How to Handle Cryptocurrency Tax Basis Reporting: FIFO vs LIFO vs HIFO vs Specific Identification - 2024 - FEDERAL LAWYERS [2024] (2024)

How to Handle Cryptocurrency Tax Basis Reporting: FIFO vs LIFO vs HIFO vs Specific Identification

When it comes to reporting your cryptocurrency gains and losses on your taxes, one of the most important things is determining your cost basis – that is, how much you paid for the cryptocurrency when you acquired it. This allows you to calculate your capital gains or losses when you sell or trade your crypto. There are a few different methods the IRS allows for determining cost basis, including FIFO (first-in, first-out), LIFO (last-in, first-out), HIFO (highest-in, first-out), and specific identification. Let’s break down the pros and cons of each method.

FIFO (First-In, First-Out)

FIFO is the default method used by the IRS if you don’t specify another method. With FIFO, the crypto you’ve held the longest is considered sold first. This means your cost basis is determined by the oldest acquisition price.

Here’s an example:

• You bought 1 BTC on January 1, 2018 for $10,000
• You bought another 1 BTC on January 1, 2019 for $5,000
• On January 1, 2020 you sold 1 BTC for $15,000

Using the FIFO method, your cost basis for the sale is $10,000 since that was the first BTC you acquired. So you would have a capital gain of $15,000 – $10,000 = $5,000.

Some pros of using the FIFO method:

• It’s simple and straightforward. Since the oldest coins are sold first, you just take the purchase date and price to determine cost basis.
• Long-term gains are maximized. Since the oldest holdings are sold first, you’re more likely to meet the 1-year holding period for long-term capital gains treatment.

Some cons:

• You may end up with larger gains. Because FIFO uses the oldest purchase prices as cost basis, if crypto has appreciated over time, it results in larger gains being realized.
• Harder to track if you’re trading actively. For frequent traders with lots of buys and sells, it can be complicated to properly apply FIFO.
• Less flexibility. You don’t have control over which tax lots are sold, so you can’t strategically choose cost basis to minimize gains.

Overall, FIFO is simple to implement but lacks flexibility. It’s a decent default choice if you’re a buy-and-hold investor, but active crypto traders may want to consider other methods.

LIFO (Last-In, First-Out)

With LIFO, the opposite of FIFO applies – the most recently acquired crypto is considered to be sold first. The cost basis is determined by the newest acquisition price.

For example:

• You bought 1 BTC on January 1, 2018 for $10,000
• You bought another 1 BTC on January 1, 2020 for $15,000
• On January 1, 2021 you sold 1 BTC for $20,000

Using LIFO, your cost basis would be $15,000 since that was the last BTC you acquired before the sale. Your capital gain would be $20,000 – $15,000 = $5,000.

Some potential benefits of using LIFO:

• Results in lower gains. Since newer, higher cost basis is used, it minimizes realized gains.
• Allows “cherry-picking” of tax lots. You can strategically choose which tax lots to sell to achieve optimal tax results.
• Can better match current values. Since newer acquisition prices are likely closer to current values, cost basis may more closely align with sale value.

Some downsides of using LIFO:

• More complex tracking is required. You need to carefully track purchase dates and prices to ensure LIFO is applied accurately.
• Difficult with long-term holdings. If you want long-term gains treatment, you may not have held more recent acquisitions for 1+ year.
• Not allowed for securities. LIFO is only allowed for cryptocurrency by the IRS, not traditional securities.
• Higher audit risk. LIFO is more likely to draw IRS scrutiny since it aims to minimize gains. Proper record-keeping is essential.

LIFO can provide great flexibility in strategically choosing tax lots and minimizing gains. But it also comes with greater complexity. It works best for active traders with specific identification capabilities.

HIFO (Highest-In, First-Out)

HIFO is similar to LIFO, but instead of selling the most recently acquired crypto first, you sell the coins with the highest cost basis first. This results in realizing the smallest possible capital gains.

