unless you are able to identify the second or the third lot as the one sold, the Revenue Service automatically assumes that you sold the first lot. Result: Instead of a loss of $2,000 on the second lot or $5,000 on the third lot that can be used to offset some investment gain or other income, you have a gain of $2,000 that is taxed the same as your ordinary earnings -- a sequence that probably differs from the order in which you intended to establish your cost.
However, it is easy to steer clear of the FIFO rule and achieve the tax result you want. You can do so even when shares bought in different lots and on different dates are held by your broker in "street name" (that is, registered in the brokerage firm's name and intermingled with shares held for other customers) or held by you but represented by a single stock certificate. Just make sure to meet these three requirements imposed by the feds and you are deemed to have adequately identified the shares you want to sell:
1. Specify to your broker (this can be done orally) the sequence in which you want the shares to be sold.
2. Identify the particular shares to be sold either by their purchase date, cost, or both.
3. Be sure the broker confirms in writing within a reasonable time.
Your instructions govern, and the shares so specified are considered sold. This holds true, says the IRS, even though the broker delivers the wrong certificate. Remember, though, that the FIFO rule remains applicable if you merely intended to sell particular shares but failed to inform your broker adequately.
TIP: There is a special rule for investors in mutual funds. They can use an average price per share to figure their gain or loss on the sale of mutual funds.
YEAR-END STOCK GAINS: When it comes to year-end stock gains, the tax law has undergone some changes.
If you sell some shares during the last week of December, you probably will not receive payment until early in the following year. This kind of sale often straddles the year-end because the New York Stock Exchange and other securities markets generally require five full trading days from the trading date (when you order the sale to be executed) to the settlement date (when you receive the sales proceeds and have to turn over the shares).
Under prior law, you could choose to report the gain from a last-week-in-December sale in the year of the trade date or the year of the settlement date. Now, however, you have no choice. You must report the profit in the year the trade takes place, regardless of when the settlement takes place. To shift the gain from this year, delay the sale until next year. As for capital losses, the rules are unchanged. Report a loss in the year the trade occurs.
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