Fidelity - Converting to Specific Shares to Reduce Realized Gain

[audreyh1]

This applies to taxable accounts at Fidelity.

The IRS changed reporting rules for assets bought in 2012 and later. Assets bought before 2012 - a brokerage does not report the basis on the 1099, but for assets purchased 2012 and later, the brokerage does report the basis.

Due to this, my mutual funds instead of being treated as all one lot with an average basis, are split into two lots - a pre-2012 lot with one average basis, and a 2012 or later lot with a different, and considerably higher, average basis. All my bond funds, and about half my equity mutual funds have this situation. Most of my mutual fund shares are pre-2012, but there are enough shares purchased afterwards to make a difference when rebalancing.

By default, Fidelity uses average cost basis for mutual funds. If you had started out configured to use specific share basis, this is a non issue. But many folks are probably like me and just used the defaults. I also used to automatically reinvest distributions as I was building my retirement fund, but I stopped that practice several years ago.

So - the average basis method ended up being broken and if I sell some shares without paying attention, by default it will come out of the older lot with the often considerably lower cost basis. This caught me by surprise one time last year when I was trying to do some tax loss harvesting. And I ended up selling more of the fund to get the larger realized loss on the newer shares with the higher basis. This really hadn't been an issue until recently because I didn't have that many shares purchased after 2012 except for bond funds which I normally haven't been trimming.

So now, if I need to rebalance by selling a mutual fund, I first check my pre-post 2012 lot situation, and if there are any shares purchased after 2012 with a higher basis, I convert that fund from Average Share Method to Specific Share Method. This assigns the (pre and post 2012) average basis to each lot bought before and after 2012, but now you can sell specific shares. Future shares purchase will take on their own basis. When the IRS changed the 2012 reporting requirements, they also did away with the requirement to get IRS permission to switch from average to specific cost share method, and Fidelity now allows you to make this change online.

It's a bit tricky to do online at Fidelity - you actually initial a mutual fund sale, choose specific shares, are told you have to convert which kicks you out of the trade and on to a screen that lets you pick that fund and any others that you wish to convert to the specific share method. Then you have to wait until the next trading day for the change to go into affect before you can sell the specific shares.

Just as an example, my REIT fund is up over 15% YTD and as a consequence my REIT allocation is 10% out of balance which has triggered a rebalance. (This is a volatile asset class). But if I did the default sale, my older shares are up over 100% since purchase and which would cause a considerable realized gain. My newest shares are up a little over 15%, so would still only add about 1/4 of the amount of realized gain to my AGI compared to the older shares, a considerable savings.

As I need to trim from funds for rebalancing that have shares purchased from 2012 or later, I will be doing this conversion in order to minimize the realized gain and subsequent increase in my taxable income.

I thought others might want to be aware of this option when you are rebalancing your taxable accounts. I think it will be saving me a considerable amount of taxes in the future when I rebalance or sell funds for income.

[audreyh1]

It's a long opening post - but there isn't really a short way to explain this!

Long story short - I was trucking along reasonably happy with the average share cost method on my mutual funds until this pre-post 2012 lot tracking bit me in the you-know-what.

[samclem]

Audrey,
Thanks. Yes, the new reporting requirements that MFs and brokers have to follow make it just as easy to use "specific share" as "average cost" methods, and that can lead to some good opportunities to reduce taxes. I'm not familiar with Fido's setup (my funds with them are in a solo 401K), but with Vanguard it is easy to change methods.
Earlier threads that some might be interested in:
Enhanced cost basis reporting: Will allow us lazy folks to save on taxes.
Beware of application of average cost

[clifp]

One nice thing about Schwab is for a few years the default reporting is using a tax minimizer program. Which roughly uses the following algorithm when picking which lots to sell.

For gains
1. Highest basis long term
2. long term
3. Highest basis short term.

For losses
1. Highest basis short term


You can at the time of the sell elect to identify any specific lot you want to sold online..

[LOL!]

Average basis always means first-in, first-out. One cannot specifically identify the shares to be sold and use average basis (unless those specifically identified shares happen to be the oldest shares owned, and thus FIF0).

