What Is Tax Lot Accounting?
Tax lot accounting is a method of tracking the purchase and sale dates, cost basis, and transaction size for each security in your investment portfolio, regardless of the number of trades made for the same security. This technique ensures comprehensive record-keeping for better investment decision-making.
Breaking Down Tax Lot Accounting
Tax lot accounting categorizes shares purchased in a single transaction as a lot for tax purposes. Additional tax lots are created when new positions of the same security are purchased at different dates and prices. Each tax lot has a distinct cost basis, and keeping track of these tax lots records crucial information such as purchase date, cost, sale price, and sale date for each security in the portfolio. This record-keeping enables investors to strategically decide which lots to sell based on factors such as the duration of stock holding and applicable tax rates.
Tax lot accounting essentially revolves around managing and analyzing tax lots.
For instance, imagine an investor bought 100 shares of Netflix in March 2017 for $143.25 and another 100 shares in July 2017 for $184.15. By April 2018, the value of the Netflix stock had increased to $331.45. The tax implications vary depending on how long each lot has been held. Long-term capital gains tax, levied by the IRS on profits from securities held for over a year, is more favorable compared to ordinary income tax on gains from stocks held for less than a year. When deciding to sell, the investor must consider the holding duration of each lot and the potential tax consequences related to the capital gains of each lot.
Opting to sell shares from the March lot would involve using the First-In First-Out (FIFO) method, where the earliest purchased shares are the first sold. This method typically applies long-term capital gains tax. Conversely, selling shares from the July lot follows the Last-In First-Out (LIFO) method, resulting in the gains being taxed as ordinary income. Various other tax lot accounting methods include average cost basis, highest cost, lowest cost, and tax-efficient harvester loss methods.
The main objective of tax lot accounting is to optimize tax liabilities by deferring capital gains realization and recognizing losses promptly to minimize current tax outlays. By employing strategic tax lot accounting methods, investors can enhance their tax efficiency and maximize their investment returns.