Other Implications
There are other implications of FIFO, beyond tax benefit from loss harvesting. Adding cash to an appreciated portfolio will tend to increase the number of tax lots, which won’t be as beneficial to tax-loss harvesting in the future as it would be under a specified tax-lot rule. Investors may need to rethink dollar-cost averaging programs.
Another implication is that selecting tax lots for gifting will also be subject to FIFO, making it harder to push tax liability out of the portfolio (although for an account that is aggressively loss harvested, this issue will be minimized).
Transitions from an existing portfolio that is highly appreciated into a tax-managed account becomes more challenging. Figure 3 shows a hypothetical transition. In this case, the portfolio had a 73 percent cost-basis to market-value ratio across 89 stocks, transitioning to a U.S. Large Cap Index. Holding the benchmark-relative risks constant, we show an increase in gain realization under FIFO. The results depend on the initial condition of the account. The high tracking error scenario was able to match gains versus losses in both specific tax-lot and in FIFO methodologies. Some investors may, therefore, consider allowing more benchmark-relative risk (tracking error) into their portfolios to counter the impact of FIFO. Additionally, investors considering a transition may wish to initiate the transition prior to the tax law changes to take advantage of specific-lot accounting. These results are highly dependent on the particular situation of the investor. For more highly appreciated accounts, the difference in gain realization could be greater.
