Tax Lot Accounting: Definition, Meaning & Example

KEY TAKEAWAYS

• Tax lot accounting keeps a record of all your transactions and their various tax implications. 
• This includes the cost basis, purchase date, and sale date of each security in your portfolio. 
• First in, first out (FIFO) and specific identification are the two methods for tax lot accounting outlined by the IRS.

What Is Tax Lot Accounting?

Tax lot accounting is a specific type of record-keeping technique. It’s used to help keep track of the cost basis, the dates of purchase and sale, and the transaction sizes for the securities included in your investment portfolio. This can affect capital losses, tax liability, and long-term capital gains.

How Does Tax Lot Accounting Work? 

When you use a single transaction to purchase a share, it’s considered as a lot for tax purposes. Even further, when additional shares of the same security get purchased, these new positions will create more tax lots. 

Essentially, tax lots are multiple different purchases that get made at different prices and different dates. This means that each individual tax lot is going to have its own unique cost basis. In terms of tax lot accounting, this refers to the record of any tax lots you have. 

After the purchase, the tax lot will record the sale price, the purchase date, the total cost, and the sale date. And this is done for each security that you have within your portfolio. One of the biggest benefits of tax lot accounting is that investors can keep track of tax lot sales throughout the year.

Investors can then gain additional insights to make more strategic decisions about potential tax lots to sell. It’s important for investors to keep in mind, however, that the specific type of investment tax that needs to be paid will depend on the length of time you hold the stock for. 

For example, let’s say that you buy 50 shares of Company X on January 1 for five dollars. On January 5, you invested another $100 in Company X at a cost of six dollars per share. 

You offer to sell 20 shares of Company X on December 15 for $10 each. What specific shares did you sell? Which shares, the $5 or the $6 ones? Keeping track of securities by tax lot helps keep everything in order and organized for when you need it.

Why Does Tax Lot Accounting Matter? 

Tax lot accounting is crucial because it enables investors to pay as little in capital gains taxes as possible. In the aforementioned example, we sold 20 shares of Company XYZ for a price of $10 each. If those shares had been $5 each, our profit would be $100, and we would have to pay taxes on that amount. 

However, if the $6 shares were the ones that were sold, the profit would only be $80 and the tax burden would be reduced. This gives even more flexibility from a tax perspective. In some circumstances, investors may record a gain or a loss on a security depending on the tax lot involved.

It’s critical to remember that the legislation requires brokerage firms to submit a 1099-B, which contains details about the gross proceeds of a transaction, and the original cost basis data (also known as tax lot data) to the IRS. 

This aids the IRS in determining whether taxpayers are accurately disclosing the cost basis of securities when they sell them.

What Are the Tax Lot Accounting Methods? 

If you don’t sell all of the shares you own when you sell a security, you must match the transaction to a tax lot or lots in order to calculate your gain or loss and holding period. 

First in, first out (FIFO), and specific identification are the two fundamental approaches that the IRS accepts for matching tax lots. 

If you don’t select a different mechanism, FIFO will be used by default. In FIFO, the sale is matched with the earliest available lot or lots that were previously purchased.

If a trader can demonstrate that the tax lots were chosen at the time of the sale, Specific Identification enables them to match sales with purchases in a different order than FIFO. You can select a technique in the Tax Optimizer up until 8:30 PM ET on the day of the trade. 

By allowing you to manually choose which tax lots to match for a certain position and adjust the tax lot-matching process, the Tax Optimizer enables direct usage of Specific Identification. Additionally, you can employ specific identification by selecting from a variety of lot matching techniques. 

When lots are matched, the gain or loss for that lot is determined by deducting the adjusted cost basis from the revenues.

Summary

Tax lot accounting is a specific type of technique used for record keeping. It helps keep track of the cost basis, purchase and sale dates, and sale price for securities in your portfolio. For tax reasons, shares purchased in a single transaction are referred to as a lot. 

Additional tax lots are created when shares of the same security are purchased. The tax lots are a collection of acquisitions made at various times and at various costs. As a result, the cost basis will vary for each tax lot.