Cost Valuation Methods: FIFO, LIFO, Identified Shares
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 the tax bill.
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. This default rule is frequently tested.
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.
Specific Identification (Identified Shares)
- The investor designates exactly which shares (tax lots) to sell
- Must identify the shares at the time of sale 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 happen at the time of sale, not after the fact. The investor must tell the broker which shares to sell before the trade executes.
- 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.
Comparison Summary
| 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). These are often confused on the exam.