For example:

• You bought 1 BTC on January 1, 2018 for $10,000
• You bought another 1 BTC on January 1, 2020 for $15,000
• On January 1, 2021 you sold 1 BTC for $20,000

With HIFO, your cost basis is the highest acquisition price of $15,000, so your capital gain is $20,000 – $15,000 = $5,000.

Some advantages of HIFO:

• Minimizes capital gains. By selectively selling the highest cost tax lots first, you realize the smallest possible gains.
• Allows “cherry-picking” tax lots. You can strategically select which coins to sell to optimize tax treatment.
• Accounts for price fluctuations. Basis reflects the highest price you paid, even if prices dropped later on.

Some disadvantages:

• More complex tracking. You need to be able to accurately track acquisition dates and prices to pick highest cost lots.
• Typically requires software. It can be extremely difficult to manually apply HIFO across numerous transactions.
• Higher audit risk like LIFO. The goal of minimizing gains may increase IRS scrutiny.
• Long-term gains treatment may be lost. High-cost coins may not have been held for 1+ year.

HIFO is one of the most taxpayer-friendly methods, but also requires robust tracking and reporting capabilities. It’s generally recommended to use crypto tax software if you want to use HIFO.

Specific Identification

Specific identification allows you to cherry-pick the exact tax lots that you want to sell, regardless of the acquisition date, cost basis, or holding period. This gives you maximum control and flexibility.

For example:

• You bought 1 BTC on 1/1/18 for $10,000
• You bought 1 BTC on 1/1/20 for $15,000
• You bought 1 BTC on 1/1/21 for $20,000
• On 12/31/21 you sold 1 BTC for $25,000

You can specifically choose to sell the coin you acquired on 1/1/18 for $10,000. This would yield a capital gain of $25,000 – $10,000 = $15,000.

Benefits of specific identification:

• You have total control over which tax lots are sold to optimize gains/losses.
• Can maximize both long-term and short-term gains/losses as tax-efficiently as possible.
• Allows perfect matching of acquisition and sale transactions.

Downsides of specific identification:

• Most complex tracking. Requires detailed record-keeping with acquisition dates, prices, and sale matching.
• Typically requires software. Extremely difficult to manage manually.
• Higher audit risk like LIFO/HIFO due to cherry-picking.

As you can see, specific identification is the most flexible method, but also requires the most legwork. It’s generally only recommended for active traders who use tracking software.

Choosing the Right Method

When deciding which accounting method to use for your crypto, consider factors like:

• Your volume of transactions – are you an active trader or buy-and-hold investor?
• Whether you want to maximize long-term gains or minimize short-term gains.
• Whether you use any crypto tax software to help track basis.
• How much effort you’re willing to put into record-keeping and tax planning.
• Any other crypto tax planning strategies you want to coordinate with.

You can actually change your accounting method each year if you want. So it may make sense to start with FIFO for simplicity, but later switch to a more advanced method as your trading volume increases.

The most important thing is maintaining excellent records with details of each transaction – dates, cost basis, sale proceeds, etc. This ensures you have the information required to accurately calculate gains and losses under any accounting method.

Other Tips for Crypto Tax Reporting

Here are some other quick tips to make your crypto tax reporting as smooth as possible:

• Use crypto tax software – this automates gain/loss calculations across exchanges.
• Export transaction histories from each exchange you use.
• Maintain detailed records of all transactions, including gifts, mining, income, business purchases, etc.
• Mark your calendar for tax deadlines – both for filing returns and making quarterly estimated payments.
• Consider working with a crypto tax professional if you have a high volume of transactions.
• Review the tax implications before making any crypto investment decisions.
• Don’t forget about state tax returns in addition to your federal return.

Key Takeaways

• FIFO is the default cost basis method, but others like LIFO, HIFO, and specific identification allow more flexibility.
• More advanced methods can minimize gains and allow strategic tax lot selection, but require more effort.
• Maintain detailed records and consider using crypto tax software to simplify reporting.
• Choose the accounting method that makes the most sense for your trading volume, tax goals, and record-keeping abilities.

Properly calculating and reporting your crypto gains and losses takes some work. But with the right planning and preparation, you can maximize your tax savings and avoid issues with the IRS. The key is finding the right accounting method for your unique situation.