Introduction
Tax lots are the records that track the cost basis and purchase date of each block of shares you own. Knowing how tax lots work matters because the specific shares you sell determine your taxable gain or loss, and that can change how much tax you owe this year.
Which shares should you sell first to manage taxes effectively? Do you want to cut your tax bill now, hold for lower long-term rates, or harvest losses to offset gains? This article will explain FIFO and specific identification in plain language, show simple numerical examples using real tickers, and give practical steps you can use when trading.
- Understand the difference between FIFO and specific identification for selling shares
- Selling older shares held more than one year typically produces long-term capital gains that are taxed at lower rates
- Specific identification lets you choose which lot to sell and can reduce taxes, but you must instruct your broker at the time of sale
- Default methods like FIFO or average cost may be applied if you don't specify a lot
- Watch for wash sale rules when selling at a loss and repurchasing the same security within 30 days
What Are Tax Lots and Cost Basis?
A tax lot is simply a record of one purchase event for a security. If you bought 50 shares of $AAPL on January 1, and another 50 shares on June 1, you have two tax lots with different cost bases and purchase dates. Cost basis is the original amount you paid for a lot, including commissions or fees when applicable.
Cost basis and the holding period determine whether a sale produces a short-term or long-term capital gain or loss. Short-term gains come from selling lots held one year or less and are taxed at ordinary income rates. Long-term gains come from selling lots held more than one year and usually face lower tax rates.
Why the lot you sell matters
When you sell shares, the gain or loss equals sale proceeds minus the cost basis of the lot you sold. If you pick a lot with a low cost basis, you’ll show a larger gain. Pick a lot with a higher cost basis, and your gain is smaller or you may show a loss. That difference changes your taxable income and possibly your tax bracket.
FIFO vs Specific Identification, Explained
Two common methods for determining which shares are sold are FIFO and specific identification. FIFO stands for first in, first out. Specific identification means you tell your broker the exact lot or lots you want to sell.
FIFO (First In, First Out)
FIFO is a default method many brokers use when you don’t say otherwise. FIFO sells the oldest shares first. If your oldest shares have the lowest cost basis, FIFO can create larger gains. On the other hand, if your oldest shares are the most expensive, FIFO could reduce gains.
Specific Identification
Specific identification lets you pick which lot to sell. You must tell your broker which lot at the time of sale and follow their instructions so the sale is properly recorded for tax reporting. Specific ID can be useful to manage short-term vs long-term gains or to harvest tax losses.
Simple Numerical Example: How Choice Affects Taxes
Numbers make the difference clear. Imagine you own 150 shares of $MSFT bought in three lots.
- 50 shares bought 30 months ago at $200 per share (long-term lot)
- 50 shares bought 9 months ago at $280 per share (short-term lot)
- 50 shares bought 2 months ago at $320 per share (short-term lot)
Now suppose you sell 50 shares today at $350 per share. Which lot you sell changes your taxable gain.
- If FIFO applies, you sell the oldest 50 shares. Cost basis is $200. Gain per share is $150, total gain is $7,500. This is a long-term gain likely taxed at lower rates.
- If you use specific ID and choose the lot bought at $320, gain per share is $30, total gain is $1,500. This is a short-term gain and taxed at your ordinary income rate, likely higher this year.
Which is better depends on your tax situation. If you want to reduce this year’s taxable income, choosing the higher-cost lot would reduce gains now. If you prefer long-term rates, selling the oldest lot could be more tax efficient even though the dollar gain is larger.
Practical Rules for Choosing Which Shares to Sell
There is no one-size-fits-all answer. Your choice should reflect your objectives this year, your expected income in future years, and your cash needs. Below are practical approaches to help you decide.
Common strategies
- Tax-minimizing in a taxable account, short term sell high cost lots, but watch holding periods for long-term rates
- To defer gains, pick lots with higher cost basis or wait until holdings cross the one-year mark to qualify for long-term rates
- To realize losses for tax-loss harvesting, sell lots with unrealized losses, but avoid repurchasing the same security within 30 days to prevent wash sale rules
- If you want to simplify bookkeeping, accept FIFO or average cost if you prefer not to track lots closely
Ask yourself what you want to achieve with the sale. Are you lowering taxes this year, preparing for an expected higher tax rate later, or rebalancing your portfolio? Your answer helps pick a lot selection method.
