What Is Tax Lot Accounting?
Tax lot accounting is a record-keeping approach that tracks the dates of purchase and sale, cost basis, and transaction amount for each investment in your portfolio, even if you trade in the same item many times.
Breaking Down Tax Lot Accounting
For tax reasons, shares acquired in a single transaction are referred to as a lot. When shares of the same securities are bought, the new holdings establish new tax lots. The tax lots are a series of purchases made on several dates at varying costs. As a result, each tax lot will have a distinct cost basis. Tax lot accounting is the documentation of tax lots. It keeps track of the price, purchase date, selling price, and sale date for each investment in a portfolio. This technique of recordkeeping enables an investor to follow each stock sale throughout the year, allowing him or her to make strategic choices about which lot to sell while keeping in mind that the sort of investment tax to be paid depends on how long the stock was held.
Tax lot accounting is largely concerned with the recording of tax lots.
Assume an investor acquired 100 Netflix shares in March 2017 for $143.25 and another 100 shares in July 2017 for $184.15. The value of NFLX shares has climbed to $331.45 in April 2018. Their initial tax lot was kept for almost a year, while their most recent lot was held for less. The Internal Revenue Service (IRS) levies a long-term capital gains tax on profits realized from the sale of a securities held for more than a year. This tax is preferential to the regular income tax on capital gains on stock held for less than a year. If an investor intends to sell, say, 120 shares, the length of time the investments were held must be documented. They must also consider the fact that the younger tax lot will have a lesser capital gain if sold, which may result in a lower tax than the older lot.
If they opt to sell shares from the March lot, they will use the First-In-First-Out (FIFO) technique of tax lot accounting, which states that the first shares acquired are the first shares sold. The long-term capital gains tax will apply in this scenario. Selling 120 shares means that their March purchase has been sold, and the remaining 20 shares are from the second lot. FIFO is often utilized as the default approach for positions that do not consist of several tax lots with various acquisition dates or big price disparities.
If the shares sold are chosen from the July lot, the accounting technique will be Last-In-First-Out (LIFO), and the realized profits will be taxed as ordinary income. If they sell 120 shares, they will sell 100 from the July lot and the remaining 20 from the March lot.
The average cost basis, highest cost, lowest cost, and tax-efficient harvesting loss procedures are among the other tax lot accounting systems.
The purpose of tax lot accounting is to reduce the net present value of current taxes by postponing capital gain realization and recognizing losses earlier.
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