Stock Tax Lot Selection: Understanding Capital Gains Treatment When Selling Shares

This analysis addresses a common misconception about stock taxation based on a Reddit discussion about selling shares from mixed holding periods. The user believed that when selling 10 shares out of a 15-share position containing both long-term and short-term holdings, they could not choose which shares to sell and would be subject to predetermined tax treatment.

Investors actually have significant control over which shares are sold and consequently how gains are taxed. The primary methods include:

• Specific Identification
  : Investors can choose exactly which shares to sell by identifying them to their broker at the time of sale [1]. This method provides the greatest control over tax outcomes and is recommended for tax planning strategies [3].

• FIFO (First-In, First-Out)
  : This is the default method used by brokerages when no specific identification is made, selling the oldest shares first [2].

• Alternative Methods
  : Some brokerages offer LIFO (Last-In, First-Out), HIFO (Highest-In, First-Out), or average cost methods, though availability varies by platform [1].

Contrary to the user’s belief, investors CAN choose which shares to sell through specific identification [1][3]. This choice directly impacts whether gains are taxed as long-term capital gains (held over 1 year) or short-term capital gains (held 1 year or less) [1]. The tax rate difference is substantial: long-term gains are taxed at 0%, 15%, or 20% depending on income level, while short-term gains are taxed as ordinary income at rates ranging from 10% to 37% [1].

Most major brokerages support specific identification through their trading platforms. Charles Schwab offers this through online order entry screens [3], while Vanguard requires changing from the default average cost method before specific selection becomes available [4]. The key requirement is that investors must identify the shares at the time of sale - this cannot be set as an automatic default method [2].

The ability to select specific tax lots provides significant advantages for tax planning. Investors can strategically choose shares to minimize tax liability, implement tax-loss harvesting strategies, or manage realized gains to achieve specific financial goals [3]. This control is particularly valuable in years with varying income levels or when trying to stay within certain tax brackets.

The analysis reveals that many investors, like the Reddit user, incorrectly believe they cannot choose which shares to sell [1][3]. This misconception often leads to suboptimal tax outcomes, as investors default to FIFO without realizing they have other options available [2].

Proper documentation is essential for specific identification to be valid. The IRS requires adequate records to establish basis for each tax lot, and failure to maintain records may force investors to use FIFO by default [2]. This highlights the importance of tracking purchase dates, costs, and quantities for each tax lot.

• Default Method Risk
  : Investors who fail to specify their preferred tax lot selection method may automatically use FIFO, potentially resulting in higher tax liabilities [2]
• Record-Keeping Risk
  : Inadequate documentation of tax lots can invalidate specific identification attempts [2]
• Timing Risk
  : Specific identification must be made at the time of sale - retroactive selection is not permitted [2]

• Rate Optimization
  : Strategic selection of long-term vs. short-term shares can significantly reduce tax rates [1]
• Income Management
  : Ability to control timing and amount of realized gains for income tax planning [3]
• Loss Harvesting
  : Specific identification enables precise tax-loss harvesting strategies [3]

Major brokerages support specific identification but with varying implementation processes. Charles Schwab integrates it into standard order entry [3], while Vanguard requires method changes before specific selection [4]. Most platforms allow investors to override default FIFO methods, but investors must actively make this selection [1].

The IRS provides specific guidelines in Publication 550 for investment income and expenses [2]. FIFO remains the default when shares cannot be specifically identified, and proper record-keeping is essential for audit protection. Specific identification requires clear identification of shares at the time of sale, with adequate documentation to substantiate the selection [2].

Tax efficiency can be significantly improved through thoughtful lot selection, affecting not just current taxes but future tax planning as well [1]. Professional tax advice may be beneficial for complex situations involving multiple holdings, varying cost bases, or sophisticated tax planning needs [3].