Tax Strategy: Tax Lot Optimization

Written by Financial Advisor Josh Kruk | April 13, 2021

As investment accounts age and grow in size, they often contain security holdings that have been accumulated gradually over time rather than purchased all at once. Each time a purchase is made in a particular security, it creates a new "tax lot" for that security. In cases where the investment is held in a taxable account (i.e., in a standard brokerage account rather than in an IRA or other tax deferred retirement account), those individual lots can be a valuable tool in managing an investor's near-term tax liability.

What is a Tax Lot?

A new tax lot is created with each purchase, and each tax lot has a unique cost basis and holding period. Consider the following hypothetical example:

On January 15, 2021, an investor purchases 1,000 shares of the XYZ Fund at a price of $20 per share. The cost basis for the lot is equal to the total amount paid for the shares. The cost basis of Tax Lot A is therefore $20,000.

On August 15, 2021, the investor purchases another 1,000 shares at a price of $30 per share. The cost basis of Tax Lot B is $30,000.

On December 15, 2021, the investor purchases 1,000 more shares at a price of $40 per share, creating Tax Lot C with a cost basis of $40,000.

On March 15, 2022, XYZ Fund is trading at a price of $35, meaning the 3,000 total shares the investor owns have a current value of $105,000 (3,000 shares x the $35 current price). The total cost basis from the three earlier purchases is $90,000 ($20,000 + $30,000 + $40,000).

The full position in Fund XYZ therefore has a net unrealized gain of $15,000. However, that net gain is actually comprised of three different parts, each of which has a unique profile.

• Tax Lot A has an unrealized gain of $15,000 (current value of $35,000 – original cost of $20,000) and has been held for more than one year.
• Tax Lot B has an unrealized gain of $5,000 (current value of $35,000 – original cost of $30,000) and has been held for less than one year.
• Tax Lot C has an unrealized loss of $5,000 (current value of $35,000 – original cost of $40,000) and has been held for less than one year.

The total net gain of $15,000 is made up of a $15,000 long-term gain, a $5,000 short-term gain, and a $5,000 short-term loss.

Tax Lot Optimization

Continuing with the example, assume that on March 15, 2022, the investor wants to sell 1,000 of the shares. The IRS allows leeway in determining which shares are identified as the ones being sold.

Many investment firms default to the “first-in, first-out,” or FIFO, method. This means that the oldest shares are assumed to be sold first. In this example, the FIFO method would result in all 1,000 shares from Tax Lot A being sold, meaning the investor would realize a taxable long-term gain of $15,000 in the 2022 tax year.

However, if the investor instead proactively elects to use Tax Lot C to identify the shares sold, the sale results in a short-term capital loss of $5,000. That loss can first be applied to offset any gains realized on the sale of other portfolio holdings. Any remaining loss up to $3,000 can then be used to offset other ordinary income on the investor’s tax return. If there is still any unused loss remaining after that, it can be carried forward for use in future years.

By selecting Tax Lot C, the investor cuts the current year tax liability while still achieving the desired investment goal of reducing the holding in XYZ Fund.

Keep in mind that, like most investment tax strategies, this approach is more about tax deferral than it is about tax avoidance. In the above example, the investor who elects to sell Tax Lot C is still left with Tax Lots A and B. These lots have a combined value of $70,000 (2,000 shares x $35 current price) and a combined cost of $50,000. So, by realizing a loss today, the investor has a larger net unrealized gain of $20,000 to deal with in the future.

However, for long-term investors, the value of tax benefit today may exceed the value of a tax benefit in the future. For example, using a loss now may allow the remaining shares to achieve long-term holding period status, meaning any gains will likely be subject to a lower tax rate when they are eventually sold. Further, if an investor expects to be in a lower marginal tax bracket in the future, realizing gains in those years may be less punitive than doing so today.

Investors who anticipate donating some or all of their shares to a qualified charitable organization also may benefit from the deferral of gains since shares are given a new “stepped-up” cost basis at the time they are donated. This means the gains are not taxable when the shares are donated.

The true return achieved by any investment strategy should include all factors that influence the ending value to the investor. This includes fees and other charges, the impact of inflation, and any taxes incurred. At One Day In July, we include tax lot optimization as part of our overall effort to integrate tax efficiency into our investment strategies.

The above article is based upon tax rules in place as of 2022. These rules may change in the future. The above should not be construed as tax advice, and investors should consult their tax professional.

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