Senate Tax Reform Bill Restricts Choice of Which Shares to Sell First

November 27, 2017

The Senate draft of the Tax Cuts and Jobs Act would require sellers of stock in any one company to dispose of shares in the order they were acquired. Sellers could no longer designate which blocks of their shares they wished to sell to minimize capital gains taxes. The new rule would be “first in, first out” (FIFO).

Under current law, shareholders who purchased stock at different times at different prices may select which blocks of stock to sell. To minimize current capital gains, the shareholder might select the stock bought at the highest price. To “harvest” losses to offset other gains, the shareholder might select the stock with the lowest cost basis. Mutual funds use the same methods to reduce, or smooth out, the reported capital gains distributions for their shareholders as they rebalance their portfolios.

For example, suppose someone bought 100 shares of the XYZ company at $25 a share in 1990, bought another 100 shares of XYZ at $50 a share in 2005, and now wishes to sell 100 shares of XYZ at the current price of $100 a share. Under current law, the shareholder could designate the second block of shares to be sold, for a gain of $5,000. Under the Senate provision, he would have to report the first block as the one sold, for a gain of $7,500. The result is a back-door increase in capital gains tax rates.

Older savers would lose some of the advantage for their heirs of step-up in basis at death if they must sell the first shares first. They would feel locked in or might sell other securities to avoid selling any of the holdings in which old gains are present. Being pressured to keep shares one does not want and sell those one would rather keep would discourage rebalancing, make shareholding less attractive, and raise the cost of capital a bit.

Taxation of capital gains is a form of double taxation. Being able to select which shares to sell, deferral of gains until realization, and step-up in basis at death reduce the double taxation. Forcing the use of FIFO acts to increase the double taxation and works against all three protections.

The back-door capital gains tax hike due to the FIFO provision is not offset by any reduction in the tax rate on capital gains or dividends in the individual side of the reform. The bill reduces the corporate tax rate, which does reduce the double taxation of corporate income from the corporate side. The FIFO provision takes back a small portion of the improvement. The goal should be to erase the double taxation altogether. FIFO runs counter to the cost-of-capital reduction from the corporate rate cut.

The Joint Committee on Taxation estimates that the provision would raise a total of $2.7 billion over ten years. The very low revenue score may reflect JCT estimates that raising taxes on capital gains from current levels has historically discouraged the taking of gains, producing little or no revenue for the Treasury.[i] Although the provision is estimated to raise only a small amount of money, it will affect the management of several trillion of dollars of individual and mutual fund assets. The inconvenience-to-revenue ratio seems very high.

The Senate tax reform bill is a major growth generator, but some of the provisions go in the other direction. This FIFO requirement is one.


[i] The Tax Reform Act of 1986 raised capital gains tax rates substantially. Realizations collapsed, and revenue fell well below pre-1986 levels for a decade as a share to GDP until the rates were brought back to pre-1986 levels in 1997.


Related Articles