Save on taxes understating FIFO or LIFO

FIFO and LIFO are two popular methods for the computation of capital gains. Understanding the differences between them allows you to save on taxes. How much money? Even up to 25% of your capital gains if you live in a country with such high taxes. Usually, the savings are less than this, but still can be a significant amount. How can I do this? By applying the so-called optimisation of your portfolio, which will allow you to reduce tax or prolong its payment. But, to optimise, you need to understand how your broker calculates your capital gains.

I assume that you are a long-term horizon investor who periodically adds shares (stock, ETFs, crypto-currencies) to your portfolio and at the same time or later reduces your portfolio by selling the shares at different prices. Picking which shares you want to sell or selecting a computation method to calculate your gain can make a significant difference in the taxes you owe. If you are an occasional investor, you bought some shares and then sold them all in one shot, you will not profit from the optimisation. If you are a short-term investor (you gamble or speculate) the optimisation is also not for you. If there is no tax on capital gain in your country of residence or the law is more complicated, you will not need or will have to consider additional constraints.

FIFO vs LIFO: capital gain calculation

Regarding the tax amount, there are several methods used to calculate its value, among them FIFO and LIFO, which I described in the earlier posts. The good news is that a proper selection of one of them may give you a significant benefit when it comes to tax payments. Let’s check out the following example:

You bought 5 stocks for 10 USD each and then purchased another 5 stocks of the same company for 12 USD. After some time, you decided to sell half of your stocks. The price that the market offers you is 12 USD per share. Should you sell the stock bought for 10 USD or 12 USD per share? If you applied the FIFO method, you would sell the stocks purchased at 10 USD and collect a 10 USD gain before tax. Using the LIFO method, you would sell the stocks bought at 12 USD, which doesn’t give you any profit, so you don’t have to pay a tax.

But isn’t it better to use FIFO and have a profit even if you have to pay tax? The answer is – it depends. Firstly, the FIFO and LIFO don’t change the balance of your account. In both situations, you receive the same amount of money (5×12 USD= 60 USD) and still own 5 shares. The computation method affects only taxation. If you employ FIFO, you will be taxed in the given year, while using LIFO will postpone the tax payment. In both cases, you will pay the same tax amount unless there are some regulations related to different taxation of short and long-term capital gains.

You can make your own calculation using our tool – just click on the link and the following data will be copied to Transcalc, where you can calculate a tax using the LIFO or FIFO methods.

2020-06-29-13.14.01;equity;B;5;10
2020-06-30-13.14.01;equity;B;5;12
2020-07-01-09.32.05;equity;S;5;12

But what if you don’t have a choice and the calculation method is imposed on you? You can still have room for optimisation.

Saving on tax with FIFO

Now, consider the following scenario.

You bought 10 shares of equity and paid 5 USD per share. The equity went higher and higher, so you decided to invest more, and when the price hit 10 USD, you bought another 10 shares. So, you have 20 shares and invested 150 USD with an average price of 7.5 USD per share. But it turned out that it was not your best bet because the price dropped shortly after. So, you decided to sell these 10 shares for 7 USD per share to avoid further losses. So, you lost 30 USD, but on paper, you gained 20 USD – you purchased 10 shares per 5 USD at the beginning, which are now worth 7 USD. So your paper loss is

-30 USD (real loss) + 20 USD paper gain = 10 USD.

You may be disappointed, but the more frustrating is that you still owe tax. Yes, according to the FIFO calculation, you made a gain. How is it? When you sold your 10 shares (First Out), you actually sold those bought at the beginning (First In). Therefore, your taxable gain is

10x(7-5) USD = 20 USD.

So you have a losing position. Additionally, you owe a tax. What went wrong? Two things

1. You had the wrong timing and continued buying on the top.
2. You liquidated only part of the position, the part which was profitable according to the FIFO.

Better, if you had liquidated the whole position, your paper loss would have converted into real loss, which is tax-free. If you want to keep still your position, you can always repurchase the shares. But in this situation, the best option would be to sell such an amount of stocks, which will nullify your gain or loss. It will reduce your transaction costs and allows you to keep some shares when the equity goes north again. Hence, your gain/loss should be as close to 0 as possible. Let’s compute how many shares you have to sell: if you sell the shares from the first transaction, you have 20 USD as a paper gain. How many shares should you sell from the second buy transaction? You have 3 USD loss per share, so the best option is to sell 7 shares

20 USD (gain) – 7×3 USD (loss) = -1 USD.

As you see, you don’t owe a tax now, and you still keep shares. Easy? No, this is not so easy and gets complicated when

1. You have many buy and sell transaction.
2. The gains are calculated by different rules, e.g. LIFO, average value.
3. The tax law imposes additional constraints, e.g. certain amount of time is required between sell and buy-again transactions.

That’s why it is better to calculate the gains (or losses) in a spreadsheet or use a dedicated tool, which will make all the calculation for you. I prepared for you a TransCalc, which is a free calculator of capital gains and taxes.