Lets say you want to sell out of a losing fund, but not entirely. Lets say you only want to unload half the shares you own. Which shares do you sell? Those you bought first? Those you bought last? An average of the two?
When making a partial sale, the IRS gives fund investors a choice of four options to determine which shares they intend to sell. Its not the shares that matter so much as the original price of the shares being sold.
The methods are: first in, first out (FIFO), in which you sell your shares in the order you purchased them; average cost single category, in which you average out the price of all your shares; average cost double category, in which you separate your shares into two groups, long-term holdings and short-term holdings, then calculate each groups average purchase price; and specific identification, in which you select, for tax purposes, which shares you intend to sell.
Which option you choose can make a big difference, Spiegelman said. Here, you should really consult an accountant.
Though FIFO works against investors in rising markets, the strategy will generally be the best option in a period of declining share values, Spiegelman said.
For instance, imagine you bought 10 shares of a fund at $20 a share. Six months later, you bought another 10 shares at $21. And six months after that, you bought another 10 at $22.
Then the market begins to tank. So, too, does your mutual fund. All of a sudden, your funds NAV per share falls to $20 and you want to sell a portion of your holdings.
Good Records Are Vital
With FIFO, you can sell the first 10 shares you bought at $20. That way, you wont incur capital gains--as you would had you averaged out your investment costs.
Spiegelman recommends using this method for selling funds that have fallen precipitously over a long stretch of time.
Selective identification has its advantages in rising markets. It can also be used by investors to lock in losses for funds that have made money.
For instance, if you bought 10 shares of a fund at $20 a share, another 10 at $25 and 10 more at $30, and then the funds net asset value per share drops to $29, you can actually lock in the losses for those 10 shares you bought at $30--despite the fact that youve still made money, overall, through this fund.
Be warned: Both FIFO and selective identification require good record-keeping on your part. When using selective identification, for instance, investors must notify their fund companies in writing, indicating which shares they wish to sell. Confirmation of the notification must also be kept for IRS reporting.
If you were fortunate enough to make money in stocks recently, but you dont want to take those gains this tax year, you may want to think about locking in those gains.
One way to do so, without actually selling a stock and triggering taxes, is through the use of collars. Lets say you own a winning stock and want to lock in the gains. You can do this by simultaneously buying a put option and selling a call option on that stock with similar strike prices--the price at which the options can be exercised.
A put is an option that gives you the right to sell a certain number of shares of the stock at a preset price by a certain date. A call gives you the right to buy a certain number of shares of a stock at a preset price, by a certain date.
Through puts and calls with a similar strike price, you in effect predetermine a range for how much more you can gain or lose on that stock in a set period.Investors need to be careful when using collars, though, because the IRS may object if you set the collar too tightly around the stocks price.
Spiegelman, for instance, says a 10% or so band on either side of the price is probably safe. For instance, if your stock is selling at $100 per share, you might consider buying a put at $90 and selling a call at $110.
On this and all the issues discussed in this column, dont neglect to consult a professional.