Considerations
This method requires that you designate which shares you would like to sell. In order for the IRS to recognize a Specific ID sell, you must, at the time of the sell transaction, tell your broker which shares to sell by referencing the purchase date and purchase price. Your broker must then respond to you with a written confirmation of these instructions. This means you cannot decide during year-end tax preparation which lots were sold by Specific ID. You must specify a Specific ID sell method at the time of the sell transaction. If you don't, the sell must be considered a FIFO sell. Specific ID methods include:
Last-In, First-Out (LIFO) - When this method is selected, the newest shares (those most recently purchased or last-in your account) are sold first (first-out).
High-Cost - When this method is selected, the shares in your account that cost the most are sold first.
Low-Cost - When this method is selected, the shares in an account that cost the least are sold first.
Specific Lot - Specifying a lot enables you to identify which shares or lots are depleted each time there is a sale.
For example:
Buy 1/4/02 100 shares of MSFT
Buy 3/1/02 50 shares of MSFT
Sell 4/1/02 50 shares of MSFT (by Specific ID on 3/1/02 lot)
Resulting Current Holdings:
1/4/02 100 shares of MSFT (original lot)
Click here for information on when to use the Specific ID Sell method
It is possible to reduce the taxes you have to pay the TaxMan by selling your highest cost shares first. Better yet, sell a lot that has a loss, so that you can offset a gain you realized on a prior sale. In the above example, if on 4/1/02 you were looking to sell 50 shares of MSFT, you must first determine if you have any realized capital gains that you can offset with a loss. If you have a capital gain, then determine if it is characterized as a long-term or short-term gain.
Note: Long-term gains are defined as securities held for more than a year. Short-term gains are defined as securities held a year or less. Since short-term gains are taxed at your income rate (possibly as high as 35%) and long-term gains are taxed at a fixed 15%, it is tax efficient to sell for a gain after you have held a stock for more than a year (long-term) and sell for a loss when you have held a stock for a year or less (short-term). Smart investors will try to offset all short-term gains with short-term losses before year's end. In addition, after you offset all your capital gains, you can use any remaining losses to offset as much as $3,000 in ordinary income (wages, dividends, etc.)
Let's imagine that in the example above, a sell of 50 shares from the 1/4/02 lot would result in a small short-term capital gain, while a sell of 50 shares from the 3/1/02 lot would result in a large short-term capital loss. Furthermore, let's imagine you recognized a short-term capital gain from a different sale. In this case, it is tax efficient to sell the most recent lot of MSFT, 3/1/02, for a loss and use this loss to offset your short-term gain. Remember that if you don't instruct your broker to sell by Specific ID, it will be sold by FIFO by default and you will be unable to offset this gain on your Federal tax return.
Reference the IRS tax laws at the IRS website, specifically documents 'Publ 550' and 'Publ 552'.
Publication 550: Tax Laws for Capital Gains & Investment Income & Expenses
Publication 552: Recordkeeping for Individuals