Crypto Tax Accounting Methods: FIFO, LIFO & HIFO Explained
|— Crypto is subject to tax, but you might be wondering how that tax applies, and what your options are.|
— When it comes to calculating tax on your crypto capital gains, you might be surprised to learn you have different tax accounting methods available to you – and it’s up to you and your accountant to select the one that is most advantageous.
— Here, ZenLedger – Ledger’s trusted crypto tax expert – explains the three tax accounting methods, FIFO, LIFO and HIFO, so you can understand the options available to you.
Like it or not, paying tax is part of owning crypto – but you might be surprised to learn of the different approaches available to you as you assess your crypto capital gains. In the latest installment of our crypto tax series, ZenLedger unpacks the basics of crypto tax accounting methods.
Your Accounting Method Options
Choosing a cost-basis accounting method is one of the most impactful decisions you’ll make from a tax standpoint. Different accounting methods yield different levels of capital gain – as well as different holding periods for that gain. Both of these have an effect on the final calculation of what tax you owe.
In the US, most people opt for the default system when it comes to calculating capital gains tax, something known as the first-in, first-out (FIFO) method. But alternative approaches also exis and could result in a lower overall tax bill for you. This is why it’s important to understand your different options, the trade-offs, and the benefits they entail.
In this article, ZenLedger recaps the significance of tax accounting methods when assessing tax liability on your crypto trading activity, and explains the different accounting methods you might use yourself.
NB. This article relates to the US tax system only. This piece is designed to give basic information only, and is not intended to serve as advice. For professional and accurate advice on your personal fiscal situation, please contact a qualified accountant trained in the legal system of your jurisdiction.
Crypto Taxes 101
For the purpose of this article, let’s focus exclusively on the US system. The IRS treats all virtual currencies as property subject to capital gains taxes. This means crypto traders and investors must pay capital gains taxes on any increase in value from the purchase price (profit, in other words).
You need two pieces of information to compute that profit:
- Cost Basis – The crypto asset’s original price, plus any fees, commissions, or other acquisition costs.
- Sale Price – The crypto asset’s sale price, minus any fees, commissions, or other selling costs.
So the amount of capital gain is simply the sale price minus the cost basis.
It might seem simple to compute your capital gains, but things can get tricky when you start combining multiple transactions. For example, suppose you purchased Bitcoin in multiple transactions over time, and at different prices, before selling a portion of your holdings. Which purchase price would you use as your cost basis – the price of the first or last Bitcoin you bought? This question would be dealt with by your choice of accounting method.
And there’s also another vector to consider. The amount of tax you pay on your gains depends on how long you’ve held that crypto (e.g., shorter or longer than one year), so cherry-picking which purchase price (and date) to use as your cost basis goes beyond the price itself, because it also impacts the “holding period” that will be applied to your capital gain, and therefore what level of tax you’ll pay on it.
Accounting Methods Explained: LIFO, FIFO & HIFO Explained
The IRS defaults to the first in, first out (FIFO) method when determining cost basis (we’ll come back to that), but it’s not your only option. You can also use alternative “specific identification” methods, which may be more advantageous to you, depending on your portfolio and the overall market. For example, you might choose a different cost basis calculation method such as last in, first out (LIFO) or highest in, first out (HIFO), which would enable you to match transactions in a way that generates a lower overall tax bill.
Let’s begin with a quick overview of each of these methods, explaining the logic that underpins it.
What is FIFO (First In, First Out)?
First-in, first-out, or FIFO, is the most popular (and default) way to determine cost basis. The “FIFO” method assumes you sell crypto assets chronologically, beginning with your earliest purchase. So for example, say you’re selling off a big part of your Bitcoin holdings – the price you purchased your first batch of Bitcoin for would be used as the first cost basis, followed by the price of the subsequent Bitcoin purchase, and so on.
Let’s say you did this in a rising market; using your earliest purchase (at the lowest price) would produce the biggest gain, but it also results in the longest holding period, increasing the odds that you would fall under long-term capital gains tax rates.
What is LIFO (Last In, First Out)?
Last-in, first-out, or LIFO, is another popular way to determine cost basis, and could be advantageous to you depending on the holding period it incurs, and the overall market conditions.
Instead of beginning with the crypto price and holding period of your first asset purchase, the “LIFO” method assumes you sell the last crypto asset you purchased first (and goes back in reverse chronological order to your first purchase). This is why it is known as last-in-first-out – because it assumes your first sale uses your most recent purchase to determine its cost basis.
Prioritizing your most recent purchase as your cost basis would clearly result in the shortest possible holding period – this makes you more likely to fall into the lower tax bracket that applies to short-term gains. LIFO might also result in a lower capital gain – for example, if the market has been constantly rising, using the most recent purchase makes for a higher initial cost basis, and therefore a lower final profit. But this element depends entirely on the market.
What’s important to understand is that starting with your most recent purchase is an option when determining your capital gains – it’s simply not the default.
What is HIFO (Highest In, First Out)?
And finally, let’s take a look at the HIFO method. The highest-in, first-out, or HIFO method, cherry-picks the highest remaining cost basis to match with each sale of the same asset, and descends in order of value. In theory, the “HIFO” method would minimize your realised gains, because you’re always using the highest initial cost basis to calculate your profit.
However, it’s also much harder to track transactions when using HIFO because they’re not in chronological or reverse-chronological order. Moreover, HIFO may trigger more short-term capital gains than the FIFO method, which has the potential to push your gains into a higher tax bracket.
In short, different tax accounting methods enable you, the taxpayer, to approach your portfolio in a way that benefits your circumstances, and they do so by playing with your cost basis. But it’s important to note that doing so will always have a knock-on effect when it comes to your holding period: so although a given method might minimize your “gain”, it may simultaneously push you into a higher overall bracket via the holding period. It’s up to you – and of course your accountant – to consider both of these things based on your specific circumstances.
CSV: Keep Track of Buying and Selling Records
Now we’ve covered the basics, you might be wondering where to actually visualize your crypto buying and selling information for yourself.
Tracking crypto transactions is simple if you use an exchange, like Coinbase, Binance, Kraken etc. In fact, most exchanges provide transaction data in something called a CSV (short for Comma Separates Values).
A CSV file serves as a detailed breakdown of your trading activities within a particular platform, along with data relating to when the activity took place. Downloading this document will enable you to see records all of your relevant activity for a given period – and this can be imported into your crypto tax management tool (such as ZenLedger) when the time comes to sort through your annual crypto trading activities and calculate your tax obligations.
Demystify the Complex
Your tax obligations can’t be properly assessed until a professional looks at your portfolio and takes the specifics of your circumstances into account. But understanding the building blocks of your tax calculation empowers you by demystifying the process and making you aware of your different options – from here you can discuss these in full with a professional.
ZenLedger is one of the leading crypto tax advisory services in the industry, and can offer bespoke advice on your portfolio. So know your options, stay on top of your tax deadlines and remember to include your crypto in your annual assessment – with that done, you’ll be pleasantly surprised to learn just how much help is available when it comes to keeping your crypto portfolio tax compliant.
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