Some people may ask that I haven’t received any tax documents or 1099-B for my bitcoin trading of the year, does it mean that I don’t need to report it on my tax returns? The short answer to that question is no. The IRS addressed the taxation of cryptocurrency transactions in Notice 2014-21, which provides that cryptocurrency is treated as property for federal tax purposes. Therefore, general tax principles that apply to property transactions must be applied to exchanges of cryptocurrencies as well. Notice 2014-21 holds that taxpayers must recognize gain or loss on the exchange of cryptocurrency for cash or for other property.
When you sold a bitcoin, it will treat as the same as when you sold a share of stock, or a property. You will need to report the gain/loss of the trading on your tax returns.
Some may ask that the trading platform has never sent me tax documents, what should tell my tax preparer to report on my tax return? However, in this case, you would need to find out the cost basis (how much you paid to acquire your coin) on your own with assistance from tax professionals or crypto tax software. Your cost basis has a significant impact on your gains and the amount you will owe the IRS. There are several different methods of calculating your cost basis, and it’s important to know and understand the differences.
In this article, we will explore a different method of calculating the cost basis of the currency.
How are Cryptocurrency Gains Taxed?
Let’s use a very simple example. You brought one bitcoin in 2018 for $5, and you sold it in 2020 for $10,000. Your cost basis is $5, and your proceed basis is $10,000. The amount of gain or loss is the difference between the proceeds and the cost basis.
It would be easy to find out the cost basis if there is one or a handful of transactions. What if there is a thousand plus transactions? So we have to use the valuation methodology to find the cost basis
Choose Your Valuation Methodology
FIFO (first-in-first-out), LIFO (last-in-first-out), and HIFO (highest-in-first-out) are simply different methods used to calculate cryptocurrency gains and losses.
Capital gains using FIFO
First In, First Out is generally the most conservative approach. In an environment where cryptocurrency prices are generally rising, this method generally assumes that the earliest purchase also has the lowest cost basis.
Let’s use the following transaction as an example for FIFO method:
In this case, you have to sell the coin that was brought first. Let’s calculate the capital gains for #3 and #4 transactions.
· Capital gains for txn#3: 200 – 350 (txn#1 of $100 + ½ of txn#2) = -150 USD
· Capital gains for txn #4: 400 – 250 (1/2 of txn#2) = +150 USD
The final taxable gain for those transactions is $0
Capital gains using LIFO
With last-in first-out, the last coins that you acquired will become the first coins that you sell.
Let’s use the same following transaction as an example for LIFO method:
Last In First Out (LIFO) is the opposite of FIFO - here the most recently bought coins are sold first. Let’s calculate the capital gains for #3 and #4 transactions.
· Capital gains for txn#3: 200 – 500 (txn#2) = -300 USD
· Capital gains for txn #4: 400 – 100 (txn#1) = +300 USD
The final taxable gain for those transactions is $0
Capital gains using HIFO
Highest In, First Out and Last In, First Out are subsets of the Specific ID methods. They are similar in that both methods assume that the coins with the highest basis (cost) are the first to be sold, generally reducing taxable gains.
With highest-in, first-out (HIFO), you sell the coins with the highest cost basis (original purchase price) first.
In our example above, HIFO would actually lead to the same total gain as LIFO. However, in a scenario with hundreds or even thousands of trades, selling your highest-cost basis coins first can lead to significant tax savings.
What is the best cost basis method?
As you may be aware that all methods will give you the same capital gain by using our example above. However, this is due to the low number of transactions and the fact that all of the bitcoin was sold. Under real trading conditions the results of FIFO, LIFO and HIFO can be quite different.
Using HIFO or LIFO instead of FIFO can help you save money on your tax bill. LIFO can also shield you from having to pay the higher short-term capital gains rate by extending the holding period of your cryptocurrency.
Last But Not Least
With cryptocurrency tax reporting, the most crucial thing is to keep track of ALL your transactions and trades. You can do your crypto taxes with excel but be prepared to spend many hours on it - generating accurate crypto tax reports is a very time-consuming and elaborate process. We at SBS Tax and Consulting Services have built cryptocurrency tax software that allows you to easily generate tax reports using the accounting method of your choice.
If you are interested in finding out more about how crypto taxation works, please contact us with the crypto taxation consultation.