Executive Summary
The specific share identification method allows investors to choose which investment is sold, which can be especially helpful when there are multiple lots purchased over time that each have a different cost basis, as advisors and their clients have the opportunity to identify exactly which shares to sell to get the best tax result. In the past, this strategy was implemented to maximize tax loss harvesting to minimize an individual's tax liability over time, although notably in today's world some advisors and clients are actually using it to ensure that long-term capital gains are harvested for those in the bottom tax brackets! Either way, though, specific share identification provided the planning opportunity, and in fact a popular feature of portfolio accounting and rebalancing software has been the ability to track and manage lot level accounting to optimize these decisions.
The rules for specific share identification were tightened up slightly in recent years, as 2008 legislation has been phasing in year by year that requires brokers and custodians to track the cost basis of newly purchased investments - so-called "covered securities" - and to report the results of sales to the IRS on a new Form 1099-B that provides information on not just the sales proceeds and sale date (as in the past), but also the cost basis, acquisition date, amount of the gain or loss, and character of the gain or loss (i.e., long-term or short-term). In addition, the new tracking rules effectively enforce the requirement that if advisors and their clients are going to use the specific share identification method, or otherwise want to set a favorable default method of accounting, it must be chosen by the time the sale occurs and the trade settles; otherwise, the lot selection is "locked in" and cannot be changed later.
In a new potential blow to the planning strategy, though, the latest 2014 Budget Proposal from President Obama would eliminate lot level accounting and the specific share identification method altogether, requiring instead that covered securities all be reported using the average cost method once they are held long enough to be eligible for long-term capital gains. Although some of the details remain unclear - most notably, whether the rules would apply only for stocks, or for mutual funds and ETFs as well - the bottom line is that the opportunity to make tax-savvy decisions about individual investment lots being sold may soon cease to be a value proposition for advisors and the technology that supports them!
Understanding The Specific Identification Method
If an investor accumulates a position in a stock over time, it's likely that the total investment will include several different "lots" that were purchased at different times and different prices. For instance, an investor might have purchased 100 shares of Apple stock in early 2010 at a price of $200 per share, and then bought another 100 shares of Apple in 2012 at $600 per share. The total cost basis of the investment is $80,000, including the early shares with a basis of $20,000 and the later shares with a basis of $60,000. At a current price of about $400/share, this distinction is significant; if the investor chooses to sell half the investment position, whether the first 100 shares are sold or the last 100 shares are sold can have a material impact, as it's the difference between reporting a $20,000 long-term capital gain or a $20,000 long-term capital loss!
Historically, investors have had the flexibility to choose which lots would be sold, under the so-called "specific identification" tax method. In order to do so, the requirement (see IRS Publication 550) was simply that the broker or custodian be informed at the time of sale which shares were being sold; for instance, to place not just an order "Sell 100 shares of Apple" but to note "Sell the 100 shares of Apple I purchased in 2010, not the shares I purchased in 2012." Notably, though, the rules were rather loose about how this even had to happen; it could be in writing (or electronically), or in theory could just be oral, and the broker just had to ultimately provide a written confirmation that your instructions had been executed as directed. If there was no guidance about which shares were sold, the assumed default in the absence of any specific identification was FIFO, or first-in-first-out, which simply assumed the earliest shares purchased were the ones sold (which, notably, often led to selling the earliest investment positions with the biggest gains).
In practice, investors were often very "sloppy" in following the specific identification method, but from a practical perspective it rarely mattered, due to poor reporting and tracking rules. Many investors would simply wait until tax season, select after the fact which investment lots had been sold in the prior tax year depending on what would lead to the best tax outcome, and then just "update" their cost basis records accordingly for future reference. At least, until the rules changed recently.
New Cost Basis Tracking Rules For Covered Securities
Under the Emergency Economic Stability Act of 2008 (the same legislation that created "TARP"), Congress passed new rules that would require brokers and custodians to actually track, and report, on the cost basis for investments. The tracking requirement was phased in over several years, requiring tracking for stocks purchased in 2011 or later, mutual funds purchased in 2012 or later, and took effect for all other investments acquired this year (2013) or beyond will take effect in stages in 2014 and 2016 for "simple" and "complex" bonds. For any such "covered securities" - purchased on/after the effective dates - the broker/custodian is required to report the cost basis, acquisition date, sales proceeds, amount of gain/loss, and character of the gain/loss (long-term or short-term) on a now-updated Form 1099-B, which in turn is reported on a new Schedule D and the supporting Form 8949 with columns for covered and noncovered securities. As many advisors and their clients have noticed, the financial institutions have been struggling over the past two years to update their systems during tax season to provide this reporting accurately, although the situation appears to be improving.
