Asset Disposal Methodology: FIFO, LIFO and Why You Need to Pick One for Your Fund
Articles by: Richey May, Sep 12, 2022
While capital assets are an essential part of doing business in any industry, it’s also important to remove them from your accounting records — aka “asset disposal” — when they’re no longer useful. Fully depreciated assets or those sold with a gain or loss need to be disposed of and accounted for to keep your books clean.
In the fund management world, no one accounting method will meet all your needs. But knowing what factors to consider can help you make the right choice.
Fund managers use various disposal methodologies, from FIFO and LIFO to High-Cost, Low-Cost and Specific Shares Identification. There are pros and cons to each, so picking the right one for your business is not a straightforward proposition. Start by asking yourself these three questions:
- What’s your trading strategy (long or short)?
- Is it more important to minimize gains/losses now versus later?
- How long does the fund want to defer gains/losses?
The key to choosing the right asset disposal method is proper planning and checking the box for the items most important for your fund. Here’s what you need to know.
What is FIFO and where is it practical? FIFO, short for First In, First Out, is the default method for most brokers. The concept is simple: Assets purchased or acquired first are disposed of first. For example, if you purchased 10 shares of XYZ for $25 on March 1, bought 10 more shares for $35 two months later, then sold five shares for $50, your gain would be reported as $25 per share based on the cost basis of the first tax lot purchased. Long-term investors benefit most from FIFO’s longer holding period. When you hold a security for over a year, you get preferential tax treatment on gains, and choosing FIFO increases your chances of the sold security falling into the long-term capital bucket. If the holdings have appreciated and the assets first in have unrealized gain, FIFO recognizes more gain now versus later.
Is LIFO the appropriate method for my fund? LIFO, or Last In, First Out, comes with its own advantages. Note that you must specifically elect this method with your broker and the IRS when reporting your gains. Using the FIFO example, the sale of five shares for $50/share would trigger a gain of only $15/share with LIFO. While you’re less likely to obtain lower tax rates from a long-term holding period, LIFO helps high-volume traders minimize their tax liability by offering higher short-term tax rates. For a position that has appreciated over time, LIFO defers gains from older positions held since the first position entered is the last position to be closed.
Is High-Cost best for me? High-Cost disposal methodology disposes of the assets held with the highest cost. This methodology may help reduce taxable gains, since the first assets disposed are those with the highest cost. If selling assets at a loss, this methodology could help increase losses recognized. The downside of High-Cost is that it doesn’t consider the holding period of the assets. In a growth market, the highest cost might apply to the most recently purchased assets. In a declining market, the assets held the longest could be the first to get disposed.
When does Low-Cost make sense? With Low-Cost, the priority of disposition relies on the lowest cost of the assets held. You might choose this methodology to prioritize realizing gains for your investors. This methodology could also reduce the amount of loss you realize when you sell assets. However, similar to High-Cost, this methodology does not consider the holding period of the assets. A market decline or growth period could affect whether your fund realizes gains on assets held the longest or assets held the shortest (long-term versus short-term).
Why choose Specific Share? This methodology offers the most flexibility in deciding which assets to dispose of. If you want to prioritize the lowest gains one day, you can pick assets that will produce the lowest gains. If you decide the next day that you want to prioritize harvesting losses, you can dispose the assets that will generate losses. Specific share methodology gives traders the flexibility to select what’s most important at the time of the sale (i.e., lowest gains, highest losses, long-term versus short-term holding period, etc.). However, this flexibility comes at a cost. Specific share is the most labor-intensive methodology since it requires specific share identification with every trade. That might be fine if you have a small number of holdings and your strategy is long, but it could be a drawback for very active trading and lots of tax lots.
Remember, there’s no one-size-fits-all methodology when it comes to asset disposal, but there are important factors to consider. For additional insights or questions about the services Richey May provides to the alternative investments industry, please contact Steve Vlasak.