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How does Capital Gains Term work in this scenario?

  1. Buy x amount of xyz stock and hold for over a year.
  2. Then buy z amount of the same asset and hold for less than a year.

Questions:

  1. If I sell the initial x amount of xyz stock (held > 1 yr) after purchasing z amount of zyx (held < 1 yr) for a profit, is it taxed at long term capital gains?
  2. If I sell all in the scenario is it all taxed as short term? or is it X amount taxed long term and Z is tax short term?

Any Documentation would be appreciated as well.

jkdba
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2 Answers2

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When you decide to sell a portion of your positions, there are several choices.

FIFO stands for first in, first out (you sell the shares bought first). This is the default position for the IRS. IOW, when you sell some shares, unless you specify otherwise, the Internal Revenue Service assumes that the assets that you sell first are also the one's that you bought first.

Here's an excerpt from a Zacks article that discusses this.

Warning: If you plan to use any method besides FIFO, including LIFO, you must specifically direct your broker as to which shares to sell so that your taxes end up the way you want. According to Internal Revenue Service Publication 550, the burden is on you to prove that you informed your broker of which shares you wanted sold and that your broker followed your requests. If you can't prove that, you're treated as having sold your oldest shares first.

Bob Baerker
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FIFO is one way to do it. But it's not really the best way.

For ordinary equities and ETFs, in an ordinary taxable account (tax-advantaged accounts like IRAs have different rules, as to different kinds of investments) the IRS also allows cost basis to be reported by specific identification. A lot is a group of shares you bought in one transaction. A lot is identified by the number of shares, the price you paid for them, and the date the trade executed. When you sell, you specify from which lot(s) you are selling, and the cost basis of that specific lot is used to calculate your gain or loss.

When using specific identification, you can sell whatever lots you want. The IRS doesn't care, as long as you don't do inconsistent things like share the same shares twice. But a common strategy is to sell lots in this order:

  1. Short term losses (held less than 1 year), with greatest losses first
  2. Long term losses
  3. Short term lots with no losses or gains
  4. Long term lots with no losses or gains
  5. Long term gains, least gain first
  6. Short term gains, least gain first

The objective of this strategy is to maximize tax deductions by realizing losses, and if gains must be realized, realizing them as long term capital gains as much as possible, as these are taxed at a lower rate. This is a more tax-efficient strategy than FIFO.

It's likely your broker can automatically perform this strategy for you (although you may have to ask for it), and the 1099-B and other tax documentation they send you at the end of the year will reflect this. These days any electronic tax package can automatically import all your trades from your broker so you don't have the tedium of entering all the data.

Since FIFO requires tracking all the lots anyway, and in practice computers automate all the tedium involved with a more tax-efficient cost basis method, I can't think of any reason to use FIFO.

The gritty details, if you want them, are in IRS publication 550.

Phil Frost
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