Average basis doesn't really kick in until you sell shares and use average basis and write "average basis" on your tax return. The broker can have some default setting of "average basis", but that does not mean you are locked into it unless you used average basis on your tax return.

With non-covered shares, a place like Vanguard would report to you the average basis, but that didn't mean you had to use it.

I have never used average basis because it was always too confusing to me. I know what I paid for each and every share that I own, so I have always used that for my basis. Even if I did not specifically identify the shares to sold, I did not have to use average basis, but I did have to use FIFO. I could even do something like this:

Sell shares bought recently and specifically identify them and use their cost basis, then ...
Sell shares without specifically identifying them and use their cost basis. By IRS default they would be the oldest shares that I owned, then …
Sell more shares and specifically identify them and use their cost basis, …


LIFO and HIFO and all those other methods are just methods to specifically identify shares so that one can figure out their cost basis without using average basis.

To me, average basis is an abomination and should never have been allowed.

[RunningBum]

Quote:

Originally Posted by LOL! Average basis always means first-in, first-out. One cannot specifically identify the shares to be sold and use average basis (unless those specifically identified shares happen to be the oldest shares owned, and thus FIF0). Average basis doesn't really kick in until you sell shares and use average basis and write "average basis" on your tax return. The broker can have some default setting of "average basis", but that does not mean you are locked into it unless you used average basis on your tax return. With non-covered shares, a place like Vanguard would report to you the average basis, but that didn't mean you had to use it. I have never used average basis because it was always too confusing to me. I know what I paid for each and every share that I own, so I have always used that for my basis. Even if I did not specifically identify the shares to sold, I did not have to use average basis, but I did have to use FIFO. I could even do something like this: Sell shares bought recently and specifically identify them and use their cost basis, then ... Sell shares without specifically identifying them and use their cost basis. By IRS default they would be the oldest shares that I owned, then … Sell more shares and specifically identify them and use their cost basis, … LIFO and HIFO and all those other methods are just methods to specifically identify shares so that one can figure out their cost basis without using average basis. To me, average basis is an abomination and should never have been allowed.

Your post is either confusing or wrong. Average cost basis is FIFO with respect to long term or short term treatment, but the basis is the average cost of all shares, not FIFO. It is true that nothing is locked into until you actually sell shares. In the old days you probably even had until you reported the sale on your tax form. Now you have to declare at the time of sale.

It's true you were never forced to use average cost basis but since that's what most mutual funds companies would usually provide you at tax time after a sale, it simplified things greatly, especially if you had dividends reinvested and monthly investing set up. Once you started with another method, you were locked into doing it yourself from there on out (until the new cost basis reporting laws came into play).

With the new reporting, as audreyh1 says, you'll get more help with specific ID or whichever method you choose. It's a great time to switch cost basis methods. I've switched to Specific ID for all of mine, which I think we are in agreement about. With Vanguard I check a box on each purchase block I want to sell all or part of, rather than just checking the box of the big blob of shares averaged together. That doesn't even hit the nuisance scale for me.

[Letj]

Does your automatic dividend reinvestment gets factored in the basis calculation?

[RunningBum]

Quote:

Originally Posted by Letj Does your automatic dividend reinvestment gets factored in the basis calculation?

Yes it does. If you use average cost, the amount reinvested and the number of shares bought are factored in. Any other method, the reinvestment is just treated as a separate purchase.

[Letj]

Quote:

Originally Posted by RunningBum Yes it does. If you use average cost, the amount reinvested and the number of shares bought are factored in. Any other method, the reinvestment is just treated as a separate purchase.

Thanks. Wow, tracking all those reinvestments seems like a lot if you use the specific identification

[RunningBum]

That's why I never did it before 2012. With the new rules, Vanguard tracks it for me, I just have to select the boxes for which lots I want to sell. At the end of the year VG tells me what the proceeds and the basis was for the sale.

[audreyh1]

Quote:

Originally Posted by Letj Thanks. Wow, tracking all those reinvestments seems like a lot if you use the specific identification

A good brokerage will track it for you.

But I also stopped automatically reinvesting distributions a while ago.