There are different ways of reporting your crypto sales, and each of them has an impact on how much tax is applicable to you. These accounting methods include first in first out (FIFO), last in first out (LIFO), and highest in first out (HIFO). We shall discuss what each of these methods entails, with examples and the tax implications they carry.
How taxation of crypto works
The IRS, the tax-collecting arm of the United States, considers cryptocurrencies as assets. Therefore, they are taxed the same way as a piece of property that accrues value over time. This means that every time you sell a crypto coin at a profit, you create a taxable event.
The IRS charges 0-20% on capital gains for crypto held longer than 12 months or 10 – 37% on gains from crypto assets held for shorter than a year. However, if you sold your crypto at a loss, the IRS would offset your taxes up to a maximum of $3,000. Any losses above this amount will be carried forward to the following year.
Crypto accounting methods
As aforementioned, there are three accounting methods through which you can report the gains from your crypto assets.
This is the most common accounting method used by most investors. In it, the first coin you sell is assumed to be the first coin you bought. For better understanding, let’s look at an example. Assume you bought 1 ETH on the 28th of September for $2,800. On 1st October, you decide to buy one more ETH at $3,200. On November 1st, you sell one ETH for $4,000.
According to the FIFO strategy, the ETH you sold in November is assumed to be the coin you bought on 28th September. Therefore, the applicable capital gains tax on this transaction will be charged on $4,000 – $2,800 = $1,200.
As its nomenclature implies, the last in first out accounting method means the last coin you purchased will be the first one out of the door. For clarity, let’s adopt the same example from above. Using LIFO, we will be selling the ETH we bought in October at $3,200. This buying price is referred to as the cost basis. Recall that we sold our ETH in November for $4,000. Therefore, the capital gains tax on this transaction will be charged on $4,000 – $3,200 = $800. From this example, you can see that LIFO would have saved us $400 in taxable gains.
Highest in first out, as the name implies, refers to the accounting method where the coins with the highest cost basis are sold first. If we use the same example from above, HIFO will amount to the same tax as LIFO. However, if you have several coins in your wallet acquired at different prices, you’ll find that HIFO results in the lowest taxable return. Therefore, you can use HIFO as a tax minimization strategy as it results in the lowest capital gains in case you made a profit and the highest capital losses.
Specific identification method
The IRS issued guidance through which you can use the specific ID method to identify the cost basis of the crypto coins you are selling. With this method, you can identify the exact coin you are selling, as long as you have records of the below information:
- The purchase date and time of each coin.
- The cost basis of each coin at the time of purchase.
- The date and time of sale of each coin.
- The market price at the time of sale and the amount of money you obtained for each coin.
Choosing the best accounting method
We have established that LIFO and HIFO lead to significant tax savings as compared to FIFO. However, this is when the crypto’s price is in an upward rally. When prices are falling, FIFO would actually yield a lower tax burden than LIFO. What’s more, LIFO can help you avoid paying the higher rate on short-term capital gains, as it will enable you to hold your cryptocurrencies for longer. Most investors use FIFO as it is pretty straightforward. To use HIFO or LIFO, you would need to keep detailed records of your transaction history.
Universal vs. per wallet tracking
A frequently asked question when it comes to reporting crypto gains is how exactly to approach the reporting if your assets are in different wallets or exchanges. A universal application of these accounting methods means that all your crypto assets are placed in one queue regardless of their location, after which you apply your preferred accounting method. A per wallet application means you may have different accounting methods for each wallet. The truth is, if you can identify each of your coins by the criteria stipulated by the IRS guidelines, you can take your pick of a universal application of your preferred accounting method or a per wallet basis.
Changing accounting methods
The IRS allows investors to switch accounting methods on a year-to-year basis. However, the more you change, the higher the likelihood of making calculation errors. This may constitute suspicious activity, which would invite an audit by the IRS. Therefore, to be on the safe side, seek a professional opinion before exacting changes on your accounting methods.
The question of which cryptocurrency to sell first boils down to the taxes that are charged to you. The IRS charges capital gains tax on all proceeds from the sale or exchange of crypto assets. Depending on the accounting method you choose to report these gains, the taxable amount may vary, and so would your tax. These accounting methods involve selling the first crypto you acquired first (FIFO), selling the last crypto you acquired first (LIFO), or selling the crypto you acquired at the highest price first (HIFO). Further, if you’ve held your crypto for more than a year, they are charged tax at a much lower rate.