How much you paid for your cryptocurrency (cost basis) greatly impacts the taxes you pay when you finally sell them. Understanding how the specific ID, first-in, first-out (FIFO), and highest first out (HIFO) affect your cost base could open up simple and easy to implement tax saving opportunities for crypto.
How do Crypto Taxes Work?
Cryptos are treated as property per IRS Notice. This means that every time you spend, exchange, or trade cryptocurrency, a taxable event is created. Three factors determine the amount of taxes you have to pay for a cryptocurrency transaction:
The market value of the currency at the time of the transaction (income)
How much you paid for the currency (base price)
The difference between (1) and (2). (Profit or loss)
Gains are subject to the applicable capital gains tax rate (0%, 15% or 20%) or the standard income tax rate (10% - 37%). Capital losses can be written off subject to capital loss limits.
Example
John sold 1 Bitcoin (BTC) for $ 12,000. He bought this BTC a few years ago for $3000. John's capital gain would be $ 9,000 ($ 12,000 - $ 3,000).
It goes without saying that if John has a higher cost base, the resulting profits and tax collection will be lower. You can optimize your cost base and reduce your tax bill using the correct batch identification methods (specific identification, HIFO, FIFO, and LIFO) appropriate for your scenario effectively for tax purposes.
Specific Identification Method
According to IRS guidelines (A39), you can use the specific identification method to calculate the cost base for each cryptocurrency unit you transact. Specific identification means that you are specifically identifying the exact units you are selling whenever you dispose of your crypto asset. To use this method, detailed records of ALL of the following information must be kept.
The date and time of purchase of each unit
Its basis and the fair market value of each unit at the time of purchase
The date and time of the sale, exchange, or disposition of each unit
Each unit's fair market value is sold, exchanged, or transferred, and the value of each unit's cash value or the property received.
Generally, reliable fiscal crypto software can meet this requirement, so there is no need to keep manual records.
Highest In, First Out (HIFO)
The highest in first out (HIFO) is a subset of the specific identification method mentioned above. The goal of HIFO is to minimize profits and maximize losses. When using HIFO, discard the coins with the highest cost base first. This results in lower profits (or higher losses) and general taxes.
For example, John bought 1 Bitcoin (BTC) with $3000 on 04.01.2017 and another BTC with $5000 on 05.05.2018. John sells 1 BTC for $ 10,000 in 2020. If you are using HIFO for tax purposes, you can allocate $ 5,000 as the cost base for the BTC sold. You could sell the BTC you bought on 05.05.2018, but it wouldn't have any tax impact if you choose to use HIFO. Using HIFO would result in capital gains of $ 2,000 less.
First in, First-out (FIFO)
If you do not have detailed records to meet specific identification requirements, you must use the first-in, first-out (FIFO) method to calculate the base price. This means that you are probably giving up the oldest coin in your wallet every time you transact your cryptocurrency assets.
Following the same example, on FIFO, John's gain would be $ 7,000, $ 2,000 more than on HIFO.
Basis Cost Tracking: Universal Application vs. Portfolio Application
One question that arises when applying tax batch identification methods is how exactly they should be applied to crypto-assets. Universal application means there is a queue for every coin in every wallet and exchange you have, and the tax lot identification method is applied universally. The wallet application means that you apply the method of identifying the desired tax batch for each wallet.
The answer to how the tax batch identification method should be applied can be inferred from logic. If you can specifically identify the units you are selling, meets the four criteria mentioned above, you can apply any tax lot identification method at your universal choice or through a wallet basis. Once the specific identification method has been reached, the limits set by wallets, exchanges, or coins does not matter; you can choose your currency from anywhere.
Modification of Tax Lot Identification Methods
Although there is no direct indication on this subject, changing the method of identifying the fiscal lot from one year to another would be done by specific identification. For example, you can switch from FIFO to HIFO, as long as you can specifically identify the selling units. Also, on tax forms, you are not required to indicate which method you use. You will only need to provide this information and validate your calculations if your tax return is revised.
In short, HIFO would result in the lowest tax value and be the preferred method of identifying the tax bundle for many crypto contributors. That being said, FIFO or Lowest In, First Out (LIFO) can also be useful if you are entering a low tax year and want to withdraw your positions subject to a lower tax rate.
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