Understanding Cost Basis Methods for Cryptocurrency
Now that mainstream businesses and investors widely accept cryptocurrencies, the profits made from them are also taxed and regulated. The taxes are charged based on the gains the investor has had, and that is where accountants introduce the concept of cost basis.
At its most basic, this refers to the original value of the crypto asset (meaning what the investor paid for it when they bought it), plus the fees paid to the crypto exchange platforms. This amount determines how much a person is liable for tax payments.
In this article, we will go over some of the most common cryptocurrency cost basis methods and how to choose the one that suits your needs as a crypto trader and a taxpayer. The main difference is between those investors who buy and store assets and those who speculate on the market.
What is Cost Basis in Cryptocurrency?
The cost basis is the foundation of calculating capital gains or losses and, therefore, of taxation. The amount you pay when you are buying crypto (plus the fees) is therefore your cost basis. The difference between the amount for which you sold crypto and the cost basis is what is taxed.
This is more complicated with crypto than with other assets, as the value of cryptocurrencies fluctuates based on market forces. For instance, if a person buys 1BTC for $10,000 and a year later buys 1BTC for $20,000 and then sells 1 BTC for $30,000, it matters which of the two they have sold, since the difference in value is not the same.
Cryptos are also more complex as:
- Many people use the same wallets and exchanges.
- Crypto prices sometimes change within a day
- Investors buy fractions of Bitcoins
- Investors can send cryptos between wallets without selling them in the process.
Why Cost Basis Methods Matter for Crypto Taxes?
The method by which crypto is valued is essential when it comes to deciding how much to pay in taxes. For an investor, the difference in cryptocurrency cost basis methods can mean a significant difference in the tax bill.
The three most common are FIFO (First In, First Out), LIFO (Last In, First Out), and Specific Identification (Spec ID). We will further break down all three and how they apply to the needs and practices of different kinds of crypto investors.
FIFO (First In, First Out) Explained
With this method, investors sell the first assets they buy before the later ones. There are many advantages of such a method, but also a few downsides.
For example, if you purchase 1 BTC at $5,000 and 1 BTC at $15,000 and then sell 1 BTC at $25,000, the tax authorities treat it as if you sold the first one you bought, giving you a $20,000 profit. This method increases reported gains in rising markets. It is the method used by the IRS and HMRC in the UK.
Advantages:
- This is the simplest method to follow and understand, and that is why many small-time traders use it.
- Many exchanges use it as a default method.
- There is less record-keeping to worry about and pay for.
Disadvantages:
- The biggest downside of this method is that the tax paid based on it will be higher than the amounts you would owe with other methods applied. This is especially noticeable in the bear market, when the values of crypto suddenly rise.
- Not all jurisdictions use this method, and depending on where you pay your taxes, the rules may vary, creating additional labor and record-keeping issues.
LIFO (Last In, First Out) Explained
Alternatively, you can calculate the cost basis by treating the last crypto you bought as the first one you sold. In most ways, it is the reverse of FIFO.
To use the same example:
If you purchase 1 BTC at $5,000 and 1 BTC at $15,000 and then sell 1 BTC at $25,000, tax authorities treat it as though you sold the last one you bought, giving you $10,000 in profits. This is the method that the traders will prefer as it results in paying less taxes.
Advantages:
- It reduces taxable gains, which in turn leads to paying less tax. It is especially useful in a bull market.
- The option is especially helpful for active traders who buy and sell many assets in a short period.
- It allows investors to hold assets for a longer period, thereby qualifying them for long-term capital gains tax.
Disadvantages:
- It can backfire in a bear market. Selling older coins later may lead to paying much more in taxes.
- Again, the option is not available in all jurisdictions. Depending on the investor’s location, the available options can vary, which in turn affects the amount they are obligated to pay.
Specific Identification (Spec ID) Explained
The third method allows investors to choose which exact crypto assets they are selling and, therefore, determine on their own how much they have made from the sale.
The requirements needed to use this method are much more complex than those of the other two cryptocurrency cost basis methods. The investors need to keep track of and store: purchase dates, amounts, wallet addresses, transaction IDs, and confirmations. They also need to have the exchange or tax software that supports tracking.
Advantages:
- This option gives investors more flexibility and helps them minimize taxes.
- It is a useful method for so-called tax-loss harvesting.
- It enables investors to align their sales with a broader strategy.
Disadvantages:
- This method requires much work in terms of record-keeping.
- Not every exchange supports it natively.
