What Is the FIFO Requirement and How Does It Work?

The FIFO (First In, First Out) requirement dictates the order in which assets are sold or closed, ensuring older positions are accounted for before newer ones. This impacts profit, loss, and tax calculations, particularly in financial markets where multiple trades of the same asset occur.

Understanding FIFO’s role in different transactions is crucial for traders and investors to comply with regulations and manage portfolios effectively.

Essential Elements

Regulatory frameworks enforce FIFO to ensure consistency in financial reporting and tax compliance. The IRS applies FIFO when calculating capital gains on securities unless a taxpayer specifies another method, such as Specific Identification. Selling older shares first affects cost basis calculations, influencing taxable income. This distinction matters because it determines whether gains are short-term or long-term, affecting tax rates ranging from 0% to 37% in 2024, depending on holding periods and income brackets.

Brokerage platforms implement FIFO rules to align with regulatory standards. In the U.S., SEC and FINRA regulations require FIFO execution in certain scenarios to prevent tax avoidance and ensure accurate reporting. Some brokers apply FIFO by default unless an investor manually selects an alternative method, which may require additional documentation. This is particularly relevant in margin accounts, where FIFO affects margin maintenance requirements and liquidation priorities.

Accounting standards also incorporate FIFO in inventory valuation, influencing financial statements and profitability metrics. Under U.S. GAAP, FIFO is an accepted inventory costing method, often leading to higher reported profits during inflationary periods since older, lower-cost inventory is expensed first. This contrasts with LIFO, which is prohibited under IFRS but remains an option for U.S. companies. The choice between FIFO and other methods affects financial ratios such as gross margin and net income, influencing investor perceptions and credit evaluations.

Transactions Subject to FIFO

FIFO applies to various financial transactions, particularly in markets where multiple positions in the same asset are opened and closed over time. This rule affects how gains and losses are recognized, influencing tax liabilities, margin requirements, and regulatory compliance.

Forex Positions

In the U.S., FIFO rules are strictly enforced in retail foreign exchange (forex) trading under National Futures Association (NFA) Compliance Rule 2-43(b). This regulation mandates that traders close their oldest open positions first when executing offsetting trades in the same currency pair. For example, if a trader buys 1 lot of EUR/USD at 1.1000 and later buys another lot at 1.1050, selling 1 lot at 1.1075 would close the first position.

This rule affects profit and loss calculations, as the cost basis of the first trade determines the realized gain or loss. It also impacts hedging strategies, as traders cannot hold opposing positions in the same currency pair within the same account. Some traders attempt to bypass FIFO by using multiple accounts or offshore brokers, but non-compliance with NFA rules can lead to account restrictions or penalties. Traders using NFA-regulated platforms must follow these rules to avoid forced liquidations or compliance violations.

Commodity Futures

FIFO is commonly applied in commodity futures trading, particularly in tax reporting and margin calculations. The IRS requires FIFO for determining capital gains and losses on futures contracts unless a trader elects mark-to-market accounting under Section 1256 of the Internal Revenue Code. If a trader buys multiple contracts of crude oil futures at different prices and later sells a portion, the earliest purchase price is used to calculate the gain or loss.

This method influences tax liabilities, as older contracts may have significantly different cost bases than newer ones. Section 1256 contracts, including many commodity futures, are subject to a 60/40 tax treatment, where 60% of gains are taxed at the long-term capital gains rate (0%, 15%, or 20% in 2024) and 40% at the short-term rate (10% to 37%). FIFO also affects margin requirements, as exchanges and clearinghouses use it to determine liquidation priorities when margin calls occur. Traders should understand how FIFO interacts with tax elections and margin rules to optimize their strategies.

Specific Broker Requirements

Brokerage firms implement FIFO rules based on regulatory mandates and internal policies. In the U.S., brokers must comply with SEC and FINRA regulations, which often default to FIFO for trade execution unless an investor specifies another method, such as Specific Identification. Some brokers, particularly those offering margin accounts, enforce FIFO to manage risk and ensure compliance with margin maintenance requirements under Regulation T.

