In the preceding post we noted the risk of an unrealized capital loss becoming long-term due to a wash sale. Tax loss harvesting also creates a situation constrained by the wash sale rule.

Tax loss harvesting

As in the preceding post, suppose you bought 100 shares of BP (BP plc ADR) at $50 per share on June 15, 2009. Less than a month ago on May 26, 2010, BP stock was at $43 per share. You had an unrealized short-term capital loss of about $700.

Rather than buying more BP stock, you sold 100 shares for $4,300. This action is also known as harvesting a tax loss. This loss would offset any short-term capital gains in your taxable portfolios.

Two weeks later on June 9, BP closed at $29.20. To rebalance your asset allocation, you were anxious to restore your holding in BP. On June 10 you bought 100 shares for $3,100. This purchase triggered a wash sale and negated the whole purpose of harvesting the tax loss.

Wash sale effect on cost basis

The short-term loss that you recognized on May 26 would be disallowed as a wash sale, because you bought substantially identical stock within 30 days after the sale.

To account for the wash sale, you must add the disallowed loss to the cost basis of the purchase that triggered the wash sale. In this case, the tax lot for the June 10 purchase had its cost basis raised by $700 to $3,800. You also change the beginning of the holding period of the tax lot to the purchase date of the stock sold.

The tax lot now has an unrealized loss of $700, and its holding period began on June 15, 2009. On June 16, this loss became long-term.

Tax loss harvesting starts a 30-day wash sale window

Recognizing a capital loss in a taxable portfolio sets up the potential for a wash sale during the next 30 days. To avoid a wash sale that would disallow the prior capital loss, you have two choices.

You can wait 31 days after the loss before buying replacement stock. While simple, this choice has a major drawback. During the period when the portfolio lacks the holding that had been sold, your asset allocation may differ from your chosen allocation.

Yesterday, the BP ADR closed at $29.20. You have fallen into deep water, with no clear vision of the horizon.

Your 200 share position in BP consists of two tax lots. The first, year-old tax lot has an unrealized loss of about $2,100 (-$21 times 100 shares). For the second, more recent tax lot you have an unrealized loss of about $1,400.

Wash sale effect on cost basis

If you sell the first tax lot for a loss, you cannot deduct that loss from your net capital gains. The loss would be disallowed as a wash sale, because you bought substantially identical stock within 30 days prior to the sale.

This is the point where most discussions of the wash sale rule end. But the real damage has only just begun.

To account for the wash sale, you must add the disallowed loss to the cost basis of the purchase that triggered the wash sale. In this case, the second tax lot has its cost basis raised by $2,100 to $6,400. You also change the beginning of the holding period for the second tax lot to the purchase date of the stock sold.

The second tax lot now has an unrealized loss of $3,500, and its holding period began on June 15, 2009. Next week, on June 16, this loss will become long-term.

Avoid a wash sale that creates a long-term capital loss

Before your recent purchase two weeks ago, the first tax lot had an unrealized loss of $700. More significantly, the holding period for that lot was approaching one year. An earlier post pointed out the importance of recognizing short-term losses before they become long-term.

Adding to a stock position which has an unrealized capital loss starts a 30-day wash sale window. During that window, a sale of the stock for a loss will be disallowed. Particularly worrisome is when the window stretches the holding period of a tax lot beyond one year.

WFMI (Whole Foods Market, Inc) had a 2 for 1 stock split on December 28, 2005. Before the split you bought 300 shares of WFMI at $60 per share.

Realize a capital gain

During 2008 you sold 200 WFMI shares for $20 each and realized a sale amount of $4,000. To figure the capital gain (or loss), you need to determine the cost basis of the sale.

After searching your trade history, you find the 300 share purchase with a trade amount of $18,000 (300 shares times $60). The WFMI position had a cost basis of $60 per share before the split.

The sale of 100 shares prior to the split did not change the cost basis per share. After that sale the 200 shares of WFMI had total cost basis of $12,000 (200 shares times $60).

A stock split leaves total cost basis unchanged

The stock split had no effect on the $12,000 total cost basis. The 200 shares received due to the stock split did halve the cost basis per share to $30 ($12,000 divided by 400 shares).

The sale during 2008 of 200 shares would have a cost basis of $6,000 (200 shares times $30 per share). Thus, you realized a long-term capital loss of $2,000.

A tax lot clarifies the effect of a stock split

A 300 share purchase would create a new tax lot with a cost basis of $18,000. This tax lot would have its shares reduced to 200 by a sale. The sale would lower the total cost basis to $12,000. At $60, the cost basis per share would remain unchanged.

After a 2 for 1 stock split, the share quantity of the tax lot would double to 400. The total cost basis would stay the same. With twice as many shares, the cost basis per share would halve to $30.

