FIFO: The New Four Letter Word


At this point, everyone is aware that a new tax bill, providing one of the biggest overhauls to the tax system in over 30 years, passed through the House of Representatives in mid-November.  Similarly, the Senate passed its own very different version of the tax bill in early December. One important difference advisors should be aware of is the Senate bill’s recommendation to force all investors to sell stock holdings on a First-In-First-Out (FIFO) cost basis, as opposed to using specific lot.  As of December 14 it was reported, by and other news outlets that the FIFO rule did not make the final tax bill. That shouldn’t mean we should ignore the series of events that transpired.

Had the proposal passed, shareholders would have been forced to part with their oldest (first) lot of a security any time they sell a portion of their holdings. Today, individuals/custodians/tax efficient programs – often use Least Tax or Highest Cost Basis methodologies – are able to choose which lots they sell in order to minimize capital gains. Though the proposal was left out of this bill, it could rear its head in the future and we have created an example below that shows how this rule could impact your clients’ wallets.

The Mechanics of Selling

When a security is sold, the size of the capital gain (profit) is determined by subtracting the price paid for the security from the price received when selling the security, minus any applicable trading costs.  For this example, let’s assume we purchased three lots of XYZ stock at three different times for three different prices, then, at a later date, we sell 100 of those shares. The cost basis methodology applied can have a major impact on the taxability of the transaction as illustrated in the following chart.

There could be a $10,000 differential between least tax and FIFO cost basis treatments. Under the current law, the 100 shares being sold could be fulfilled using the most recent purchase of the security, therefore resulting in no capital gain, because the cost basis (price paid) is the same as the sale price of the security.  For a tax-aware investor, this is the best-case scenario.

The FIFO cost basis methodology forces the seller to use the oldest (first acquired) lot to fulfill the sale of the security, which leads to the lot purchased for $50 being sold and a realized capital gain of $100 per share or $10,000. That is a $2,000 capital gain tax differential even if the 20% long-term capital gain tax rate applies.

The good news is that this rule has not been included in the final tax bill.  The bad news is that there is a chance it could be revisited in future tax bills.

The Mechanics of Tax Management

Rest assured, if the FIFO provision would have made the final bill, we would have been prepared to adapt to that regulation. We continue to strive to be your advocate in leading the tax management initiative in the industry.

We were prepared to work with our providers to ensure that tax loss harvesting, though muted, would still provide measurable benefit to your end clients in Managed Account Solutions, including SEI ETF Strategies.  We were also set to re-evaluate rebalancing frequency on our tax managed solutions to help alleviate some of the pain associated with moving to a FIFO world. Finally, we had a contingency plan with our operations and accounting teams to line up necessary account updates to start the new year off in accordance with the FIFO methodology.  Fortunately, all this work fell by the wayside as the proposal fell out of the bill.  We were planning for the worst and hoping for the best.

There are a lot of proposed changes that could be good for your clients and for businesses both corporate and small. Let’s keep a close eye on the government’s reconciled bill to see how the tax implications affect our business. At least we know the power and effectiveness of tax management will continue on unabated for now. As we get our arms around the final bill, we will take the opportunity to share our views with you. Have a Merry Christmas and a Happy New Year!

Information provided by SEI Investments Management Corporation (SIMC), a wholly owned subsidiary of SEI Investments Company (SEI). Neither SEI nor its subsidiaries is affiliated with your financial advisor. 

Neither SEI nor its affiliates or subsidiaries provides tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.

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John Frownfelter

John Frownfelter

John Frownfelter is the investments contributor for Practically Speaking and the managing director of investment solutions within the SEI Advisor Network.

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