What Are Tax Lots?

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Computers & TaxesWhen the market took a nose-dive earlier in the year, I tried to catch a falling knife. Several times.

What I saw were some storied franchises being unfairly punished for the sins of other companies, so I tried to take advantage. I bought shares of companies like Kraft and Costco, Apple and Southwest, and after I bought them, they continued to fall (because the investing gods hate me). So I bought more. My crowning achievement, in terms of intestinal fortitude, has to be Yahoo, which I’ve purchased on five separate occasions since the very first announcement that Microsoft was interested in buying them. If you know what the share price was then, you’d probably be surprised to know that I’m actually profitable on the investment (at least on paper) because I kept on buying.

By buying a stock multiple time, you create what are known as tax lots.

In my example with Yahoo, I purchased it five different times on five different days. When I go to sell, I have to tell my brokerage which of the five lots I want to sell. This is important primarily for tax purposes. As you know, if you hold a stock for more than a year, the tax rate on the profits is at the long term capital gains rate, which is at most 15%. If you hold a stock for less than a year, the tax rate on profits is at the short term capital gains rate, which is your marginal tax rate.

There are some great techniques you can use, by specifying how you sell your lots, to minimize your tax burden. I won’t go into them all here but you can read about it at Investopedia.

So what are some strategies? Well consider this, let’s say that you carried over some losses from last year (I know I did!). If you have $5,000 of short term capital losses and $2,000 of long term capital losses, you might want to structure your sale such that you take short term capital gains first. Common sense would say, sell the older shares first because you pay less in taxes (long term capital gains). However, since you have $5,000 of short term losses, you should sell the short term ones because those get offset against the $5,000. You can wait until later on to sell the long term, perhaps by then you’ll have overcome all of your losses from last year!

That’s only one case of where the general advice (sell old shares first for lower taxes) is not the correct advice and why knowing your tax lots is very important.

(Photo: blmurch)

{ 7 comments, please add your thoughts now! }

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7 Responses to “What Are Tax Lots?”

  1. Cap says:

    I always assumed that its a FIFO basis but then I realized that’s why they have broker assisted trades.. never traded enough to realize until I hold certain fun shares like you and your Yahoo shares. Haha.. good times.

  2. eric says:

    Oh you rebel 😀

  3. Jeremy says:

    Great post, I have overlooked this fact because I don’t make enough income to be taxed substantially therefore it does not make a difference, but hopefully I will be coming to a point where this can save me some money.

    Keep up the posts on investments, it is silly for people to work hard at their job and be unable to invest wisely. Getting just a 5% return on investments over a year can greatly increase the value of your earnings and maybe even let you retire early.

    While it is crucial to be active in managing investments, learning to do it yourself will save you even more money because your financial adviser is cut out of the loop. Simple advise like this post nullifies the need for proffessional advice with all of the great resources out there.

  4. Kate Kashman says:

    Here lies one of the reasons I’m scared of investing in individual stocks. The whole thing looks like a tax nightmare, and I actually don’t mind taxes. {{shivers}} There has got to be a better way.

  5. @katekashman…there is, it’s called hiring a fee based financial manager..

    they are in the best interest of your portfolio…when it goes up, its win/win…when it goes down…its lose/lose..

    not to mention the legal, tax, banking, insurance services they offer for free

  6. Andrew says:

    I was always under the impression that you were obligated to sell the oldest lots first, but per IRS publication 550 this appears not to be the case. Thanks for pointing this out!

  7. I like it when you dispel conventional wisdom. This is a perfect example. Thanks for the tip.

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