A Move to FIFO

Major tax reform might just be a couple of weeks away, but it sure is coming down to the wire. The lateness leaves precious little time for planning. A common question has been what, if anything, should we be doing now given how Congress's planned tweaks to the tax code might impact investors. The short answer is nothing... well, almost nothing, until the legislation is signed and we have more details.

Last week I wrote about the potential change to how the government calculates CPI and how this could impact tax rates, and even Social Security benefit payments, long-term. But this week let's review one provision that could have more near-term impacts for investors.

We all know that Congress has to close a variety of loopholes to pay for some of the planned tax cuts. This makes good intuitive sense. But too often closing some of these loopholes has what should be obvious unintended consequences that impact typical investors, not just the hedge fund guys or other "corporate" folks. This leads me to assume that most members of Congress don't understand what's in the legislation they're voting on. Unfortunately, this is a common (and scary) practice to get large and complicated legislation through the process and into back offices where the important details are hammered out by fewer, and presumably more expert, members. This process is happening now, and we're all waiting for more details.

One of the key details for investors is the potential change to how we realize gains and losses in our investment portfolios. This is another one of those seemingly small things that adds up to big money over time. According to the Joint Committee on Taxation and CNBC, this change could generate roughly $2.7 billion in additional tax revenue from investors over the next ten years. Granted, many of those impacted will be wealthy fund managers and the like, but many others will be swept up by the change as well.

Currently, investors have lots of options when they sell shares of an investment in a taxable (non-retirement) account. They can sell their oldest or newest shares, shares bought on such-and-such date, or an average of all purchases. The options can get complicated but they all center around investor's having choice about when and how gains become taxable. The idea is that each purchase, whether it's one or many over time, are individual transactions and you ought to be able to decide which one you want to sell and when. The proposed change would force you to sell your oldest position first. No more choice.

Say you bought $10,000 worth of stock in a company when it was trading for $10 per share. Some years later the stock is worth $50 per share and the 1,000 shares you bought are now worth $50,000. You still like the stock and decide to buy $10,000 more. Now you have $60,000 worth of stock and a cost basis (purchase price plus transaction cost) of $20,000.

Sometime later you need to generate some cash, so you'll sell some stock. If you sell the whole position determining your gain is simple. You'll owe tax on the $40,000 gain. But what if you only needed $10,000? Maybe your recent purchase isn't growing as much so you think, hey, I'll just sell the shares I recently bought. It will be cheaper tax-wise and I like the idea of my initial investment being left alone. Under current rules you can do this and pay relatively little tax because selling the more recent shares would mean realizing fewer gains. Under the new rules, however, you'd be forced to get your $10,000 from your first purchase and pay tax on, in this simplistic example, $8,000 of gains. In industry and tax jargon this is called "FIFO", or first-in-first-out and it can get expensive.

So, what to do about this in the meantime? Some brokers are recommending selling aggressively now, in 2017, while you still have some choice. Others are recommending creating multiple accounts at multiple firms because of the strange way the potential FIFO mandate is worded in the proposed legislation. Others are recommending doing nothing and waiting to see what Congress comes up with.

I'm with this latter group. Remember, nothing is set yet with the tax overhaul. The legislation is in flux, so it's not time to start making big (and probably expensive) changes to your investment portfolio based on assumptions about what Congress will ultimately do.

However, if you might need cash soon and have a variety of purchases in a taxable account to choose from, we could opportunistically sell select shares before year-end. Congress has an unofficial deadline of the 22nd to get a bill to the President, so any selling would likely need to be done in the last few days of the year. Again, it's coming down to the wire.

Hopefully, the various committees who are working on this will come to their senses and not mandate FIFO to help pay for tax cuts. The change would be a blow to investor choice and would likely lead to more accounting shenanigans to work around it. But until we know more, a wait-and-see approach is probably the most prudent.

Have questions? Ask me. I can help.