TRADING ACCOUNTS TAXABILITY
First of all we must define short term and long term trading. If you buy and sell shares less that a year later this is a short term sale. If you hold the shares more than a year this is a long term sale. And the tax rates may differ between short and long term sales.
DEFAULT ASSIGNMENT IS NORMALLY LIFO (LAST IN FIRST OUT)
More likely than not when you opened your account you have no idea about LIFO (Last In First Out) vs FIFO (First In First Out) and the brokerage set your account to LIFO. This is what happened to me. The company I was investing in had some major problems and either had to go bankrupt or bring in a world class team to fix the problems and do a complete “clean sheet” design. The stock price dropped from $10 a share to $1.60. Then they found all kinds of strategies to start recovering. During this period I bought a lot of shares on the way up at $2, $3 all the way to $10. When it hit $10 I bought some shares at $10 and the same day I sold the shares for $11 thinking I made $1 time a nice quantity of shares. Wow! But then the accounting system looked at my setting and instead of using shares that I just bought for $10 it chose my oldest shares at $2. This meant that for tax purposes I had a taxable liability of $11 sell price – $2 cost basis or buy price and now the IRS was going to pocket more money than necessary.
I LEARNED AND CHANGED MY SETTINGS TO LIFO
So after I learned the next time I sold shares the accounting system took the new purchased shares instead of the oldest and the situation improved quite a bit.
NOW IT IS THE NASTY IRS WHO ADDS WASH SALES TO THE SITUATION
The IRS figured that there are powerful big investors that see that towards the end of the year that the stock price of a certain company is going down and that they can take a very big loss to lower their tax liability. But the strategy of the company is to buy back the same shares after January 1st when the stock price has continued to drop and profit from selling at the higher prices but still taking a tax loss. But then buying back the same shares at a price lower that what they sold it for, they can win both ways. So the IRS made new rules that if you buy back the same share in less than 30 days it is a “WASH SALE” and you are not allowed to take the original loss from the first sale. I know this is a bit confusing but we may return to this at a later time. The mechanics of this is that they add back the amount of the loss that you tried to take.
NOW THE STUPIDITY OF THE BROKERAGE ACCOUNTING SYSTEM KICKS IN
It turns out in many if not most brokerages the accounting system is pretty stupid and does not know how to use a clock. I am going to give you a simple fictitious example based on many real occurrence with easy number to make it easier to understand.
You arrive at your desk in the morning and put in an order to buy 100 shares of XYZ (fictitious company) for $1000. A while later you sell the shares for $2000. The as you get ready to go for lunch you buy back the same shares for $3000 and when you get back from lunch you sell the same shares for $4000. Now you are thinking I bought at $1000 and sold for $2000 so I made $1000. I bought for $3000 and sold for $4000, That’s another $1000 for a total of $2000. But that is not the way the brokerage accounting system did its match. Any transactions on the same day are all the same and the time makes no difference. So the accounting system took the $4000 sale against the $1000 purchase creating a $3000 taxable gain. It then takes the $2000 sale against the $3000 purchase and crease a $1000 lost. So the result looks the same until you understand that you have a $3000 taxable gain and there is nothing that is going to change that. But the $1000 lost was within 30 days of the other transaction so the lost becomes a “Wash Sale” and you may not be able to recover this for days, weeks, months, or even longer.
SO WHAT CAN YOU DO?
You can talk to your broker, to your CPA, to your Tax lawyer and even the IRS an no one is going to be able to help you. But I will and I do this every time I sell shares.
I ALWAYS TAKE CONTROL AND DO “LOT OPTIMIZATION”
Most people simply let the brokerage accounting system use the default FIFO or LIFO and let it be. Your CPA will not get involved until the end of the year when you get your brokerage 1099-B form regarding all your stock transactions and by then it is too late the damage is done.
YOU CAN CHANGE THE ASSIGNMENT UNTIL THE SETTLEMENT DATE.
This means that once you sell your shares the status of the lot is “CLOSED POSITION NOT SETTLED”. So now you can go to see all of the lots that you are holding and change the lot the brokerage accounting software for an exact same number of shares that you sold taking the shares from any lots that you own in that account of exactly the same company shares. So in the example above, we could have associated the $1000 buy with the $2000 sell and the $3000 buy with the $4000 sell and we now have the correct expect $2000 gain and no “WASH SALE” problems.
BUT WE CAN EVEN DO BETTER THAN THAT
Let’s take a case where we bought 1000 shares of XYZ at $10 a share. We later on the same day sell the same shares for $11 a share and have $1 gain on 1000 shares for a taxable gain of $1000. But I know that I am hold a bunch of shares at all kinds of prices. So I go in after the accounting system software posts the days transaction and I always do my “LOT OPTIMIZATIONS”. So I to do my re-assignments and I find that I am holding 2000 shares of the stock at a cost basis of $10.80. I then assign the 1000 I sold taking 1000 of the 2000 and reassigning it to the sale. So now I still made the same amount of net profit but for IRS I have $200 in taxable gain and I place the other $800 in my unrealized profit meaning that my net worth has gone up $800 that is not taxable. This way I can build my net worth and minimize my IRS liability.
Everything we have discussed here has been in conjunction with normal trading accounts. Next we will talk about the difference between normal trading account and IRAS and 401K’s