Divide split shares among tax lots for multiple purchases

Your portfolio might include several WFMI purchases with share quantities of 250, 350 and 400. The broker would report that you have received 1,000 shares due to the stock split.

The cost basis and holding period for the added shares correspond to each of the three purchases. Without using tax lots, sorting out the cost basis of various shares can become a burden.

Early each year, investors receive a ‘Proceeds from Broker Transactions’ report, IRS Form 1099-B, from each of their brokerages. This form lists the gross proceeds from stock sales for the prior year.

The bad news: the Form 1099, with just the sales listed, provides only a part of the data needed to determine the capital gains for Schedule D. For each sale, the amount of capital gain, or loss, is the difference between the gross proceeds and the ‘cost or other basis’.

Cost basis depends on which stock was sold

From IRS Pub 550, the cost basis for a stock position is the purchase price plus any purchasing costs such as commissions. To know the purchase price, one needs to identify which stock was sold. When an investor has made purchases at various times, this can become difficult.

Identify stock sold with tax lots, not stock trade history

Every opening trade to purchase stock creates a new tax lot. The cost basis of the lot is the purchase price plus any purchasing costs.

Later, a sale of stock will reduce the number of shares in the lot being sold. When all of the shares are sold, the lot is closed. If only a portion of a lot is sold, the lot will have its shares reduced by the number of shares sold. The cost basis is the fractional part of the shares sold to the total cost basis of the lot.

A sale of stock may also involve multiple lots. Each lot will have a distinct cost basis and holding period. Such a sale will result in a separate capital gain or loss for each affected lot.

Cost basis record keeping is a burden

The taxpayer bears the responsibility for tracking the cost basis to substantiate their capital gains. Along with a list of current stock positions, brokerage reports include the history of trades. Except for the simplest cases, neither coincides with the tax lots.

Investors have few tools to help track cost basis over time. Many use tax preparation software to calculate capital gains at year-end. While this may appear to be a reasonable approach, this may not result in the lowest tax.

Some do maintain a record of each tax lot in their portfolios. Nevertheless, taking on this task with a spreadsheet would be time-consuming and error-prone.

A cost basis app for individual investors

A great cost basis app would make tax lots easy. Investors who know their tax lot situation can make better trades year-round. This helps them get better after-tax returns, since they trade stock with an eye on lowering their capital gains tax. With the tax lots already set up, calculating the capital gains and Schedule D becomes automatic.

Providing investors with a simple tool to maintain their tax lots is another reason why we developed the Realized app for managing stock portfolios.

An investor has purchased 200 shares of a stock at four different times:

• 18 months ago at $16 per share
• 14 months ago at $23
• 10 months ago at $24
• 6 months ago at $17

Today the latest quote for the stock is $20. His brokerage account shows the 800 share position as having a market value of $16,000.

Selling stock using FIFO

Because the stock has not performed as well as he hoped, he has decided to sell half of the position for $20 per share.

He will use FIFO, or first-in, first-out, as the cost basis for the sale. This results in two distinct capital gains. For the shares purchased 18 months ago, he has an $800 long-term gain (200 shares times $4 per share). In addition, he will have a $600 long-term loss (200 shares times $3 per share) for the shares purchased 14 months ago.

For the sale, he will have a net long-term gain of $200. This will incur a capital gains tax of $30, ($200 times 15%).

Selling the stock lots with the highest cost basis

Instead of using FIFO, he could have sold the stock having the highest basis. Rather than two gains, this would result in two capital losses. For the stock with the highest basis, purchased 10 months ago, he would have an $800 short-term loss (200 shares times -$4 per share). Selling the next highest basis stock, purchased at $23, would result in a $600 long-term loss (200 shares times -$3 per share).

Altogether, he would realize a $1,400 capital loss by using HIFO, or highest-in, first-out cost basis. Since he falls into the highest marginal tax bracket of 35%, this loss would reduce his tax by $490 ($1,400 times 35%).

In either case, he still holds 400 shares of stock. Selling the highest basis stock has lowered his tax by a net $520 ($490 plus $30). As mentioned in a previous post, to use HIFO an investor must make an adequate identification of the stock being sold.

Review each tax lot before selling

Each closing trade may produce various taxable outcomes. As we saw above, this is notably true for stock positions composed of multiple purchases, or tax lots.

A typical brokerage account will display each position’s current market value and the share quantity. This is not enough. Without knowing the cost basis of each lot being sold, an investor has no idea what the prospective capital gain might be. By relying on FIFO as his cost basis, he risks incurring capital gains tax that might have been avoidable.

Instead, imagine him already having an estimate of the expected capital gain, prior to placing a trade order. With that information in hand, he could place a trade with a specific capital gain outcome already in mind.

Providing investors with that insight (and more) is one reason why we developed the Realized app for managing stock portfolios.

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.