Creation date 04/23/08

The IRS (see Publication 550, Investment Income and Expenses) allows you to use several different accounting methods for identifying which shares to sell in a taxable account.  Specific identification of shares is the most favorable method for tax purposes, although it does impose an extra record-keeping burden.

In order to meet the IRS requirement, you need to tell the broker or other agent holding the shares which specific shares are being sold, and receive written confirmation within a reasonable time.  Vanguard investors report that the best way to ensure confirmation is to send Vanguard a secure Email with a text such as, "I am about to place an order to sell 234.456 shares of the XYZ Fund.  Please sell 123.456 shares purchased on 1/2/04 and 111.000 shares purchased on 2/1/04; please send confirmation of this Email."  You may also send a letter if you are making the sale by mail; if you do, enclose a second copy of the letter with a request that Vanguard return a copy to you.

The advantage of specific identification is that you can choose the shares to minimize your gains, maximize your losses, or realize long-term rather than short-term gains.  The savings are valuable when you need to sell, and specific identification also makes it much more likely that Tax Loss Harvesting will be possible.

For example, suppose you have 3000 shares of a fund, purchased at prices between $20 and $40 over a long period; your total investment was $90,000, so your average purchase price is $30.  Your most recent purchase, made last year, was 250 shares at $40.  You now want to sell 250 shares at a price of $40.  If you use first-in-first-out accounting (the IRS default), you sell the first 250 shares you purchased, which have a basis of $20, so your taxable capital gain is $5000.  If you use average-cost accounting (using the information provided by Vanguard), your basis in the shares is $30 a share, so your taxable capital gain is $2500.  If you use specific identification, you can choose to sell the shares bought last year, which have a basis of $40 a share, so your taxable capital gain is zero.

Similarly, suppose that you hold the same shares, and the fund has dropped in value to $30 a share.  If you use specific identification, you can choose to sell the shares bought last year for $40, claiming a $2500 capital loss.  If you do not use specific identification, you cannot harvest any loss; any sales will be of shares with an average price of $30 and thus no loss.