Specific identification of shares

Introduction
You might purchase shares of a fund at different prices at different times. The IRS (see Publication 550, Investment Income and Expenses and Publication 564, Mutual Fund Distributions)allows you to use several different accounting methods for identifying which shares to sell in a taxable account. 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.

Execution
In order to meet the IRS requirement, you need to tell the broker or other agent holding the shares which specific shares are being sold, and receive written confirmation within a reasonable time. 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.

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.

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.

Links

 * Selling Mutual Fund Shares