Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

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.

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