How much you paid for your cryptocurrency (the cost basis) has a major impact on the taxes you pay when you eventually sell them. Understanding how Specific ID, First in, first out (FIFO) & Highest in, first out (HIFO) affect your cost basis could unlock straight forward, easy to implement tax saving opportunities for crypto users.
How Crypto Taxes Work?
Cryptocurrencies are treated as property per the IRS Notice 2014-21. This means that every time you spend, trade or exchange cryptocurrency, that creates a taxable event. How much taxes you have to pay on a cryptocurrency transaction is determined by three factors:
- Market value of the coin at the time of the transaction (Proceeds)
- How much you paid for the coin (The cost basis)
- The difference between (1) & (2). (Gain or loss)
Sam sold 1 Bitcoin (BTC) for $10,000. He purchased this BTC a few years ago for $2,000. Sam’s capital gain would be $8,000 ($10,000 – $2,000).
Needless to say that if Sam has a higher cost basis, the resulting gain and the tax bill would be lower. You can optimize your cost basis and reduce the tax bill by properly using tax lot ID methods (Specific ID, HIFO, FIFO & LIFO) that suit your scenario. The Tax lot ID method dictates which cryptocurrency units you are deemed to be selling (not actually selling) for tax purposes.
Specific Identification Method
According to the guidance issued by the IRS (A39), you can use the Specific ID method to figure out the cost basis of each unit of crypto asset you are disposing of. Specific ID means that each time you are disposing of your crypto asset, you are specifically identifying exact units you are selling. In order to use this method, you must keep detailed records of ALL the following information.
(1) the date and time each unit was acquired
(2) your basis and the fair market value of each unit at the time it was acquired
(3) the date and time each unit was sold, exchanged, or otherwise disposed of
(4) 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.
Typically, a reputed crypto tax software can fulfill this requirement so you don’t have to keep manual records.
Highest In, First Out (HIFO)
Highest in, first out (HIFO) is a tax friendly subset of the aforementioned Specific ID method. The goal of HIFO is to minimize gains and maximize losses. When you use HIFO, you first dispose of the coins with the highest cost basis. This leads to the least amount of gains (or highest amount of losses) and overall taxes.
For example, Sam purchased 1 Bitcoin (BTC) at $3,000 on 2/5/2018 and another BTC at $5,000 on 3/5/2018. He sells 1 BTC for $10,000 in 2020. If he uses HIFO, for tax purposes, he can assign $5,000 as the cost basis for the BTC he sold. In reality, he could be selling the BTC he purchased on 2/5/2018 but it has no impact on taxes if he chooses to use HIFO. Using HIFO would result in $2,000 less capital gains.
First in, First Out (FIFO)
If you don’t have detailed records to meet the Specific ID requirements, you have to use the First in, first out (FIFO) method to calculate your cost basis. This means each time you dispose of your crypto assets, you are presumably disposing of the oldest coin you had in your wallet.
Going with the same example, under FIFO, Sam’s capital gain would be $7,000, $2,000 higher than HIFO.
Cost Basis Tracking: Universal Application Vs. Per Wallet Application
A question that arises when applying tax lot ID methods is how exactly they should be applied to crypto assets. The Universal application means that there is one queue for each coin across every wallet and exchange you have and the tax lot ID method is applied universally. Per wallet application means that you apply your desired tax lot ID method for each wallet.
The answer to how tax lot ID method should be applied can be inferred by logic. If you can specifically identify the units you are deemed to be selling by meeting all the four criteria mentioned above, you could apply any tax lot ID method of your choice universally or per wallet basis. In essence, once the Specific ID method is achieved, boundaries set by wallets, exchanges or coins do not matter; you can pick your coin from anywhere.
Changing Tax Lot ID Methods
Although there is no direct guidance on this issue, changing the tax lot ID method from year to year would be accomplished by using Specific ID. For example, you could go from FIFO to HIFO as long as you can specifically identify the units you are selling. Moreover, in the tax forms, you are not required to report which method you are using. You will only have to provide that info and substantiate your calculations if your tax return gets examined.
In summary, HIFO would result in the least amount of taxes and be the preferred tax lot ID method for many crypto taxpayers. With that said, FIFO or Lowest in, First out (LIFO) could also come in handy if you are moving to a low tax year and want to cash out your positions subject to a lower tax rate.
Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.