One of the tax law changes proposed in the U.S. Senate bill, but not in the House of Representatives bill, would require investors to use a First In, First Out (FIFO) accounting methodology for tax lots when calculating capital gains tax. This would impact the way portfolios are managed with respect to taxes. Specifically, FIFO takes away some flexibility—instead of choosing the most favorable tax lot to sell, investors are forced to sell the oldest tax lot first. Assuming the provision makes it into the final tax bill, and that Congress is able to pass the bill in the next month or so, the new rule would become effective January 1, 2018.
Using FIFO tax accounting is simpler, but tax management becomes more complex under this methodology. While there will still be significant value to tax management, it will be harder to unlock and will require the specific expertise of a tax-aware manager.
We have been following the potential for FIFO legislation for much of 2017. Parametric Research and Strategy teams have been testing systems and processes across various market scenarios. Also, due to restrictions at a particular custodian, Parametric already manages a number of accounts under a FIFO accounting methodology. As a result, we have built out the required systems to manage portfolios in this fashion, and are ready should the tax laws change.
We have navigated multiple tax-code changes over the past three decades and we understand that there is often a window of opportunity between when the law is passed and when it goes into effect that allows investors to position their portfolios for the new environment. In this case, the window could be very narrow—the few weeks at the end of 2017. We are prepared to maximize each client’s after-tax performance in the final weeks of 2017, if and when tax-code changes become clear.
How Does FIFO Change Tax Management?
Based on our experience managing client portfolios and our research backtests, we estimate the tax benefit for tax management to be about 5 to 14 basis points lower under FIFO than when using tax lot identification.
The three reasons below help provide some basis for why there is only a small difference in tax benefit under FIFO compared to specified-lot accounting:
1. When there is only one tax lot for a security, then there is no difference between FIFO and specified tax-lot accounting. When trading baskets of stocks, especially stocks outside of the top-ten mega caps, it is very common to sell completely out of the position to realize a loss. This leaves only one tax lot when the holding is repurchased later.
2. Many of the benefits of tax-loss harvesting come from large price moves. If the loss is significant, there will usually be benefits regardless of the accounting method.
3. The optimization process for tax loss harvesting can be modified to balance the tradeoffs of selling an older tax lot to get a short-term capital loss in a newer tax lot.
In other words, each trade is more constrained, but across multiple time periods and trades, the opportunity for tax management is not diminished very much.