FIFO vs. LIFO for Stocks: Calculating Your Capital Gains

When you sell an investment for a profit, the resulting gain is subject to tax. For investors who buy shares of the same stock at different times and prices, calculating this gain requires determining the cost basis of the specific shares being sold. The cost basis is the original value of an asset for tax purposes, and it is used to figure out whether you have a capital gain or a capital loss on the sale.

This calculation is particularly relevant when you sell only a portion of your total holdings. Since different blocks of shares, or lots, were likely acquired for different prices, the lot you choose to sell directly impacts the amount of your taxable gain. Understanding the methods to assign a cost basis helps in managing your investment-related tax obligations.

The Default Method FIFO

First-In, First-Out (FIFO) is the standard method brokerage firms use to account for stock sales. The FIFO method operates on the principle that the first shares you purchase are the first shares you sell. This is the default accounting treatment required by the Internal Revenue Service (IRS) unless an investor specifies otherwise, making it a straightforward approach that requires no special action.

To illustrate, imagine an investor makes two purchases of XYZ Corp. stock: 100 shares at $50 per share in January, and another 100 shares at $60 per share in June. If that investor later sells 100 shares at a market price of $70, the FIFO method dictates that the shares sold are the first ones purchased in January for $50.

The capital gain calculation uses the cost basis of that first lot. The total proceeds from the sale are $7,000 (100 shares x $70), and the cost basis is $5,000 (100 shares x $50), resulting in a taxable capital gain of $2,000. This is the gain that would be reported on the investor’s Form 1099-B unless a different method was chosen.

The Alternative Method Specific Identification

The primary alternative to FIFO is the Specific Identification method, which gives investors more control over their tax outcomes. This method allows you to choose precisely which lot of shares you want to sell at the time of the transaction. This flexibility means you can manage your capital gains by selecting shares with the highest cost basis to sell, potentially minimizing your tax liability.

Some investors refer to a “LIFO” method for stocks, but Last-In, First-Out is not a formally recognized accounting method for securities by the IRS. A LIFO-like result is achieved by using the Specific Identification method to sell the most recently acquired shares. You are not electing LIFO, but rather specifically identifying the last shares you bought as the ones you are selling.

Using the same scenario, the investor holds two lots of XYZ Corp. stock: 100 shares bought at $50 and 100 shares bought at $60. When selling 100 shares at $70, the investor can use Specific Identification to designate the second lot, purchased at $60, as the shares being sold.

In this case, the cost basis becomes $6,000 (100 shares x $60). The resulting capital gain is only $1,000, which is half of what it would be under the FIFO method.

How to Use Specific Identification

To use the Specific Identification method, you must instruct your brokerage firm which shares to sell before the trade settles, which is one business day after the trade date (T+1). The choice must be made at the time of the sale, as you cannot decide which shares were sold weeks or months later when preparing your taxes.

Many online brokerage platforms allow you to choose the cost basis accounting method on a trade-by-trade basis. When placing a sell order, you can often select the specific tax lot you wish to liquidate from a menu. If this feature is not available, you must notify your broker in writing, such as through a secure message, identifying the specific shares to be sold.

After providing the instruction, obtain a written confirmation from the broker verifying that your request was honored. This confirmation, along with your own detailed records of each purchase lot, serves as the necessary substantiation for your tax return. These records are your proof to the IRS that you properly identified the shares sold.