For example, in equity trading, if an investor purchases 100 shares of a stock at $50 and later buys another 100 shares at $55, selling 100 shares at $60 would close the first lot under FIFO. This affects capital gains calculations, as the cost basis of the first purchase ($50) determines the taxable gain ($10 per share). Some brokers allow investors to override FIFO by selecting a different accounting method at the time of sale, but this often requires additional documentation, such as a trade confirmation specifying the lot being sold.

Investors using margin accounts should be aware of how FIFO influences margin calls and forced liquidations. If an investor holds multiple positions in the same security and a margin call occurs, the broker may liquidate the oldest shares first, potentially realizing larger taxable gains. Understanding a broker’s FIFO policies and available alternatives can help investors manage tax liabilities and margin risks effectively.

Documentation Requirements

Maintaining accurate records is necessary for individuals and businesses subject to FIFO rules, particularly when preparing financial statements or filing tax returns. Proper documentation ensures compliance with regulatory requirements and provides a clear audit trail in the event of an IRS examination or brokerage inquiry. Investors and traders must retain detailed transaction records, including trade confirmations, purchase and sale dates, cost basis, and realized gains or losses.

For securities transactions, brokerage firms typically provide annual tax documents such as Form 1099-B, which reports proceeds from sales along with cost basis information. While brokers generally apply FIFO by default, discrepancies can arise if an investor elects a different accounting method or transfers assets between accounts. In such cases, maintaining personal records that reconcile with brokerage statements is necessary. The IRS requires taxpayers to retain supporting documents for at least three years from the filing date, though longer retention may be prudent if transactions involve complex tax treatments or international holdings.

Businesses that apply FIFO for inventory valuation must maintain comprehensive records of purchases, sales, and inventory levels. Under IRS regulations, companies using FIFO for tax reporting must file Form 3115 (Application for Change in Accounting Method) if they switch to another inventory costing method. Auditors and tax authorities may request historical purchase invoices, inventory counts, and cost allocation methods to verify FIFO compliance. Inadequate documentation can result in adjustments to taxable income, affecting financial statements and tax liabilities.

Exemptions

Certain financial transactions and entities are exempt from FIFO requirements due to regulatory carve-outs, tax provisions, or specific market structures. These exemptions provide flexibility in how gains, losses, and valuations are reported.

One exemption applies to tax-advantaged accounts such as IRAs, 401(k)s, and other qualified retirement plans. Because these accounts defer taxes on gains and dividends, FIFO rules do not apply when determining cost basis or realizing capital gains. Investors can buy and sell assets within these accounts without triggering taxable events. However, required minimum distributions (RMDs) from traditional IRAs and 401(k)s follow separate IRS rules based on account balances and life expectancy tables.

Certain derivative instruments, including options and short sales, may also be exempt from strict FIFO application. Options traders can often designate specific contracts when closing positions, particularly in cash-settled options or those held in separate brokerage accounts. Short sales introduce additional complexity, as IRS regulations generally require the cost basis to be determined based on the date the short position is closed, rather than the purchase order of previously held shares.

Possible Consequences

Failing to adhere to FIFO requirements can result in financial, regulatory, and tax-related repercussions. Investors and businesses that misapply FIFO in taxable transactions risk IRS penalties, interest on underpaid taxes, and potential audits. If FIFO is incorrectly reported on capital gains, the IRS may require amended returns and impose accuracy-related penalties of up to 20% of the underpayment amount under IRC 6662. In cases of willful noncompliance, additional fines or legal action may follow.

Regulatory violations can also impact traders and financial institutions. Brokers that fail to enforce FIFO where required by SEC, FINRA, or NFA regulations may face compliance sanctions, including fines or trading restrictions. Individual traders operating in regulated markets, such as forex or futures, may experience forced liquidations or account suspensions if FIFO rules are not followed. Businesses using FIFO for inventory valuation must ensure consistency in financial reporting, as discrepancies can lead to restatements, affecting investor confidence and creditworthiness.