Tax Lot Accounting
What it is:
Tax lot accounting is a method of record keeping that tracks the cost, purchase date, and sale date for every unit of every security in a portfolio.
How it works (Example):
For example, let's assume that you purchase 50 shares of Company XYZ at $5 a share on January 1. You purchase another 100 shares of Company XYZ on January 5 for $6 per share.
On December 15, you sell 20 shares of Company XYZ for $10 per share. Which shares, exactly, did you sell? The $5 shares or the $6 shares? Tracking securities by tax lot helps determine the answer. Your financial institution will provide documents that help you do this.
Why it Matters:
Tax lot accounting is important because it helps investors minimize their capital gains taxes. In our example above, we sold 20 shares of Company XYZ for $10 per share. If those shares were the $5 shares, then the profit is $100 and we would pay taxes on $100. But if the shares sold were the $6 shares, then the profit is only $80, and we would pay less in taxes. In some cases, investors may record a gain or a loss on a security depending on the tax lot involved, which adds even more flexibility from a tax perspective.
It is important to note that the law requires brokerage firms to report the original cost basis data (tax lot data) to the IRS, along with a 1099-B, which provides information about the gross proceeds of a transaction. This helps the IRS determine whether people are reporting the correct cost basis of the securities when they sell.