Investment and Asset Allocation — Using Tax-Efficient Lots When Rebalancing Taxable Accounts

Why tax-efficient lot selection matters

When you rebalance a taxable investment account you typically sell assets that have outperformed and buy assets that have underperformed. Those sales in a taxable account can trigger capital gains tax. Over time, repeatedly realizing gains on the wrong lots can materially reduce portfolio performance. Using tax-efficient lots helps you control the timing and size of taxable events so you keep more after-tax return in your portfolio.

IRS guidance treats lot selection and basis reporting carefully. Brokers report basis to the IRS for most securities and offer lot-selection options, but your chosen method must be documented and executed at the time of sale (see IRS Publication 550: Investment Income and Expenses) (https://www.irs.gov/publications/p550).

Key lot methods and tax consequences

• Specific identification (including HIFO — highest-in, first-out): You name exactly which shares to sell. This is the most tax-efficient when used intentionally, because you can select lots with the highest cost basis or those held more than one year to secure long-term capital gains treatment.
• FIFO (First In, First Out): If you do not specify, many brokers default to FIFO. That often realizes larger gains because the oldest lots (usually with the lowest cost) are considered sold first.
• Average cost: Allowed for mutual funds and certain dividend reinvestment plans, average cost simplifies tax reporting but eliminates the ability to cherry-pick advantageous lots for tax reasons.

Note: HIFO is effectively a specific-identification strategy (choose the lots with the highest basis first) and can be implemented only if your broker supports specific-ID and you follow their documentation process.

Practical, step-by-step approach to using tax-efficient lots when rebalancing

1. Rebalance in the right order

• Use tax-advantaged accounts (IRAs, 401(k)s) first to fix big allocation drifts without tax friction.
• Then consider trading within taxable accounts using lot selection.
• If you need new cash to rebalance (contributions), direct those to underweight asset classes inside taxable accounts to reduce sales.

1. Review cost-basis and holding periods

• Pull lot-level cost basis from your broker or custodial statements. Confirm which lots are short-term (<= 1 year) vs long-term (> 1 year) because short-term gains are taxed at ordinary income rates, while long-term gains use preferential capital gains treatment (IRS Topic No. 409).

1. Choose lots with tax-efficient objectives

• Minimize gains: sell highest-basis lots (HIFO) or lots with small unrealized gains.
• Maximize long-term treatment: prioritize lots held more than 1 year.
• Harvest losses: sell loss lots to offset realized gains (observe the wash sale rule below).

1. Document the selection at the time of sale

• Specific-ID requires telling your broker which lot(s) you’re selling when you place the order; many brokers provide checkboxes or lot-selection fields on online trade screens.
• Keep a confirmation and the trade ticket—this is required if the IRS challenges your basis choice (see IRS Pub 550).

1. Run the numbers before executing

• Use pre-trade modeling: estimated tax on the realized gain × net proceeds lost to tax compared with the rebalanced expected value. Sometimes the after-tax benefit of rebalancing now is less than the cost.

1. Use complementary strategies

• Tax-loss harvesting: if you have loss lots, sell them to create losses that offset gains. Remember the 30-day wash sale rule: repurchasing a substantially identical security within 30 days before or after the sale disallows the loss (IRS Publication 550).
• Gifting or donating appreciated securities: consider donating highly appreciated shares to charity to avoid triggering capital gains (donors can generally deduct the fair market value subject to AGI limits; consult tax advisor).

Numerical example

Suppose you own 3 lots of Fund A in a taxable account:

• Lot A: 100 shares bought at $50 (basis = $5,000), held 4 years
• Lot B: 100 shares bought at $80 (basis = $8,000), held 2 years
• Lot C: 100 shares bought at $120 (basis = $12,000), held 9 months

Current value per share = $150; total value = $45,000. You need to sell $15,000 to rebalance.

• If you use FIFO, you would sell Lot A first: 100 shares × $150 = $15,000, realized gain = $10,000 (long-term) on that sale.
• If you use HIFO/specific-ID, you would sell Lot C first: 125 shares needed? But Lot C has only 100 shares. You could sell Lot B or a portion combining high-basis lots to realize smaller gains or even a loss if prices have changed.

Choosing Lot C (the short-term lot) would realize short-term gain taxed at ordinary income rates, so it’s usually better to avoid selling short-term lots except to realize losses or meet specific cash needs. HIFO typically sells Lot C only if it has the highest basis; choose the lots that align with your tax objectives.

This is why modeling pre-trade is essential: different lot choices produce very different tax and after-tax allocation outcomes.

Wash sale and other tax traps to avoid

• Wash sale rule: If you sell a loss lot and replace it with a substantially identical security within 30 days (before or after), the loss is disallowed and added to the basis of the new shares. This can complicate frequent rebalancing strategies that try to maintain exposure.
• Broker defaults: If you don’t specify an alternative, the broker’s default method (often FIFO) applies and your tax outcome may be worse.
• Recordkeeping gaps: If lot selection isn’t properly recorded when the trade is executed, the IRS may not accept your intended basis allocation.

Refer to IRS Publication 550 for details on the wash sale rule and lot identification requirements (https://www.irs.gov/publications/p550).

Tactical considerations and planning

• Tax-bracket timing: If you expect to be in a lower tax bracket next year or in retirement, delaying realization of gains can be sensible. Conversely, if you will be in a higher bracket, accelerate tax-efficient lot sales sooner.
• Use municipal bonds or tax-efficient muni funds inside taxable accounts for income that’s exempt from federal tax; see our article on “Tactical Use of Municipal Bonds in Taxable Portfolios” for context (https://finhelp.io/glossary/tactical-use-of-municipal-bonds-in-taxable-portfolios/).
• Embrace partial rebalancing: Instead of selling an entire overweight position, sell only enough to restore target allocation. Combine with lot selection to prioritize lots with smaller gains or long-term status.
• Consider donating appreciated securities or using a donor-advised fund (DAF) to receive a charitable deduction while avoiding capital gains.

Execution checklist (practical controls)

• Pull lot-level statements from your custodian at least quarterly.
• Set default lot-selection preferences with your broker if you want to avoid surprises; periodically verify that your broker is following your instructions.
• Run pre-trade tax-impact estimates for material rebalances (>$10k or other threshold you set).
• Keep trade confirmations and notes about lot selection as part of your tax records.

When to call an advisor

In my practice as a CPA and CFP®, I find the biggest mistakes come from treating taxable and tax-advantaged accounts the same during rebalancing, or from failing to document specific-ID selections. If you have concentrated positions, anticipate large taxable events, or manage multiple brokerage accounts, working with a tax-aware financial planner or CPA can materially improve after-tax returns.

For additional reading on rebalancing strategies and timing, see our glossary pieces on Rebalancing and Rebalancing Strategies and Timing Considerations.

Sources and further reading

• IRS Publication 550, Investment Income and Expenses (Wash sales, basis, lot identification): https://www.irs.gov/publications/p550
• IRS Topic No. 409, Capital Gains and Losses: https://www.irs.gov/taxtopics/tc409
• Consumer Financial Protection Bureau: general investor tools and protections: https://www.consumerfinance.gov/

Professional disclaimer: This article is educational only and does not provide personalized tax or investment advice. Tax rules can change; consult your CPA or tax attorney before executing material taxable trades.