What it means
Imagine buying shares in the same company at three different times and at three different prices. Each purchase is a lot, and the cost and date of each decide the gain and how it is taxed when the shares are sold.
Reinvested dividends also create small lots of their own. The default method is often first in, first out, which treats the oldest lot as the one sold first.
Other methods include last in, first out, average cost, and specific identification, which lets you name the lot you are selling. Which of these is allowed depends on the type of asset and the country.
Each method gives a different taxable gain for the same sale. Selling a lot bought at a high price produces a smaller gain or a loss, while selling a cheap lot produces a larger gain.
The total gain over the life of the investment does not change, but the timing of the tax can. The holding period also matters.
In many systems, assets held for longer than a set period are taxed at a lower rate, so choosing a lot you have held for a long time can reduce the tax rate on the gain. Selling a lot just before it qualifies for the lower rate can be a costly mistake.
Brokers and portfolio software normally keep lot records, and some let you choose a method for each account. You should set your choice before the sale, since a method cannot normally be changed after the trade settles.
Keep your own copy of the records as well, in case you ever change broker. The nuance is that the rules differ by country and by type of asset.
Some systems require specific methods or pool purchases together, so check the rules that apply to you. Some countries pool shares of the same company together and use an average cost instead of tracking lots.
In practice
Real-world examples.
Example
A parent has invested $500 a month in the same fund for ten years. Each monthly purchase is a separate lot with its own cost. When she sells part of the holding to pay for tuition, she selects the lots with the highest cost to minimise the gain. She records the choice in writing before the sale, in case of a later query.
Example
A small company holds shares as a long-term investment and buys more each quarter. At year end, the finance manager reviews the lots to decide which to sell for cash needs. He prefers lots held for over a year because the tax rate on those gains is lower. He notes the date each lot was purchased so the holding period is clear.
Example
A wealth manager uses software to track lots across hundreds of client accounts. When a client needs cash, the software suggests lots that produce losses or small gains. The advisor records the choice in writing before placing the sell order. The report is shared with the client and filed for audit purposes.
Formula
Calculation
Gain on sale = Sale proceeds - Cost basis of the lot sold
Suppose an investor bought 100 shares at $50 and another 100 shares at $70, then sells 100 shares at $80 each, for proceeds of $8,000. Under first in, first out, the cost basis is 100 x 50 = $5,000, so the gain is 8,000 - 5,000 = $3,000. If she names the $70 lot, the cost basis is 100 x 70 = $7,000, and the gain is 8,000 - 7,000 = $1,000.Case study
Seen in the real world.
Linden Advisory is an illustrative, fictional firm that manages portfolios for private clients. One client sold $60,000 of a fund, and the broker defaulted to the oldest lots, which carried a very low cost and produced a $22,000 gain.
When the advisor reviewed the statement, she saw that more recent lots had been bought at much higher prices. Had those been sold instead, the gain would have been around $6,000.
In this illustrative story, the firm changed the default setting for all accounts to specific lot identification and trained staff to choose lots before each trade. On that trade alone, the client would have saved tax on $16,000 of gains, and the firm added a lot review to its trading checklist.
Watch out
Common mistakes.
- Accepting the broker's default method without checking, which may create a larger gain than necessary.
- Choosing lots after the trade is settled, when most systems require the choice to be made at the time of sale.
- Losing purchase records after transfers between brokers, which can leave the cost basis unknown.
Questions
People also ask.
What is specific identification?
It is a method that lets you name exactly which lot you are selling, giving the most control over the gain or loss.
Does tax lot accounting apply to funds as well as shares?
Yes, each purchase of a fund, including reinvested distributions, usually creates a separate lot.
Can I change methods later?
Rules vary, but in many systems a change applies only to future sales, and some methods require approval or a formal election.
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