FIFO, LIFO, or HIFO - which accounting method will you be using on your crypto tax return?
While the answer may vary based on your specific situation, this guide will break down the benefits of each method with the help of a few simple visual examples. By the time you finish reading, you’ll have a better understanding of how each of these accounting methods work for your crypto taxes.
To understand the importance of accounting methods, it’s helpful to know how cryptocurrency is taxed.
The IRS considers cryptocurrency a form of property. When you sell cryptocurrency, you’ll be subject to capital gains tax, which is calculated through the following formula.
If the value of your tokens at the time of sale is higher than your purchase price, you’ll end up with a capital loss, which can be used to offset capital gains for the year. For more information, check out our article on tax loss harvesting.
Check out the infographic below and see if you can come up with the answer to James’s dilemma.
This is a trick question. Depending on the accounting method James chooses, he will either be selling the tokens he purchased for $20,000 or the tokens he purchased for $50,000.
If he chooses the latter option, he can potentially save thousands of dollars on his tax return.
While your situation may not be exactly the same as James’s, it’s possible the accounting method you choose can significantly reduce how much you pay in taxes.
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.
To better understand how they work, let’s calculate capital gains on the following transaction using each one of these different accounting methods.
With first-in-first-out, the first coin that you purchase (chronologically) is the first coin that is counted for a sale.
If we apply FIFO to the example above, the purchase price of the 1 ETH that you sold in August will be $2,250. That’s the cost basis of the first token that you bought.
We can use that information to calculate your capital gains.
With last-in first-out, the last coins that you acquired will become the first coins that you sell.
To illustrate this further, let’s use the exact same example from above.
Using LIFO, our cost basis (or original purchase price) of the ETH we sold in August would be $2,500. That’s the cost basis of the last token that you bought.
Doing the math then:
In the example above, using LIFO instead of FIFO would save you $250 in capital gains.
The accounting method that works best for you can vary based on market conditions. In a period of rising cryptocurrency prices, using LIFO will most likely lead to significantly less total taxable gains. In a period of falling prices, FIFO will most likely yield better results.
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.
HIFO can be used as a “tax minimization” method as it will lead to the lowest capital gains and the largest capital losses. 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).
According to IRS guidance, you can use a specific identification method like LIFO or HIFO if you have records containing the following information:
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.
Still, FIFO is used by most investors since it is considered the most conservative accounting method. HIFO and LIFO should only be used if you’ve kept detailed records of your crypto transactions.
If you’re looking to track your cryptocurrency trades across multiple wallets and exchanges, get started with CryptoTrader.Tax. More than 100,000 investors use the platform to record their complete crypto trading history and report taxes.
Switching from one accounting method to another on a year-to-year basis is allowed by the IRS. However, flipping back and forth between methods may lead to calculation errors, which can be a red flag for the IRS to investigate further. Consult your tax professional to see if this is something you want to do.
Let’s take some time to answer a few frequently asked questions about HIFO, FIFO, and LIFO.
Can I use HIFO for crypto?
Yes. The IRS’s guidance states that crypto investors can use HIFO provided that they keep detailed records and can identify specific units of cryptocurrency.
Can I change calculation methods from year to year?
Yes. IRS guidelines allow investors to change calculation methods from year to year. However, you have to be sure you are properly accounting for each sale.
What accounting method should I use for my crypto?
While American crypto investors can use FIFO, LIFO, and HIFO, many choose to use FIFO because it is the most conservative option.
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.
Get started with a free preview report today. You don’t need to enter your credit card information until you’re 100% sure your transaction information is accurate!
*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.