Quick Answer
FIFO (first-in, first-out) is the default method and sells the oldest, lowest-cost shares first, usually producing the largest gain in a rising market. LIFO sells the newest shares first. Specific identification lets the investor choose exactly which lot to sell, but the choice must be made no later than the settlement date.
When an investor buys the same stock multiple times at different prices, they hold multiple tax lots. The cost valuation method determines which lot is sold first, and that directly affects both the size of the gain and whether it is short-term or long-term.
What Is FIFO (First-In, First-Out)?
- Default method: if the investor does not specify which shares to sell, FIFO is assumed
- The oldest shares (purchased first) are sold first
- In a rising market: FIFO typically produces the largest taxable gain (oldest shares have the lowest cost basis)
- In a declining market: FIFO produces the smallest loss
Example: An investor made three purchases of XYZ stock:
| Purchase | Shares | Price | Total |
|---|---|---|---|
| January | 100 | $30 | $3,000 |
| April | 100 | $40 | $4,000 |
| July | 100 | $50 | $5,000 |
The investor sells 100 shares in November at $55.
Using FIFO: The January shares ($30 basis) are sold first.
- Gain = $55 - $30 = $25/share = $2,500 gain
Exam Tip: Gotchas
- FIFO is the default method. If a question does not specify which method the investor uses, assume FIFO.
What Is LIFO (Last-In, First-Out)?
- The newest shares (most recently purchased) are sold first
- In a rising market: LIFO generally produces smaller gains than FIFO (newest shares have the highest cost basis)
- In a declining market: LIFO produces the largest loss
Using the same example above with LIFO: The July shares ($50 basis) are sold first.
- Gain = $55 - $50 = $5/share = $500 gain
That's a dramatically different tax result: $500 vs. $2,500.
What Is Specific Identification (Identified Shares)?
- The investor designates exactly which shares (tax lots) to sell
- Must identify the shares no later than the settlement date and notify the broker
- Provides the most flexibility for tax planning
- Requires adequate recordkeeping to substantiate the identification
Using the same example, the investor could choose to sell the April shares ($40 basis):
- Gain = $55 - $40 = $15/share = $1,500 gain
Or choose the July shares to minimize gains, or the January shares to maximize gains (perhaps to offset losses elsewhere).
Exam Tip: Gotchas
- Specific identification must be made no later than the settlement date. The investor may substitute a different lot after execution but before settlement; after settlement the designation is final.
- Different tax lots may have different holding periods. The method chosen can determine whether a gain is short-term or long-term, not just the dollar amount.
How Do the Three Methods Compare?
| Method | In a Rising Market | In a Declining Market | Flexibility |
|---|---|---|---|
| FIFO (default) | Largest gain (sells low-cost shares first) | Smallest loss | None - automatic |
| LIFO | Smallest gain (sells high-cost shares first) | Largest loss | Must specify |
| Specific ID | Investor chooses | Investor chooses | Maximum - pick any lot |
Exam Tip: Gotchas
- In a rising market, FIFO produces the largest gain (sells lowest-cost shares first). LIFO produces the smallest gain (sells highest-cost shares first).
What Should You Check on Exam Day?
- FIFO is the default; assume it whenever a question doesn't specify a method
- Specific identification requires the investor to name the lot no later than the settlement date
- Different tax lots can have different holding periods, so the method chosen can flip a gain between short-term and long-term