What Is a Tax Lot and How Does It Impact Your Investments?

Investors often focus on buying and selling assets, but how these transactions are recorded can have significant tax implications. Each time shares of a stock or fund are acquired, a separate record—known as a tax lot—is created. These lots determine how gains or losses are calculated at the time of sale, directly affecting tax liability.

Understanding tax lots is essential for managing investment taxes efficiently. Different methods exist for selecting which lots to sell, each with its own impact on capital gains and losses.

Key Characteristics of a Tax Lot

Each tax lot has attributes that determine how an investment is recorded for tax purposes. These characteristics influence cost basis calculations, capital gains, and tax liabilities when assets are sold.

Acquisition Date

The date of purchase establishes the holding period, which determines whether gains or losses are classified as short-term or long-term. Assets held for one year or less generate short-term gains, taxed at ordinary income rates ranging from 10% to 37% in 2024. Long-term gains—on assets held for more than a year—are taxed at lower rates of 0%, 15%, or 20%, depending on taxable income.

For example, if an investor buys 100 shares of a stock on March 1, 2023, and sells them on February 28, 2024, any gain is short-term. If they wait until March 2, 2024, it qualifies as long-term, potentially reducing their tax burden. The acquisition date also determines wash sale violations, which disallow capital loss deductions if a substantially identical security is repurchased within 30 days.

Purchase Price and Fees

The original purchase price, or cost basis, determines taxable gains or losses upon sale. The IRS requires investors to include not only the price paid for the security but also transaction-related expenses such as brokerage commissions, exchange fees, and SEC charges.

For instance, if an investor buys 200 shares of a company at $50 per share, their initial investment totals $10,000. If they pay a $15 trading commission, the adjusted cost basis becomes $10,015, increasing the per-share cost to $50.075. When the shares are sold, taxable gain or loss is calculated based on this adjusted figure.

Some brokerages offer automated cost basis tracking, but investors should verify calculations, especially when dealing with corporate actions like stock splits or dividends that can alter cost basis. Errors in reporting can lead to discrepancies when filing IRS Form 8949, which reports capital gains and losses.

Shares or Units Held

The number of securities in a tax lot determines the volume available for sale under different lot selection strategies. When shares are bought on multiple occasions, each transaction creates a separate tax lot with its own cost basis and acquisition date, even if it’s the same security.

For example, an investor might buy 50 shares of a mutual fund at $40 per share in January, another 50 shares at $45 in June, and 75 shares at $38 in September. Though all represent ownership in the same fund, each has a unique tax lot. When selling, the investor can choose which lot to liquidate, affecting realized gain or loss.

Dividend reinvestment plans (DRIPs) create numerous small lots over time. Investors using DRIPs may accumulate hundreds of tax lots, complicating cost basis tracking but offering opportunities for tax-loss harvesting by selling higher-basis lots to minimize gains.

Tracking Realized and Unrealized Gains

Investment performance is assessed through realized and unrealized gains, each with different tax implications.

Unrealized gains represent the increase in value of an investment that has not yet been sold. These are often called “paper gains” since they exist only on financial statements and do not trigger taxes. For example, if an investor buys stock for $5,000 and its market value rises to $6,500, the $1,500 increase remains unrealized until the shares are sold.

Realized gains occur when an asset is sold for more than its cost basis. At this point, taxes become relevant, as the IRS requires individuals to report and pay capital gains tax on these profits. Investors who sell at a loss may offset gains through tax-loss harvesting, where losses from one investment reduce taxable income from another. The IRS limits the amount of capital losses that can offset ordinary income to $3,000 per year ($1,500 for married individuals filing separately), with excess losses carried forward to future tax years.

The timing of realizing gains can impact tax liability. Selling in a year with lower taxable income may result in a reduced capital gains rate, while deferring sales can delay tax payments. Certain investment accounts, such as traditional IRAs or 401(k)s, allow gains to grow tax-deferred, meaning taxes are not owed until withdrawals are made. This differs from taxable brokerage accounts, where gains must be reported annually once realized.

Methods of Lot Identification

When selling investments, investors can choose which tax lots to liquidate, influencing their taxable gains or losses. The IRS allows different methods for identifying which shares are sold, each with distinct tax consequences.

FIFO

First-In, First-Out (FIFO) is the default method used by the IRS unless an investor specifies otherwise. Under this approach, the earliest purchased shares are sold first, often resulting in higher taxable gains in a rising market. Since older shares typically have a lower cost basis, selling them first increases the difference between the sale price and the original purchase price, leading to larger capital gains.

For example, if an investor buys 100 shares of a stock at $30 per share in 2020 and another 100 shares at $50 per share in 2023, selling 100 shares in 2024 under FIFO would mean liquidating the $30-cost-basis shares first. If the stock is now worth $60 per share, the taxable gain per share would be $30 ($60 – $30), resulting in a total gain of $3,000. In contrast, selling the later-purchased shares would yield a lower gain of $1,000 ($60 – $50 per share).

LIFO

Last-In, First-Out (LIFO) prioritizes selling the most recently acquired shares first. This method can be advantageous in a rising market because newer shares often have a higher cost basis, reducing taxable gains. However, LIFO is not the default method and must be explicitly selected when selling shares.

Consider an investor who purchases 200 shares of a stock—100 at $40 per share in 2021 and another 100 at $55 per share in 2023. If they sell 100 shares in 2024 at a market price of $60 per share using LIFO, the cost basis would be $55 per share, resulting in a taxable gain of only $5 per share ($60 – $55), or $500 total. Had they used FIFO, the gain would have been $2,000 ($60 – $40 per share). LIFO can help minimize short-term capital gains, which are taxed at higher ordinary income rates, but it may leave older, lower-cost-basis shares in the portfolio, potentially leading to higher future tax liabilities.

Specific Identification

The Specific Identification method allows investors to choose which tax lots to sell, offering the most flexibility in managing capital gains and losses. This approach requires detailed record-keeping and must be explicitly communicated to the brokerage at the time of sale.

For example, assume an investor holds three tax lots of the same stock: 50 shares purchased at $35 per share, 50 shares at $45 per share, and 50 shares at $55 per share. If they sell 50 shares at $60 per share, they can choose which lot to liquidate. Selling the $55-cost-basis shares results in a taxable gain of only $5 per share ($60 – $55), while selling the $35-cost-basis shares would generate a $25 per share gain. This method is useful for tax-loss harvesting but requires meticulous tracking and proper documentation to comply with IRS regulations.

Corporate Actions That Affect Tax Lots

Corporate actions can alter tax lots by changing the structure, cost basis, or holding period of securities. Stock splits adjust the number of shares an investor holds without changing total market value, requiring cost basis recalculations. In a 2-for-1 split, an investor with 100 shares at $80 per share would now hold 200 shares at $40 each. The IRS mandates that cost basis be adjusted proportionally, though the acquisition date remains unchanged.

Mergers and acquisitions can have more complex tax implications. If an investor receives shares of the acquiring company in a tax-free reorganization, the original cost basis transfers to the new shares. However, if cash is received in addition to shares—known as “boot”—a taxable event occurs, with gains recognized up to the amount of cash received.