As an investor, you have probably heard of the specific identification method. This is one of the methods used in accounting to determine the cost basis of investments sold. The specific identification method involves identifying which shares or units were sold and using their purchase price to calculate gains or losses.
The other methods used for cost basis calculation are FIFO (first-in-first-out) and average cost. These methods assume that shares purchased first are also sold first and use a weighted average of all purchases, respectively. However, the specific identification method allows you to choose which shares/units to sell, giving you more control over your tax liability.
Let’s look at how this works with an example. If you purchased 100 shares of XYZ Company at $10 per share on January 1st and another 100 shares at $15 per share on March 1st, then decided to sell 50 shares on May 1st when they were valued at $20 per share:
– Using FIFO: You would assume that the first 50 shares purchased were sold, so your cost basis would be calculated as ($10 x 50) + ($15 x 50) = $1250.
– Using Average Cost: Your cost basis would be calculated as (($10 + $15)/2) x 100 = $1250.
– Using Specific Identification: You could choose which shares to sell – either all your January or March purchases or a mix – therefore determining your actual gain or loss based on their respective costs.
As you can see from this example, using the specific identification method can result in different outcomes depending on which stock lots are chosen for sale. It would be best if you kept accurate records by noting both purchase dates and prices for each lot held.
This brings us to another benefit of using the specific identification method – it allows investors to minimize capital gains taxes by selecting low-cost lots with higher holding periods first for selling before moving onto higher cost lots. This strategy can significantly reduce taxes on short-term capital gains.
However, it is worth noting that the specific identification method may not always be beneficial to the investor. It requires more record-keeping and tracking than other methods, making it time-consuming and potentially challenging to manage for investors with a large portfolio of stocks or mutual funds.
The specific identification method is also subject to certain restrictions set by the Internal Revenue Service (IRS). For example, if you purchased shares at different times but paid the same price for all of them, you cannot use this method. Additionally, when selling shares in a mutual fund or exchange-traded fund (ETF), you must choose which shares to sell based on their purchase date rather than their actual cost.
Moreover, some brokerages may have special rules regarding specific identification. They may require investors to make an election before they can use this method and might limit how frequently an investor can switch between accounting methods.
In conclusion, the specific identification method offers investors greater control over tax liability by allowing them to select low-cost lots with higher holding periods first for sale. However, using this method requires accurate record-keeping and may not always be beneficial compared to FIFO or average cost methods. Investors should consult with a financial advisor or tax professional before deciding which accounting method is best suited for their investment goals and portfolio size while keeping in mind IRS regulations as well as brokerage policies regarding specific identification usage.