Tax Lot Selection: Avoid Uncle Sam's Shaft

Your largest expense in life will likely be taxes. When we trade, we must pay capital gains tax on any position we close in the green. This post will discuss how to minimize taxation when wheeling multiple lots of 100 shares of the same stock. I will use my recent experience with LRCX to demonstrate why this is important.

As we begin, keep in mind the IRS tracks each share individually for purposes of taxation. Therefore, if you buy 100 shares of stock for $10 and later sell 50 shares for $20 each, the IRS will not assess that you bought and sold $1,000 of stock. The IRS will assess that you bought 50 shares at $10 and sold 50 shares at $20, resulting in a $500 gain on which you must pay tax.

If you hold a position for less than a year before closing, you must pay short term capital gains tax, which is taxed as normal income as though you made it at work. If you hold a position for more than a year, you will pay long term capital gains tax, which is lower. If you are in the low income bracket, long term rates can reach 0%. If you would like more information about these tax rates, especially with regard to the wheel strategy, check out this post. 

Tax Lots

Tax lot is a term used to describe a block of shares that you acquired at a particular time for a particular price. For example, if you buy 100 shares at $10 in June 2020, and then later buy 100 shares for $15 in January 2021, then you have purchased two different tax lots.

Lot 1: 100 shares purchased in June 2020 for $10/ea. This will be taxed at long-term rates if held until June 2021.
Lot 2: 100 shares purchased in January 2021 for $15/ea. These will not be taxed at long-term rates until January 2022.

This becomes important when you wish to sell a piece of your position, but not the whole thing. This includes selling shares as part of getting assigned on a covered call.

In the example above, your broker will tell you that you own 200 shares at an average price of $12.50. However, your broker will also keep the information regarding your tax lots in the background. The information regarding your dates and prices of each individual tax lot is not lost, and should be accessible through your broker (though perhaps not Robinhood).

Selling Shares and the Effect of Tax Lots

Let's continue with the example above. Assume you sell a covered call at the $15 strike for $100 and get assigned in March 2021. You must now sell 100 shares of stock, and you will pay taxes on any gains.

Would you prefer to sell the shares you bought last June at $10 each, or would you prefer to sell the shares purchased in January for $15 each? You would of course prefer to sell the shares bought in January. Why?

1) The shares purchased in June 2020 will be eligible for the lower long-term tax rates in 3 months. We don't want to ditch those shares now and pay much more tax.

2) The shares purchased in January have a cost basis of $15. If we get assigned at $15, we do not have to pay tax on the shares since there is no gain (although we still pay tax on the $100 covered call premium). If we sold the shares bought in June at $10, then we would have to pay tax on the $5/share gain by selling them at $15.

If we sell the June 2020 tax lot, we would pay taxes on $500 gain on the shares + $100 covered call premium. If we sell the January tax lot, we only need to pay tax on the $100 covered call premium. 

At the end of the assignment, we still have 100 shares. But if we sell the January tax lot, we pay much less tax.

We can even go further with this. What if we got assigned at the $14 strike instead of the $15 strike? Selling the June tax lot would cause a capital gain of $400 on which we must pay tax. Meanwhile, selling the January lot would actually cause a loss of $100, which would save us money on tax. Selling the right tax lot could be the difference between paying tax and getting a tax deduction.

Selling the Right Tax Lot

It is easy to see the reasons to sell the most tax-advantaged tax lot. But how can we ensure we sell the right set of shares?

If we sell or get assigned to sell shares without telling our broker which tax lot we want to sell, our broker will assume we want to use the FIFO method. FIFO stands for "first in, first out." In other words, the broker will sell whichever shares we acquired first. And in our example above, that would mean selling the June tax lot and incurring a higher tax. That's no good.

If we want to sell a different tax lot, then we have to tell our broker what we want to do. How to communicate this intent to your broker will vary by platform. On Merrill Edge, you must call the broker and get assistance from a trade specialist. On Fidelity, you can select a tax lot on the website. I have no idea how to select tax lots on Robinhood, or if you even can select tax lots.

In our example, we would want to use the LIFO method. LIFO stands for "last in, first out." By choosing this method, we would sell the January tax lot, which as we discussed is more advantageous from a tax point of view.

If you want to, you can even specify specifically which shares you want to sell from multiple tax lots. So if you bought shares on 10 different occasions, you can tell your broker to specifically sell the shares with the highest cost basis in order to minimize tax, even if the ones you want to sell were purchased sporadically in odd clumps. 

Keep in mind you don't need to specifically say to your broker, "I want to use the LIFO method to sell shares." You just explain in plain language what you want to do, and they'll facilitate.

Mikey's LRCX Adventure

This past week, I got assigned on an LRCX $550 covered call. At the time, I had 203x shares of LRCX acquired at different times and prices.

I originally bought 100 shares in September 2020 at $318.51. I picked up a few more shares later in November and December, but these few shares are not relevant to what happened next.

I later picked up another 100x shares by getting assigned on a short put at $550. I collected $1,499.42 for selling the short put. For tax purposes, this will assign me 100x shares at a cost basis of about $535.

I wanted to sell a covered call on this tax lot. I sold a covered call at the $550 strike and collected $1,149 premium. This covered call got assigned and I was forced to sell 100x shares. For tax reasons, this means I effectively sold the shares at the strike + premium, or $561.49.

But here is where I ran into an issue. If I let my broker use the default FIFO method of selecting shares to sell, my broker would sell the shares I acquired in September at $318! The tax implications of buying shares at $318 and selling at $561 are huge. Plus, I would lose all the time I had accrued toward long-term tax rates.

By calling my broker and communicating my intent to sell the March tax lot instead, I was able to switch to the LIFO method. This meant selling shares that I acquired at a much higher basis and thus reduced my tax burden.

Switching my tax lot meant saving over $5,300 in taxes and preserving the time I had accrued toward long-term tax rates on my first lot. Ironically, if I had to sell the September tax lot, I would have paid more in tax than I gained by selling the covered call. I would have actually lost money that way, even though I should have come out with a gain. Swapping tax lots literally saved my gains.

Consider carefully your tax lots when you sell shares, and communicate with your broker when you don't want to use the FIFO method. Consider both time accrued toward long-term rates and your cost basis. Select the most tax-advantaged lot, and you will save yourself big bucks.