Tax-Loss Harvesting
Tax-loss harvesting is when you sell assets at a loss to cut your tax bill. The method that is best suited to this practice is therefore Spec ED, as it allows the investor to choose which crypto asset they are selling.
Simply put, the investor can strategically sell the coins purchased at the highest cost basis when the market dips. This strategy is much harder to execute under other cryptocurrency cost basis methods.
Investor Profiles and Best-Suited Cryptocurrency Cost Basis Methods
Different types of cost basis calculations suit different types of investors. Before deciding on a method, it is helpful to understand your current and future investor type. For the most part, there are three types of investors.
A long-term holder is someone who buys crypto assets and holds them in order to make long-term gains. FIFO is the best option for them.
Active traders are those who buy and sell crypto assets frequently, as their value fluctuates on the market. LIFO is the best option for them.
Strategic investors buy and sell specific cryptos based on their exact knowledge of them and insider industry experience.
A single investor can change and try all of these profiles throughout their career, depending on market conditions.
Switching Between Cryptocurrency Cost Basis Methods
Some inexperienced investors are confused about their ability to switch between different methods, even by those who understand the methods themselves. The ability to do so depends on the tax jurisdiction in which the investor operates. Most jurisdictions allow the change but set limits on how you can do it.
The IRS, for example, allows taxpayers to change the method once a year. Tax authorities fine investors who switch cryptocurrency cost basis methods mid-year and may also audit them.
Tools for Tracking
Manually tracking all of your transactions so that you can be aware of these dates and values soon becomes impossible. That is why even small-time investors and traders invest in software tools that track and organize data for the needs of tax authorities.
These tools automatically handle cryptocurrency cost basis methods by pulling data from exchanges and generating compliant tax reports.
Legal and Regulatory Considerations for Cryptocurrency Cost Basis Methods
Not all tax authorities are the same when it comes to rules on calculating cost basis. For instance, US authorities default to FIFO, sometimes use Spec ID, and rarely allow LIFO. The UK’s HMRC has specific “share pooling” rules that complicate matters.
Canada and Australia, on the other hand, allow all three cryptocurrency cost basis methods, but they have stricter rules as to how often an investor can switch between them.
Long-term vs Short-term Capital Gains
It is also important to make a distinction between the long-term and short-term capital gains. In the US, cryptocurrencies that are held in an account for less than a year and then sold generate short-term capital gains, while those held for more than a year are considered long-term. It changes the taxation policy, since tax authorities charge long-term gains at a lower rate.
FIFO often pushes older, long-term coins into the “sold” category, which can be beneficial in securing lower tax rates. Specific identification can also help investors pay their taxes by focusing on holding assets for a long time.
Best Practices for Crypto Investors
There are a few practices that the crypto investors should adhere to regardless of the method they decide to use. These include:
- Maintaining close records of crypto trading and having access to a comprehensive library of data. This helps the process and aids in disputing some findings made by the tax authorities.
- Having an investment strategy is important, as it helps you choose your method wisely with long-term goals in mind.
- Stay consistent with both your strategy and your method for at least as long as it takes to see the results within your tax obligations.
- Do not hesitate to use the latest technology to keep track of records and generate the tax documents needed. It reduces both errors and labor needed to pay taxes on crypto gains.
- Plan if you are expecting to sell some of your assets.
It also helps to use resources such as Webopedia to follow the news on the crypto authorities and regulations. The landscape is changing rapidly, particularly with the widespread adoption of cryptos and the increasing number of small-time investors turning to them as a means to plan for their financial future. This, in turn, led the governmental authorities to focus on crypto regulations more heavily.
Challenges with Decentralized Exchanges and Wallets
Decentralized exchanges and crypto wallets are relatively recent compared to centralized crypto exchanges, but they have quickly become an important part of the industry. Tracking the changing cost of crypto when traders use these platforms becomes even more challenging.
Heavy users of platforms like Uniswap or PancakeSwap make hundreds of trades in a year. Tracking the changing costs and profits becomes impossible without employing new tools and software solutions. Blockchain analytic tools, which automate this process, may be a solution.
Final Thoughts
Understanding cryptocurrency cost basis methods is essential for crypto traders since profits made in crypto are subject to taxation. There are three main methods—FIFO, LIFO, and Specific Identification—each with unique benefits and downsides.
When choosing which method to use, investors should consider their trading strategy and the duration they intend to hold their crypto assets. It is also possible to switch up methods, but different jurisdictions have rules on how and when to do it.
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