The new cost basis tracking rules also indirectly provided the first crack-down on improper use of the specific identification method for selecting which investment lots were sold. As discussed in the December 2011 issue of The Kitces Report, covered securities were required not only to be tracked and reported on by brokers/custodians, but to be tracked and reported based on whichever shares were identified as sold at the time of sale (or more accurately, by the time the trade settled). As a result, investors could not simply go back long after the fact - such as during tax reporting season - and decide which shares were sold to optimize the tax outcome. Instead, the decision about which shares were sold was locked in when the trade occurred, which meant investors for the first time had to be proactive - or at least timely - to ensure that the correct shares were sold, if specific lot identification mattered.
Given that it isn't always practical or feasible to choose the exact lot at the time of sale in every scenario - especially for a financial advisor, across dozens or hundreds of clients and potentially thousands of accounts - the new rules also provided flexibility for the selection of "default methods of accounting" that would apply in the absence of any specific share identification. While historically the default method of accounting was FIFO, investors were now permitted to select more flexible defaults, and change that method for remaining investment shares at any time (to apply a new/different rule for subsequent sales). As a result, it became increasingly important for advisors to help select an appropriate default method of accounting for clients, especially given that in the current environment with four capital gains tax rates, some investors might want "highest cost" (taking losses first to minimize current tax liabilities) while others might prefer "lowest cost" (taking gains first to harvest them at favorable tax rates).
The President's Budget Proposal On Specific Lot Identification
So what's changed recently? Under the President's 2014 Budget, as discussed in last week's blog and explained in the Treasury Green Book, a proposal has been set forth that would change the rules again, requiring that for covered securities (i.e., stocks purchased since 2011, mutual funds since 2012, and everything else purchased in 2013 and going forward), if the investment has a long-term holding period that all identical shares would be required to use average basis. Which means average cost accounting would no longer just be the default for mutual funds (and ETFs organized as '40 act funds), it would be the required method. For everything.
In other words, there would no longer be an option to use specific share identification, nor in fact would there be a choice to use highest cost or lowest cost (or even FIFO) either; instead, all fungible shares would have cost aggregated together, and average cost would be required to be used for each sale. (Notably, the proposal is explained in terms of portfolio stock, although it is likely that the rule would ultimately apply to stocks, mutual funds, and ETFs, just as the current cost basis reporting rules do, since they all represent fungible shares of an investment.) And there would no longer be any options to change the method of accounting for portfolio investments.
Although the Federal revenue anticipated to be raised by this change is not huge - projected to be about $2 billion over the next decade - the ramifications for investment advisors may be significant. After all, many advisors promote tax-sensitive investment decisions as a major benefit of working with them. The complexity of the situation has also been conducive to technology, and as a result a lot of portfolio reporting and rebalancing software programs have undergone extensive programming to track and effectively manage lot level accounting decision; in addition, savvy lot-level tax loss harvesting strategies have also been extensively promoted as a major feature of so-called "robo-advisors" like Wealthfront. If the proposal to require average cost across the board goes through, it would eliminate the tax planning strategy and associated value proposition for investors, and advisors, and their technology. For instance, in the earlier example, the average cost of Apple shares was $400, and the proposal would require that any/every sale assumes the same $400 average cost, eliminating both the opportunity to harvest losses or to harvest gains!
It's worth noting that at this point, the proposal is only that: a proposal. It hasn't been codified into law, nor even directly proposed in legislation before Congress. Nonetheless, it seems quite possible that these new rules will be implemented, especially given other crackdowns on perceived-to-be-abuse tax accounting rules. Ironically, one benefit for many consumers of the rule would at least be that cost basis could be easier to track when average cost is uniformly applied, although ironically such simplification probably wasn't necessary now that automated cost basis reporting on covered securities is already the law of the land anyway (which means all of this was already being tracked on behalf of investors going forward). On the other hand, with cost basis tracking from brokers and custodians, it also becomes easier to implement a new average cost rule, as it will now be feasible for the IRS to determine if investors are properly complying.
Of course, for the time being, many investors still hold non-covered securities as well - those longer-term investments purchased before the effective dates - which wouldn't be subject to the new rules, and of course the rules would have no impact if the entire investment position is purchased all at once or sold all at once; lot-level accounting decisions are only relevant where there are multiple prices at different prices, followed by partial sales where lot selection matters. In addition, it's not clear how the rules would apply to investors that hold identical investment positions across multiple accounts or custodians (where it would be difficult for automated average cost reporting to be implemented). Nonetheless, as the years go by and client investor portfolios turn over, the percentage of covered securities will continue to increase, and it seems quite feasible that at some point, this proposal for uniform average cost for long-term investments may become law, eliminating it as a tax planning strategy for savvy advisors and their supporting technology!
It’s always something! Thanks for the update Michael!
A consequence (intended?) of this move to average cost basis seems to be that it would lessen the tax effectiveness of donating highly appreciated shares to charity. Is that your understanding?
It’s always something! Thanks for the update Michael! stock lot online