An investor may purchase a company's stock at various times and in varying quantities. When part of that stock is later sold, the capital gain is the difference between the sale amount and the cost basis of the stock.
If multiple purchases occurred, the IRS considers the default cost basis to be the amount paid for the stock purchased first. This is also known as FIFO, or first-in, first-out. In a taxable portfolio, relying on FIFO cost basis may raise your capital gains tax. This can do real damage to your after-tax return.
Capital gain using FIFO
Six months ago an investor bought 200 shares of stock for $27 per share. Three months later she bought 200 more shares of the same stock for $33 per share. Today she sold 200 shares at $30. The sale amount is $6,000 (200 shares times $30).
Using FIFO, the cost basis of the stock purchased first is $5,400 (200 shares times $27). The capital gain, sale amount minus cost basis, is $600. This short-term gain is taxed at the marginal rate of ordinary income. With that rate at 35% for many investors, the tax is $210.
When is FIFO cost basis not the right choice?
Using FIFO is easy, and most tax software uses it as a default for stock cost basis. If investors had no other choices for cost basis, this would not be a problem.
But, they do. A different choice would have been to sell the stock purchased later at $33. The cost basis for the later purchase is $6,600 (200 shares times $33). Rather than a gain, the sale would realize a loss of $600. Instead of paying tax, the loss would offset other gains or ordinary income and lower her tax by $210.
By selling the stock bought later, she lowered her current year tax burden by a net $420.
Minimize gains by selling the stock with the highest basis
The change from a costly taxable gain to a loss happened by choosing not the later, but rather the higher cost basis. HIFO, or Highest-In, First-Out, cost basis takes a smaller gain now and defers the larger gain into the future.
In both cases, what remains is a stock position of 200 shares worth $6,000. The differences are the current year tax and the unrealized gain.
With FIFO, the remaining cost basis is from the later purchase, or $6,600. The investor owes $210 in tax and is sitting on an unrealized loss of $600.
Using HIFO, the investor has lowered her tax by $210 and holds an unrealized gain of $600. The lower tax provides $420 more for reinvestment. Further, she may choose not to sell that stock for a number of years, thereby deferring the tax.
Opting out of FIFO cost basis for stock sales
To repeat, the IRS considers FIFO the default cost basis for stock sold. To use HIFO, an investor must make an adequate identification of the stock being sold. Some call this method specific identification.
An investor has no control over market movements, but she can control when she sells stock. By also pinpointing what to sell, she gets a new tool to lower her tax and raise her after-tax return.