How to implement specific ID with your broker
Specific ID requires timely instructions. When you place a sell order, most brokers let you select the lot in the trade ticket or by phone. Make sure the lot is confirmed in the trade confirmation and on your year-end cost-basis reporting. If you fail to specify, the broker may default to FIFO or average cost.
Different brokers have different rules for submitting specific ID. Verify the process with your broker and keep written confirmations. Always check your 1099-B tax form to confirm the lots reported match your records.
Tax Rules and Caveats You Must Know
Taxes make lot selection more complicated. Below are key rules and common traps to watch for as you plan sales.
Long-term vs short-term
Holding period is crucial. Long-term gains, from sales of lots held more than one year, generally get lower tax rates. Short-term gains are taxed at ordinary income rates. If a lot is close to the one-year mark, consider whether waiting makes sense for the likely tax savings.
Wash sale rule
If you sell a lot at a loss and buy the same security within 30 days before or after the sale, the loss is disallowed under the wash sale rule. The disallowed loss is added to the basis of the newly purchased shares. Be careful when harvesting losses and re-entering positions.
Broker reporting and 1099-B
Brokers report sales on Form 1099-B with cost basis information. When you use specific identification, confirm the broker reports the correct lot and holding period. Mistakes can happen so reconciling your broker statements and keeping records is important.
Real-World Examples and Scenarios
Here are practical scenarios you may face, with suggested steps to take. These are educational examples and not advice. Verify with your broker or a tax professional before acting.
Scenario 1: You want to reduce this year’s tax bill
You own $AAPL shares in multiple lots. One small lot bought recently at a higher price shows a small gain today. You could select that lot to sell using specific ID, reducing your taxable gain compared with selling an older low-cost lot. Make sure the selected lot is confirmed in your broker’s trade details.
Scenario 2: You need cash and want lower taxes
If you need cash but want lower tax rates, selling a long-term lot that’s been held over a year gives long-term capital gains treatment. Even if the gain is larger than selling a short-term higher-cost lot, the long-term rate might reduce your tax liability at the end of the day.
Scenario 3: Tax-loss harvesting
If $TSLA shares you bought last year are down, you can sell those lots to realize losses. Avoid buying $TSLA again within 30 days to prevent a wash sale. You might buy a similar but not identical ETF to stay invested without triggering the rule.
Common Mistakes to Avoid
- Assuming specific ID is automatic, many investors don’t specify a lot and let the broker default to FIFO. How to avoid: always select the lot in the trade ticket and save the confirmation.
- Ignoring holding periods, selling a lot just days short of one year can cost you higher short-term tax rates. How to avoid: track lot purchase dates and consider waiting if tax savings make sense.
- Triggering wash sales, selling at a loss then buying the same security within 30 days disallows the loss. How to avoid: wait 31 days or buy a substantially different security.
- Failing to reconcile 1099-B, mismatched reporting can lead to tax surprises. How to avoid: compare broker statements with your tax records and correct errors early.
- Over-optimizing without considering future needs, focusing only on taxes can lead to bad investment decisions. How to avoid: balance tax planning with long-term investment goals and consult a tax professional.
FAQ
Q: Can I change a method after a sale if I forgot to specify a lot?
A: Usually no, once a sale settles the lot selection is locked. Contact your broker immediately if you believe an error occurred. Some brokers will correct genuine errors but don’t rely on after-the-fact changes.
Q: Do all brokers support specific identification?
A: Most major brokers support specific ID but the process and interfaces vary. Confirm in advance how to submit specific ID and get written trade confirmations showing the lot selected.
Q: How do wash sale rules affect my ability to harvest losses?
A: Wash sale rules disallow losses if you buy the same or substantially identical security within 30 days before or after the sale. To keep tax losses you can wait 31 days or buy a different but similar investment that is not substantially identical.
Q: Will using specific ID increase my audit risk?
A: Using specific ID correctly and keeping records does not inherently increase audit risk. The risk comes from inconsistent reporting or missing documentation. Keep confirmations and ensure broker 1099-B matches your records.
Bottom Line
Choosing which tax lots to sell matters because it changes your cost basis, your holding period, and the tax you owe. FIFO is a common default, but specific identification gives you control when used correctly. Always weigh tax effects against your broader financial and investment goals.
Before making decisions, check your broker’s process for specific ID, save trade confirmations, and consider consulting a tax professional. You now have the tools to ask informed questions and take practical steps to manage taxes when selling shares.
