Specific identification of shares

Introduction
You might purchase shares of a fund at different prices at different times in a taxable account. The IRS (see Publication 550, Investment Income and Expenses and Publication 564, Mutual Fund Distributions) allows you to use several different accounting methods for calculating your cost basis for the shares sold. Specific identification of shares is the method which usually gives the lowest tax bills; See Cost basis methods for more details on the other methods.

Note: Specific identification of shares and other cost basis methods are only relevant for taxable accounts. They are not applicable to tax deferred or tax free accounts.

Execution
Treasury regulations section 1.1012-1(c)(1) permits taxpayers to use specific identification if they can make "adequate identification" of the shares sold. Otherwise, they are required to use FIFO, or, for mutual funds, one of the average-basis methods.

Identification at the time of trade and confirmation
Treasury regulations section 1.1012-1(c)(3)(i) says that if the investor tells the broker or other agent holding the shares which specific shares are being sold at the time of the sale, and the investor receives written confirmation back from the broker within a reasonable time, then "adequate identification" has been made and so specific identification is available. Vanguard investors report that the best way to ensure confirmation is to send Vanguard a secure Email with a text such as,

"'I am about to place an order to sell 234.456 shares of the XYZ Fund. Please sell 123.456 shares purchased on 1/2/04 and 111.000 shares purchased on 2/1/04; please send confirmation of this Email.'"

You may also send a letter if you are making the sale by mail; if you do, enclose a second copy of the letter with a request that Vanguard return a copy to you.

Adequate identification by other methods
Nothing in the regulation says that informing the broker and getting confirmation is required in order to have "adequate identification," just that it is one type of adequate identification. Both the IRS and courts have accepted other procedures:


 * Revenue Ruling 67-436 considered the situation of an investor whose broker made trading decisions. The investor would inform the broker after the trade date, but before settlement date, which shares it wanted to sell; it appears that confirmations did not repeat the identification.  The IRS ruled that "adequate identification" was made under those circumstances.  It is not clear whether an investor making his own trade decisions could rely on this, though, because it is the fact that the investor didn't know when sales would be made that made the normal identification procedure impossible.


 * In PLR 9728021, customers gave a broker standing written instructions to always sell the shares with highest basis first ("HIFO" accounting), except when otherwise specified; the broker's confirmations would repeat either that general policy or the specific instructions received. The IRS ruled that this also constituted "adequate identification."  Only the taxpayer to whom the letter was addressed is technically allowed to rely on this ruling.

Advantage
The advantage of specific identification is that you can choose the shares to minimize your gains, maximize your losses, or realize long-term rather than short-term gains. The savings are valuable when you need to sell, and specific identification also makes it much more likely that tax loss harvesting will be possible.

For example, suppose you have 3,000 shares of a fund, purchased at prices between $20 and $40 over a long period; your total investment was $90,000, so your average purchase price is $30. Your most recent purchase, made last year, was 250 shares at $40. You now want to sell 250 shares at a price of $40. If you use first-in-first-out accounting (the IRS default), you sell the first 250 shares you purchased, which have a basis of $20, so your taxable capital gain is $5,000. If you use average-cost accounting (using the information provided by Vanguard), your basis in the shares is $30 a share, so your taxable capital gain is $2,500. If you use specific identification, you can choose to sell the shares bought last year, which have a basis of $40 a share, so your taxable capital gain is zero.

Similarly, suppose that you hold the same shares, and the fund has dropped in value to $30 a share. If you use specific identification, you can choose to sell the shares bought last year for $40, claiming a $2,500 capital loss. If you do not use specific identification, you cannot harvest any loss; any sales will be of shares with an average price of $30 and thus no loss.

Disadvantage
While specific identification of shares is the most favorable method for tax purposes, it does impose an extra record-keeping burden. Specifically, if you invest with Vanguard or any other fund company or brokerage that does not provide a good user interface for selling specific shares, you have to personally keep track of tax lots, where a tax lot consists of the purchase date, the purchase price, and the number of shares. As you sell specific shares, you have to update the number of shares remaining in a tax lot that you sell shares from.

Operational Tips
You might want to employ the following techniques to alleviate the record keeping burden of specific identification of shares, or to determine whether it is worthwhile


 * You may consider not automatically reinvesting dividends and capital gains distributions, in order to reduce the number of tax lots you will have to keep track of. See Whether to Reinvest Dividends in a Taxable Account for details.
 * While it is possible to sell a part of a given tax lot, some people sell an entire tax lot to simplify the cost basis accounting. For example, if you've bought 100 shares of a fund in the past, you might consider selling all of the 100 shares, essentially crossing off the tax lot completely.
 * You may consider the following and possibly other methods to keep track of tax lots and pick one that works for you:
 * Use paper and pencil.
 * Develop and maintain a custom spreadsheet with Microsoft Excel or OpenOffice.org Calc.
 * Use personal finance software packages, such as Microsoft Money and Quicken.
 * Use a brokerage that supports specific identification of shares, such as Fidelity.
 * If you are not planning to do tax loss harvesting, and your average holding period is fairly short, use of average cost basis may not be very disadvantageous compared to specific  identification of shares because there is no big disparity in cost basis among shares you hold.  Although your mileage may vary, the difference between the two cost basis methods may be small in the following cases:
 * The fund is a bond fund, so its share price does not vary significantly. (You might use specific identification only in your stock funds.)
 * You are in a very low tax bracket for your capital gains.
 * All or the vast majority of your taxable assets were purchased in a short time period (such as a catch-up just before retirement, or a windfall)
 * You sell all or the vast majority of your taxable holdings late in the accumulation phase and buy other funds (possibly because you switch to low-cost index funds from expensive and/or tax-inefficient actively managed funds).

Links

 * Selling Mutual Fund Shares