Prior to the new 2019 IRS cryptocurrency tax guidance, it wasn’t explicitly clear which costing method you were supposed to use when calculating your cryptocurrency capital gains and losses for your tax reporting. Because of this uncertainty, the majority of traders in the past used FIFO (first-in first-out) as this was deemed to be the most conservative approach. The new 2019 guidance officially declares that specific identification methods like LIFO (last-in first-out) or HIFO (highest-in first-out) can be used provided that you can specifically identify particular units of cryptocurrency. This is a very good thing for cryptocurrency traders, and it provides them with a great tax saving opportunity.
According to the IRS guidance, you can specifically identify a unit of cryptocurrency if you have records containing the following information:
Cryptocurrency tax software like CryptoTrader.Tax automatically tracks all of this information for you, so you can use specific identification costing methods like HIFO or LIFO with confidence. All of this information will be included in your full Audit Trail Report that CryptoTrader.Tax exports to all of its users.
Are you confused how cryptocurrency taxes work? You can checkout our Complete 2019 Guide on Crypto Taxation for a complete breakdown.
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. From an accounting standpoint, each method “sells” specific assets in a different chronological order which ultimately leads to a different total capital gains or loss numbers on paper. We will break down how each method works below.
Using first-in-first-out works exactly how it sounds. The first coin that you purchase (chronologically) is the first coin that is counted for a sale.
You buy 10 ETH on Coinbase on January 15th, 2018 for $500 each. Two weeks later, you buy 3 more for $600. In June 2018, you sell 5 ETH for $3,000 total.
To calculate your capital gain on this transaction, you need to know at what price you purchased those ETH.
Because we are using FIFO, the purchase price of those 5 ETH that you sold in June will be $2,500 as each one was purchased for $500 in the first group that you bought (5 * $500).
Doing the math then:
$3,000 (selling price) - $2,500 (purchase price or cost basis) = $500 capital gain.
As you can see, by using FIFO, we sell the coins that we purchased first. First in, first out.
LIFO works exactly opposite of FIFO. Instead of selling off the first coins you acquired, you sell the last coins that came in (i.e. the most recent coins you acquired).
To illustrate this further, let’s use the exact same example from above.
Using LIFO, our cost basis (or original purchase price) of the 5 ETH that we sold off in June would be $2,800 ($600 + $600 + $600 + $500 + $500).
$3,000 (selling price) - $2,800 (purchase price or cost basis) = $200 capital gain
As you can see with LIFO, we pull from the latest coins we bought—in this case we bought 3 ETH for $600, so we sell this group of coins first. Once that group is gone, we sell the 2 ETH that were bought for $500. In this example, using LIFO led to a $200 total gain where FIFO led to a $500 total capital gain.
In a period of rising cryptocurrency prices, using LIFO will lead to significantly less total taxable gains. It will also shield your earliest purchased cryptocurrency from getting “sold” off right away. This can lead to other benefits like extending your cryptocurrency holding period. Remember, long-term capital gains (assets held longer than one year before being disposed of) are taxed at the long-term capital gains rate, which is less than the short term capital gains tax rate.
Highest-in first-out (HIFO) works exactly how it sounds. You sell the coins with the highest cost basis (original purchase price) first.
HIFO can be used as a “tax minimization” method as it will lead to the lowest capital gains and the largest capital losses, best of both worlds. Keep in mind, net capital losses can be used to offset other income up to $3,000 dollars (the remaining will be carried forward to future tax years).
Using our example above, HIFO would actually lead to the same total gain as LIFO. But you can imagine how a scenario with hundreds of trades would work—selling your highest cost basis coins first to minimize your capital gains.
It’s important to note that the IRS likes to be retroactive when it issues guidance. For instance, Notice 2019-24, which was the most recent guidance released that provided clarity to this specific identification question, was issued in 2019, but still can be applied to transactions that took place before 2019. This means that certain taxpayers who used FIFO in previous years may be able to reasonably go back and amend previous years tax returns using a different, specific identification costing method.
As always, you should consult your CPA or cryptocurrency tax professional.
Using HIFO or LIFO instead of FIFO can lead to lesser amount of total capital gains on paper. Methods like LIFO can also shield you from having to pay the short term capital gains rate by extending the holding period of your cryptocurrency.
Cryptocurrency tax software like CryptoTrader.Tax can automatically handle all of your cryptocurrency tax reporting. Simply upload your crypto transaction history into the platform and generate your necessary crypto tax reports with the click of a button. The platform supports several different costing methods like FIFO, LIFO, and HIFO.
You can take the tax reports that the platform generates to your tax professional or simply upload them into your tax filing software like TurboTax or TaxAct.
*This post is for informational purposes only and should not be construed as tax, investment, or legal advice. Please speak to your own tax expert, CPA or tax attorney on how you should treat taxation of digital currencies.