How the proposed FIFO rule would change wealth management
December 14, 2017 Update: According to unofficial reports, the FIFO rule has been removed from the final tax bill emerging from the House and Senate conference committee. Read on for our take on this might-have-been.
The Senate version of the tax bill includes a provision requiring that investors use the First In First Out (FIFO) tax lot selection method when selling a portion of their holdings in a security. The FIFO rule may not become law. But what if it does? How would this change things?
What’s FIFO anyway?
Suppose you purchase a share of IBM at $90 and the next day you buy another share for $110. You now have two tax lots. Suppose you then sell one share at $100. The amount of tax you owe depends on which tax lot you sold.
FIFO is a method for determining this tax lot selection. With FIFO, you must sell the oldest lots first. In our example, this is the lot you purchased at $90, which means you will owe tax on a $10 gain.
In contrast, the specific tax lot selection method, which most advisors use today, allows you to pick whichever lot you want. In the above example, you might choose to sell the 2nd lot and realize a $10 loss, which you can use to lower your tax bill.
How we think the law would be interpreted
As written, the FIFO rule would seem to apply at the investor level, regardless of whether their holdings (and tax lots) are spread across multiple accounts at multiple custodians with multiple advisors. However, we assume that if the FIFO rule becomes law, it will be interpreted to apply separately to each registered account, rather than to the client’s holdings as a whole. We say this not because we have a secret connection to the halls of Congress, but because we think that anything else would be unimplementable and unenforceable. If the law were interpreted to apply across accounts belonging to the same client, it would create interactions between accounts that current systems and custodians are not prepared to handle.1
How FIFO changes rebalancing
Whether FIFO makes rebalancing more complicated depends on what you’re doing now.
There are three basic levels of tax management, each affected differently by the new rule:
Level 1: “Tax aware”
Basic idea: Sell decisions are made without consideration of tax consequences, but then tax lots are selected to minimize taxes.
A FIFO rule would eliminate the only part of this process that is “tax aware”: selecting tax lots. Implementing FIFO wouldn’t actually complicate the rebalancing workflow; there just wouldn’t be any tax management left.
Level 2: “Tax sensitive”
Basic idea: Sell decisions are made without consideration of tax consequences EXCEPT
- There’s an effort to 1) hold onto lots with unrealized short-term gains and/or 2) harvest losses.
- Tax lots are selected to minimize taxes, as with the tax aware approach.
Deferring sales of short-term lots would be unchanged by FIFO. Long-term lots are, by definition, older than short-term lots, and so would be sold first under FIFO anyway.
On the other hand, loss harvesting would be more difficult. With individual tax-lot selection, you can simply apply a rule, such as “sell every lot whose current value is below 80% of basis.” With FIFO, you can still loss harvest, but in order to sell a newer lot at a loss, you would need to also sell all the older lots, some of which may have gains. It might be worth it, but doing the math is harder than just identifying lots with large losses. The good news is that while it may be challenging to do this by hand, it’s reasonably easy for a computer. As long as you have tax-sensitive rebalancing software to help you, implementing tax-loss harvesting in a FIFO world won’t be much harder.
It will, however, be less valuable. There will be cases where loss harvesting would make sense in a individual tax-lot selection regime that, because of the need to sell all the older lots first, wouldn’t make sense in a FIFO regime.
Level 3: “Tax optimized”
Basic idea: Sell decisions jointly consider tax, cost, risk and constraint implications. That is, you don’t just apply simple rules like “don’t sell short term gains” or “sell tax lots whose current value is below 80% of basis.” Instead, each potential trade is subject to its own cost/benefit analysis that would, under some circumstances, recommend the sale of lots even if they have short-term gains or not loss harvest a position with large losses.2
FIFO makes this type of tax-optimized rebalancing harder. The reasons are a bit technical: when you have individual tax lot selection, it’s possible to line the lots up in your preferred selling order.3 You can then, one by one, consider the costs and benefits of selling one share, two shares, three shares, etc. You keep going until the costs of selling one more share outweigh the benefits. It sounds complicated, but it’s fairly straightforward—it’s what optimizers do. In contrast, with FIFO, the lots are still lined up (in, well, FIFO order), but you can’t just walk through considering selling one more share and stop when the incremental benefit is less than the costs. The problem is that it might be worth selling all the shares in the first lot, even though none of them pass a cost/benefit test, in order to get to the second lot, whose shares do pass muster. This looking-past-one-lot-to-get-to-the-next logic is more compute intensive. Fortunately, modern computers are more than up to the challenge, so the analysis can still be automated.
How much does FIFO reduce tax efficiency?
Because selling the oldest lot first is not always optimal from a tax perspective, FIFO would reduce tax efficiency for portfolios managed in a tax aware or tax optimized manner. But by how much?
That’s hard to answer, in part because managers may alter their behavior to work around the new rule. For example, if, as we speculated in the beginning, the rule is enforced one registration at a time, then managers might be able to transfer low basis holdings to a special “long term investment” registration, freeing up higher basis lots in the remaining accounts. Less speculatively, advisors, especially those who pursue passive strategies, can create “equivalence sets” (a list of acceptable substitutes) for every security in model. Once they’ve done so, they can cycle through the equivalence set for each new purchase (e.g. first purchase IBM, then HP, then Dell, etc.), which would create a series of one-lot positions, effectively undoing FIFO’s impact.
Is there anything I should do before year end in preparation?
If the FIFO rule does become law, you may wish to take advantage of the benefits of individual lot selection while you still can. That is, squeeze out all available loss harvesting opportunities, as well as opportunities to sell down overweight positions at relatively low cost (shameless self-promotion: rebalancing systems like ours make this relatively easy).
Will FIFO become the law?
Will FIFO actually become the law? Our own best guess is no, at least not in a form that will take effect January 1, 2018. It’s too disruptive with too little time. Implicit in this statement is the perhaps increasingly quaint-sounding belief that rationality will win out in the end.
Despite our belief that it likely won’t become law, Smartleaf is preparing to support FIFO January 1st, just in case. While we think the law is rash and ill-advised, it would probably be good for our business—it makes rebalancing more complicated, which increases demand for our products. That being said, we’ll gladly forsake the extra business for a more deliberate and thoughtful legal process.
For more on this topic, check out The Three Types of Wealth Management Firms.
1 Specifically, the sale in one account could change the cost basis in another. Suppose you had one lot each of IBM in two separate accounts. If you sold the new lot of IBM and the FIFO rule were enforced across accounts, then the investor would be deemed to have sold the other lot in the other account. The best way to interpret this would be that the unsold lot of IBM would inherit the sold lot’s newer tax basis. At present, there is no way for different custodians to communicate this to each other, or even for one custodian to implement this across multiple accounts belonging to the the same investor.
2 For example, it may make sense to sell a lot with short-gains if, say, the security is very overweight, the short-term gains are small, the security being sold is expected to perform poorly and the lot that still has 300 days until it’s long term. The same type of trade off logic applies to loss harvesting decisions: Are there good substitutes in terms of risk characteristics? In terms of expected returns? How much are transaction costs? Etc.
3 The preferred order for selling lots can be more complicated than just minimizing your tax bill. For example, suppose you had two tax lots, one that would generate a $10 tax bill from long-term capital gains and the other that would generate a $9 tax bill from short-term capital gains. Selling the short-term lot would generate less taxes, but over the life of the investment, it might be more prudent to sell the long-term lot instead, pay the extra $1, and hope the short-term lot becomes long-term before it is sold. (Smartleaf’s software would, in fact, likely recommend selling the long-term. The specific recommendation depends on the client’s tax rates and the time to long-term status of the lot).
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