As with any investment, if you’re buying, selling, or trading cryptocurrencies, any gains you make will need to be reported to the IRS. Because of the astronomical rise of cryptocurrency prices over the past few years, many early adopters have made huge gains — and the IRS wants their cut.
Depending on how long you held the currency, gains are taxed either at capital gains rates or at ordinary income tax rates. Losses can be written off up to $3,000 per year, with the ability to carry forward additional amounts.
Of course, your cost basis (how much you paid to acquire your tokens) has a significant impact on your gains and the amount you’ll owe the IRS.
There are several different methods of calculating your cost basis, and it’s important to know and understand the differences. (There are also forms from certain platforms, like Coinbase.) The IRS has given crypto holders and traders a certain amount of leeway in determining the method with which they calculate their own cost basis. Because your calculation methodology actually determines the magnitude of your gains, selecting the right one can create major tax savings.
You may have seen the acronyms FIFO, LIFO, and HIFO (the latter two are basically a subset of Specific ID) in association with cryptocurrency and tax. Let’s take a look at what they mean, and what they mean for you.
How are Cryptocurrency Gains Taxed?
Bitcoin (BTC), Ethereum (ETH), and other cryptocurrency tokens are considered property in the eyes of the IRS. As such, any transaction involving crypto is essentially a taxable event.
For example, if you buy a coffee or a pizza with a tiny amount of BTC you have essentially “sold” that amount of crypto and must report the gain (or loss) as part of your income. When filing your annual return, you then pay taxes on the gains and to a certain extent can deduct the losses.
The amount of gain or loss is the difference between the proceeds (market value at the time of the sale) and the cost basis (what you paid to acquire the coins).
At the end of the tax year, your capital gains will be subject to either capital gains tax rates or ordinary income tax rates. Whether it’s considered short- or long-term capital gains depends on how long you held the coins.
Choose Your Valuation Methodology
What do the acronyms mean for you? LIFO, FIFO, HIFO, and specific ID are all different methodologies for evaluating your cost basis when selling crypto. This is done by theoretically determining which coins you are disposing of.
While there are four methods listed, there are essentially only two:
- First in, first out (FIFO)
- Specific ID (of which LIFO and HIFO are subsets.)
The methodology you choose can have a major impact on your tax liability. While you are able to choose whichever method is best for you, your eligibility depends on your record keeping. For anything besides FIFO, you must keep extremely detailed records — either manually or through the use of software.
FIFO – the most conservative
First In, First Out is generally the most conservative approach. In an environment where cryptocurrency prices are generally rising, this method generally assumes that the earliest purchase also has the lowest cost basis.
Disposing of the first in gives you the highest taxable gain and is generally considered the safest approach because it reduces the risk of underpayment penalties from the IRS.
It’s important to note that you must choose this methodology if you’re unable to meet the specific ID due to a lack of detailed records.
Specific ID Methods
The Specific ID methods assume that each time you buy, sell, or trade you are doing so with a specific unit of cryptocurrency. Choosing this approach gives you the most flexibility with your tax strategy, but it is the most complex.
According to the IRS, in order to go this route, the following information must be available for each trade:
- The date and time each unit was acquired,
- Your basis and the fair market value of each unit at the time it was acquired
- The date and time each unit was sold, exchanged or otherwise disposed of
- The fair market value of each unit when sold, exchanged or disposed of, and the amount of money or the value of property received for each unit.
Fulfilling these criteria requires you to keep track of your coins and transactions either through special crypto tax software or through manual record-keeping (which can be challenging).
HIFO and LIFO
Highest In, First Out and Last In, First Out are subsets of the Specific ID methods. They are similar in that both methods assume that the coins with the highest basis (cost) are the first to be sold, generally reducing taxable gains.
- In December 2019, Felix bought 3 ETH for $900.
- In November 2020, he purchased another 3 ETH for $1800.
- In December 2020 he sold 3 ETH for $2000.
Using HIFO (and LIFO) he would have a capital gain of $200 ($2,000 – $1,800).
On the other hand, if Felix’s record-keeping was sloppy and he was forced to choose FIFO his capital gains would be $1,100 ($2,000 – $900)
The ability to choose the HIFO method would reduce Felix’s capital gains (and his tax liability) significantly.
Is it Possible to Change Methods?
Unlike some tax elections, where you must live with your selections permanently (or until you file new paperwork), there is currently no requirement to stick with one valuation method. As long as you can specifically identify which units or coins you’re selling, it’s not an issue to change from HIFO to FIFO, depending on how it suits your situation.
For example, if you know your overall income will be lower it might make sense to choose the FIFO method in order to take some gains at a lower tax rate, and increase your average cost basis. The only caveat is that you must be able to justify your calculations if you get audited and the IRS wants a closer look.
Talk to your CPA
As with all complicated financial and tax topics, it’s best to talk to a CPA. At Founders, we specialize in crypto tax situations. Get in touch today about choosing a strategy that works best for you and your situation. Together, we can define a way forward in order to minimize your long-term tax liability.