December 5, 2017— The Senate tax bill contains a provision that would force individual investors to use first-in-first-out (FIFO) tax treatment for sales of the shares of most stocks.
- Markets have risen substantially in recent years, making management of taxable gains an important consideration in delivering after-tax returns to investors.
- Under current law, individual investors are able to control taxable gains by selling specifically selected shares of stocks. Shares with higher tax cost basis are usually selected, so taxable capital gains would be lower. Shares purchased in earlier years generally have a lower tax cost basis.
- By contrast, the FIFO treatment proposed by the Senate would force investors to sell the earliest purchased shares first. Such shares would generally have lower tax cost bases, and so would produce larger taxable capital gains.
- The Senate proposal would affect shares owned directly by investors. This includes shares within brokerage accounts.
- The rule would particularly impact investors who hold a large proportion of their equity wealth in a single stock, as they would have fewer opportunities to offset gains on its shares from losses on shares of other stocks.
- Also, the rule would impact tax treatment of share donations. As is currently the case, investors will still be able to deduct the current fair market value of donated shares, however, the shares donated would now be determined on a FIFO basis.
- The Senate proposal would also extend to shares within separately managed accounts, as these shares are directly owned by investors.
- FIFO treatment would now be required for tax-loss harvesting. The opportunity for generating tax losses would be reduced, because there would now be fewer stocks held for the longest period of time with capital losses, given that markets have risen substantially since many shares were originally purchased. Additionally, under the FIFO rules, if an investor does have loss lots, he or she may need to sell additional shares at a gain to get to the loss position; this is another reason why loss harvesting may prove more difficult under FIFO rules. While the effectiveness of systematic tax loss harvesting would be reduced, such strategies will still remain attractive under a FIFO regime.
- After lobbying by the Investment Company Institute and larger mutual fund families, the Senate exempted mutual funds and ETFs from the FIFO requirement. Such regulated investment companies have long been permitted to use average cost of shares for their tax basis and they will continue to be allowed to do so.
- It remains to be seen whether the tax bill will become law and/or whether the FIFO provision will be included. If investors need to raise cash over the next few months, it may be advisable to sell some of their shares with a higher basis before January 1, when the new law might go into effect, in order to avoid a potentially large capital gains tax bill in 2018.
- As always, every investor’s circumstances are highly individualized, with different proportions of short-term gains versus long-term gains, as well as different objectives, such as donation of shares. We would encourage you to discuss tax management of your accounts directly with your Wilmington Trust Investment Advisor.
Our core narrative calls for continued market appreciation of equities, against a favorable global economic backdrop. Consequently, FIFO treatment of share sales would likely lead to even greater taxable gains in future years than at present.
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