The U.S. Senate recently introduced the Senate Tax Cuts and Jobs Act which includes one provision that, as it is currently written, could have a large impact on individual investors. This section (13533) will require individual investors to use a single cost basis methodology for tax reporting that has the potential to negatively impact them by increasing their tax burden.
Even small seemingly innocuous provisions in larger, important legislation can have consequences that are not good for individual investors. Below we’ll take a look at what the proposed change is and how it could impact a typical individual investor who has enjoyed the freedom to determine the tax method used when selling stocks and ETFs; retaining control over the way their gains and losses are taxed.
What is The Proposed Change?
Each time you purchase a stock or ETF, the new position is considered a distinct and separate tax lot (which is a record of the transaction and its tax implications). If you purchase the same security at different prices over time, there are multiple tax lots for those purchases. Currently, investors have several tax reporting choices available to them when they sell securities, known as “tax lot ID methods”. Investors can choose between strategies such as “first-in, first-out”, “last-in, first-out”, “highest cost”, “lowest cost”, or “average cost”.
“Right now, investors have the freedom to decide how best to allocate their losses or gains on their investments, giving them more control over their tax obligations. This specific provision in the Senate Tax Bill would eliminate that,” said JJ Kinahan, Chief Market Strategist at TD Ameritrade, who participates in the firm’s advocacy efforts. Section 13533 of the Senate Bill would impose first-in, first-out (FIFO) as the sole cost basis methodology available on all sales of securities except mutual funds.
What this means is if you purchased the same stock or exchange-traded fund several times over the years, you will be forced to sell the first shares you purchased first, instead of having the freedom to decide which tax lot to sell based on the gain or loss and tax implications of your specific circumstances. Since generally an investor’s oldest holdings appreciate the most, thereby typically carrying higher capital gains, you could end up having to pay higher taxes (see example below).
If approved, the Joint Committee on Taxation estimates the change would generate an additional $2.4 billion in taxes over 10 years from America’s investors.
An Example of FIFO Cost Basis Requirements
Suppose you, as an individual investor, have a large holding of company stock that was accumulated over a 30-year career. Now retired, you want to sell some of that stock to diversify your portfolio. Your purchases started at $5 per share and, over time, ranged up to $90 per share, but the stock is now trading at $50.
If the stock is sold at $50, rather than being able to choose to take losses on the stock purchased above $50, the Senate Tax Bill will require you to sell the stock you purchased at $5 and pay capital gains taxes on the appreciation of the stock from $5 to $50. Even if you have experienced sizeable losses on the purchases above $50, the Senate Tax Bill may force you to pay taxes calculated on the largest gains possible.
How Could it Impact the Average Investor?
Beyond the obvious potential impact on investor’s taxes, this change may have other unintended consequences. For example, will investors choose to hold on to stock to avoid paying high taxes and, as a result, forego proper diversification? Will they simply avoid the capital gains taxes entirely and decide to pass on such investments to their heirs, who will enjoy a stepped up cost basis? Also, many financial advisors, as well as robo-advisors, employ different strategies to reduce their client’s taxes on capital gains and boost investment returns. Those strategies would disappear under the Senate’s proposal.
“Since retirees and older investors have typically held securities for a long time, and those shares might have the greatest gains in their portfolio, this change could have an outsized impact on them,” according to Kinahan. These groups of investors who might have been counting on certain tax strategies during retirement could now be forced to reevaluate their plans. This proposed change does not benefit retail investors.
If this bill is passed these changes would apply to sales starting in 2018, only a few short weeks away.
We believe this detail within the larger Tax Bill deserves attention and that our elected officials in the House and the Senate should act on behalf of individual investors and reject imposing a FIFO cost basis methodology on sales of securities. We have created a site to help you stay informed on this important issue. You’ll find a summary of current issues, and should you want to reach out to your government representatives on this issue, we’ve provided template letters to help you get started.