Death & Taxes

Identifying Stock Sold for Tax Purposes
The Rules

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By Roy Lewis

Did you know that identifying the shares of stock you sell might save you a few tax dollars? Consider this:

On January 10th, you purchase 1,000 shares of for $15 a share. The stock does well, so on February 25th you purchase another 1,000 shares for $35 a share. Wizzbang has some problems, and the stock slips back to $32 a share. You tell your broker to sell 1,000 shares on April 12th. Your broker deposits $32,000 into your account (let's ignore brokerage commissions for the purpose of our discussion). Life is good... or is it?

Which shares did you sell? On first blush, you might not think it matters. But, look closer and you'll see that it matters a great deal. If you sold the first block of shares (the January 10th shares), you'll recognize a taxable gain of $17,000. If you sold the second block of shares (the February 25th shares), you'll realize a tax loss of $3,000. So which shares did you sell?

Your Options

Some folks might tell you that it doesn't matter, since you can simply come up with an "average" cost for these shares. Don't listen. You don't have the choice of "averaging" your cost for individual stocks and securities. The rules for mutual funds do allow for averaging, but we're not talking about mutual funds here.

When you sell a stock, you only have two options for reporting your cost basis for tax purposes:

  1. First In First Out (FIFO)
  2. Specific Identification

The FIFO method is the "default" method. If you do nothing, you have effectively elected the FIFO method. In our example above, the FIFO method would cause the sale of the shares originally purchased in January (the "first" you purchased), and would generate the $17,000 gain. FIFO simply means that the first shares purchased ("first in") are the first sold ("first out").

But, let's say you don't want to take that $17,000 gain this year. You would rather have the $3,000 loss. What can you do? Well, if you take the right steps and your broker cooperates, you can specifically identify the shares you purchased in February as the shares that were sold.

What You Must Do

Using the specific identification method requires that you do certain things. Publication 550 and Regulation 1.1012-1(c)(2) state that, to use this method, you must tell the broker which shares are being sold. This doesn't have to be a long or detailed message, just a short statement that makes it clear which shares you sold. In our example above, you could tell the broker "Sell the 1,000 shares of that I originally purchased on February 25th." Or you could even say "Sell 1,000 shares of that I originally bought for $35 a share." That does it -- at least for your end of the transaction.

Does this instruction to your broker have to be in writing? Nope. Your oral identification to your broker over the telephone works just fine, as would an e-mail.

What Your Broker Must Do

Now we get to the hard part. As required by the Regulations, your broker must provide you with written confirmation of your instructions, within a reasonable time after the stock sale occurs. Your broker doesn't have to confirm that they actually sold the specific shares you identified. Your broker only has to confirm the instructions you provided. A simple statement such as, "We confirm that you identified the 1,000 shares of sold on April 12th as shares purchased on February 25th" would work fine.

Can the broker confirmation be oral? Nope. The rules are very specific: the confirmation must be in writing. Can the broker confirmation be via e-mail? The IRS hasn't provided any guidance to tell us if an e-mail constitutes "written confirmation." It would be much safer to have your broker provide a written confirmation by regular mail.

Your Broker Balks

The sad news is that most brokers drag their feet in keeping up their end of the bargain, especially online brokers. When you question your broker about the written confirmation requirement, they'll likely send you a return e-mail that says something like: "The lot designation of shares sold on trade confirmations is no longer required by the IRS." You might also see: "Since we hold shares in street name, you don't have to tell us which shares are to be matched against each other for buy or sell transactions." I've even seen a blanket statement that says, "It is your responsibility to reconcile each side of a transaction, and determine your gain or loss."

All of this is, in short, bull droppings!

If your broker won't play ball, you may not be able to use the specific share method of reporting your gains and losses. If you don't receive the appropriate written confirmation from your broker, you run the risk that the IRS could require you to restate some or all of your stock sales to the FIFO method. That could be very painful to your wallet.

The rules are in place for a reason. Uncle Sammy doesn't want you to be able to specify shares some time down the line, or when you're actually preparing your tax return. It's quite possible that future facts or circumstances might alter your original decision.

In our example above, what would you do if you had a stock sale in December that generated a capital loss of $20,000? In that case, you might want to use the shares that generated the $17,000 gain in order to "net" those gains and losses. In hindsight, your decision in April to sell the shares of Wizzbang that generated a $3,000 loss might not be such a good one now.

Uncle Sammy doesn't want to give you the opportunity to change your mind. Hence, the requirement for a written confirmation from your broker of the shares identified, within a reasonable time from the date of the sale.

What You Can Do

Well, you can quit trading the shares. That'd do it. Or, you can simply sell all of your holdings at one time, in which case the specific identification method becomes moot. But many times this just isn't possible.

Your only real option, if your broker won't play ball, is to play elsewhere: find another broker. But, before you leave your old broker, make sure your new broker will do what is required to provide you with written confirmation on specific shares sold. If you consistently buy and sell the shares of the same company, and you want to use the specific identification method, you'll want the comfort of a written confirmation from your broker.

There is a lot of controversy surrounding this issue that we don't have the space to discuss here. There is, sadly, substantial misinformation out there in cyberspace regarding use of the specific share method. You're free to make your own choices. Just understand that anything short of the requirements, as set forth in the IRS Regulations, could cause you problems if Uncle Sammy wants to take a look at your stock transactions.

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