Tax reform efforts have been fast and furious in recent months, and with both the House of Representatives and the Senate having gone through their own processes to come up with proposals, key differences emerged. Yet not all of those differences really made sense. One issue that emerged as highly controversial and potentially destructive to individual investors was the Senate's FIFO provision. Getting its name from the abbreviation of the tax reporting method that it sought to make mandatory, FIFO would have had a huge impact on longtime investors, creating a large effective tax increase.
To their credit, lawmakers have reportedly moved swiftly to eliminate the FIFO requirement from the unified tax reform proposal. Yet the fact that the measure got as far as it did is a testament to the dangers of working so quickly to try to find even minimal revenue-raising measures to offset tax cuts. Let's look in more detail at what FIFO is and why it just got the ax.
What is FIFO?
FIFO stands for first in, first out, which refers to a method for recovering cost basis when you sell an investment. What is says is that if you have bought shares of a certain stock on multiple occasions, when you sell them, you have to sell the shares that you acquired first. So for instance, if you bought 100 shares of stock every year from 2000 to 2015 and sell 500 shares in 2017, then under FIFO, you'd be treated as if you had sold the shares from from 2000 to 2004.
Under current law, investors are allowed to use the FIFO method, but you're not required to do so. Instead, you can use an alternative method known as specific identification to select the shares you want to sell. Again using the example above, you could direct your broker to sell the 500 shares you bought between 2011 and 2015 instead, or you could choose any five individual years you wanted.
What's the big deal about FIFO?
The reason FIFO is often less than ideal has to do with the upward path of the prices of successful stocks over time. For long-term investors, the shares you buy the earliest tend to be the ones that you paid the least for. As share prices go up, subsequent investments cost you more money.
When you decide to sell part of your investment, the amount of tax you'll pay depends on the capital gains on the shares you sell. The more you paid for those shares, the less capital gains get generated from the sale, and so the smaller your tax bill will be. It's therefore generally in your best interest to choose to sell the shares that have the highest cost basis.
FIFO almost never results in selling the highest-basis shares that you own. The consequence is therefore that individual taxpayers faced the prospect of having to pay much higher taxes if they wanted to trim their positions in a certain stock, with the biggest penalty coming on the stocks that had done the best over time.
An uproar over FIFO
News of the proposal sparked concerns from several corners of the investment industry. The Motley Fool took the step of publicly advocating for the removal of FIFO, citing the damage that it would have done to individual investors and their financial health.
Some businesses faced threats to their models as a result of the proposed rule. Several robo-advisors offer tax-loss harvesting services that use specific identification to optimize after-tax returns on their individual portfolios. FIFO would have eliminated many of the benefits of such a service, reducing not only their investors' overall returns but also removing some of the competitive advantages that such services offer over more passive investing methods like indexing.
Taking out the provision wasn't particularly costly for lawmakers. Because scoring models assumed that most investors would simply defer sales as long as possible, the measure wasn't expected to bring in much new revenue. Yet the impact on investor behavior would have been substantial, locking up capital and potentially slowing shifts to more productive investments.
Be on your guard
The need for haste in doing tax reform is understandable from a political perspective, but it can lead to problem areas like FIFO coming up without much warning. It's imperative to watch Washington, D.C. closely and speak up when provisions threaten your financial situation. There's no guarantee you'll get as quick a response as lawmakers made with FIFO, but the saga does show that at least sometimes, your political representatives are responsive to your needs.
The Motley Fool has a disclosure policy.