Normally, when one disposes of property, realized gain or loss is directly dependent upon basis. Being closely related to initial cost, basis is a tax attribute over which the taxpayer generally has little control at the time of the property’s disposition. An antique, for example, purchased by a casual investor in 1970 for $10,000 and sold in 1992 for $110,000 will produce a realized capital gain of $100,000.
Suppose, however, this casual investor also purchased 1,000 shares of IBX in 1970 and another 1,000 shares in 1980 and 1986. Assume that he paid $50, $75 and $200, respectively, for those shares, that IBX is now worth $100 per share, and that the investor now wish to sell some of this stock. By identifying the source of the particular shares being surrendered, the investor will be presented with the rare tax opportunity of unilaterally deciding whether to realize gain on this sale, or whether to realize loss.
Treasury Regulation 1.1012-1(c) provides generally that where the taxpayer purchased stock on different dates or at different prices, a sale of a portion of the taxpayer’s holdings will be charged against the earliest of such purchases. This means that if the investor in our example sold 1,000 shares of IBX on January 1, 1993, he would be deemed to sell shares purchased in 1970. Consequently, he would realize a capital gain of $50 on each share sold. However, an important exception exists where the taxpayer can identify the actual shares being sold: If the stock certificates relating to a particular purchase are delivered to the (new) purchaser, then the stock sold is charged to the stock purchase attributable to the certificates delivered. Thus, if the investor delivered the certificates from the 1986 purchase of IBX, then instead of realizing a capital gain of $50 on the sale, he would realize a capital loss of $100 on each share. Moreover, even if the investor had not taken possession of the stock certificates, but had instead left them in the custody of his broker, he could still benefit from the “specific identification” rule, by specifying to the broker at the time of the sale which particular stock certificates should be sold.
The tax planning opportunities presented by this rule are apparent. Suppose the taxpayer and his wife, as part of their estate tax plan, wish to make a gift of $20,000 each to their ten grandchildren, and wish to fund the transfer with the proceeds from the sale of the antique and 1,000 shares of IBX. By claiming the annual exclusion, the transfer can be made gift tax-free. By designating the IBX stock purchased in 1986 as that being sold, the transaction is also income tax-free. Although the sale of the antique will generate $100,000 in capital gains, that gain will be exactly offset by the $100,000 in capital losses produced by the sale of the designated IBX stock purchased in 1986. Of course, having sold the high basis stock, future sales will occasion less favorable tax consequences, since the taxpayer will have less desirable lots of stock from which to “cherry pick”. This prospect is mitigated somewhat by the possibility of his holding the remaining stock until his death, at which time it would receive a step up in basis to fair market value.