Congress is hard at work trying to take various provisions from the House tax reform package and the Senate's follow-up proposed legislation to produce an agreeable bill that both can support. Yet there are still major differences between the two proposals. One in particular has drawn fire from investors because of the way it would limit their ability to make a crucial choice when they sell stocks and other investments. Losing that freedom would impose a huge cost for ordinary investors.

This controversial provision is known as first in, first out, or FIFO for short. Under the Senate proposal, taxpayers would be required to use this method for determining cost basis, with huge implications for the amount of capital gains tax they have to pay when they sell stocks and other investments. The law is especially important because of the way that most investors accumulate shares of their favored investments over time, but even though the amount of money at stake appears to be minimal, it hasn't been easy for lawmakers simply to agree to take it out of the final tax reform package.

U.S. Capitol as seen from off-center at foot of steps.

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Why you need to know about FIFO

FIFO deals with the common situation in which you want to sell a portion of your holdings in a particular investment. If the price of that investment has gone up over time and if you've made regular additions to your position, then the shares that you've held onto the longest will often be the ones that you paid the least to buy, while the shares you most recently purchased will have the smallest gains.

Currently, the tax laws allow you to choose from multiple options when you sell a portion of your investment position. FIFO is one of those options, but it's generally the one that's least favorable for taxpayers. Because your first-purchased shares typically have the lowest tax basis, the amount of capital gain you'll realize when you sell them is higher than you'd pay if you sold shares that you acquired later.

The other method that's available for all investments is known as specific identification. Using this method, you're allowed to choose the actual shares that you want sold, letting your broker know in advance when you submit your sell order which particular position you want to include. This allows you to choose the shares with the highest tax basis, which will often be those that you purchased more recently. You can then hang onto the shares with the lowest tax basis, preserving the tax deferral until you decide to sell off your entire position in the stock.

Even more basis reporting choices for mutual fund owners

Mutual fund investors have other options. Some brokerage companies allow you to choose what's known as LIFO, or last in, first out, which is essentially the opposite of the FIFO method. This often results in your paying the minimum tax bill, but only in situations in which the fund shares have risen steadily in price. Essentially, this is a form of specific identification in which you specify in advance which shares you'll want to sell.

An alternative is the average cost basis method for mutual fund sales, which takes the overall average that you paid for all of your fund shares throughout the lifetime of the account and then assigns that average basis to the shares that you're selling. This method typically results in a middle ground between what FIFO and LIFO would produce. One thing to keep in mind, though, is that if you elect to use average cost basis, you're stuck with it on future sales and can't go back to specific identification or another method.

A smack-down on longtime investors

The impact of the move disproportionately affects older investors who've spent a lifetime accumulating assets. These investors are most likely to have multiple positions in stocks, purchased either through subsequent trades or via dividend reinvestment plans. Forcing them to sell their oldest shares first could mean the difference between having minimal gains and having nearly all of their sales proceeds treated as taxable.

What's particularly odd is that the move isn't projected to generate much revenue. The Joint Committee on Taxation found that the move would raise an estimated $2.7 billion over 10 years. For a bill that's dealing with nearly $1.5 trillion in tax cuts, that revenue is pretty trivial. Yet the way in which it would restrict investors from making rational decisions about making trades would dramatically impact behavior.

It's not too late for lawmakers to eliminate the FIFO requirement, and stakeholders including tax policy analysts and financial institutions have criticized the move. With any luck, reconciliation will find a way to remove FIFO from tax reform, but investors need to watch closely so that they can move quickly to make sales in 2017 if an imminent change makes it into the final bill.