Specific identification of shares
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)[note 1] 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.
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, average basis.
If you sell covered shares of a mutual fund at Vanguard (shares purchased in 2012 or later), and you have chosen specific ID as your accounting method, then you will be given a list of lots at the time you place the request to sell, and you can fill in this list. If you have non-covered shares, there will be only one lot listed (even if you purchased multiple lots), and you will have to identify the shares in a secure Email. If you write a letter to Vanguard to make the sale, you also need to identify the shares in your letter.
For Vanguard Brokerage Services, you will choose an accounting method for each stock or ETF you hold. If you choose Specific ID, you will have to indicate which lots are included in your sale order when you place the order; you may change this before the settlement date. You may also use a method such as HIFO (highest-in, first-out); Vanguard will automatically assign shares to your sale order according to the rules.
If you sell non-covered shares, you have to identify them separately. Vanguard requests that you include the following information (quoted from a Vanguard form letter):
- Your name.
- Your address.
- The last four digits of your Social Security number.
- The Vanguard(R) fund and account number from which you're redeeming or exchanging shares.
- The share amount to be redeemed or exchanged.
- Whether the shares were redeemed or exchanged.
- The specific date(s) on which the shares were originally purchased.
- The number of shares purchased on each date.
- The net asset value (NAV) on the date the shares were purchased.
If you sell shares online, send a secure Email on the same day with this information; if you sell by mail, include this information in your letter.
Identification by standing order
New Treasury regulation section 1.1012-1(c)(8) clarifies that the investor may give a standing order to the broker, such as, "Always sell the highest-cost shares" (which usually minimizes taxes) or "Always sell the lowest-cost shares" (which might be chosen by an investor in an unusually low tax bracket for one year); this will constitute specific identification if the broker acknowledges the transactions. (This is what Vanguard Brokerage allows investors to do, specifiying highest-in-first-out.)
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. A new section 1.1012-1(c)(8) clarifies that "at the time of the sale" requires the identification to be made by the settlement date, which is two days after the date of sale for most stock purchases but is the next day for most mutual fund trades.
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. The new Treasury regulations clarify two procedures which the IRS had accepted in previous rulings, identifying the specific sales by settlement date and making a standing order.
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.
While specific identification of shares is the most favorable method for tax purposes, it does impose an extra record-keeping burden. Specifically, if you have your fund company or brokerage that does not provide a good user interface for selling specific shares (such as Vanguard with "non-covered" mutual fund shares purchased before 2012), 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.
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 Reinvesting 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 (no longer active) 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).
- ↑ IRS Publication 550 Investment Income and Expenses (direct link: Stocks and Bonds), has incorporated IRS Publication 564, Mutual Fund Distributions.
See Cost Basis Reporting Overview and FAQs for reporting methods starting in 2012.
- Selling Mutual Fund Shares
- Federal Register publication of 2011-2012 tax changes
- How do you keep track of tax lots? (forum topic)
- VANGUARD ANSWERS YOUR COST BASIS QUESTIONS, comprehensive discussion by forum member Rebecca_Katz (Vanguard employee) on Vanguard's cost basis methodologies and processes. Contains detailed answers to forum member's questions.