Tax Season Must-Read | Tax-saving Tips: Choose the Cost Basis of Crypto Assets Wisely!
1. What is Cost Basis?
Cost basis refers to the original price you paid when purchasing crypto assets, as well as any related fees. In other words, it represents the actual cost you incurred to acquire these crypto assets. For U.S. crypto asset investors, there are mainly two types of federal taxes to be paid: income tax and capital gains tax. When calculating capital gains tax, understanding and accurately determining the cost basis is crucial.
When you sell crypto assets, the capital gains tax you need to pay often depends on the “capital gains” of the assets. Your capital gains = selling price – cost basis. If you only own and sell one bitcoin, the calculation is quite clear. However, when you own multiple bitcoins (or other crypto assets) but only sell a portion of them, the way to calculate cost and gains can vary depending on different methods. If you do not choose the right method to calculate the cost basis, you may end up paying unnecessary taxes. Understanding the different cost calculation methods can help you optimize your taxes within the legal framework and save a significant amount of tax!
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2. Common Cost Basis Calculation Methods
2.1 Specific Identification (Spec-ID)
The specific identification method allows you to designate the exact crypto assets you are selling. For example, you first purchased 1 Bitcoin for $30,000, and later bought a second one for $50,000. If you now choose to sell 1 Bitcoin, you can arbitrarily select one as the cost basis for this transaction.
Advantages: Since this method takes into account the specific purchase price of the sold item, it enables accurate cost basis calculation. This is particularly helpful for investors who wish to carefully select which units to sell based on cost basis and holding period to optimize tax outcomes. Moreover, this method is the most likely to withstand scrutiny from tax authorities.
Disadvantages: Every crypto asset transaction must be meticulously recorded, including purchase price, date, and related costs. Compared to other methods, even though it provides the highest level of accuracy, it can be more difficult and time-consuming to implement, especially for investors with frequent transactions.
2.2 First In First Out (FIFO)
The FIFO method assumes that the assets purchased first are the ones you sell first. For example, you first bought 1 Bitcoin for $30,000, and later purchased a second one for $50,000. If you now choose to sell 1 Bitcoin, the cost basis will automatically be the price of the first Bitcoin you bought (i.e., $30,000).
Advantages: This cost basis calculation method is simple and easy to understand. It mimics the natural inventory flow, where assets purchased first are sold first, which aligns with most people’s logic. Additionally, it conforms to the default tax regulations: for investors not using the specific identification method, FIFO is usually the default method allowed by the IRS.
Disadvantages: Using FIFO may lead to higher capital gains tax. Since the earliest purchased assets typically have a lower price, selling them according to the FIFO method may result in a larger capital gain, leading to a higher tax burden.
2.3 Last In First Out (LIFO)
LIFO is the opposite of FIFO. It assumes that the last assets you purchased are the first ones you sell. For example, you first bought 1 Bitcoin for $30,000, and later purchased a second one for $50,000. If you now choose to sell 1 Bitcoin, the cost basis will automatically be the price of the last Bitcoin you bought (i.e., $50,000).
Advantages: In some cases, the LIFO method can be beneficial, especially when the value of crypto assets is rising. Investors can reduce capital gains by selling the most recently acquired assets first, thereby reducing their tax liability. However, if the cost basis of the most recently acquired assets is lower than that of the older assets, LIFO may also result in higher taxes.
Disadvantages: Although LIFO may have tax-saving effects, it is less commonly used to determine the tax liability of crypto assets. Calculating the cost basis according to LIFO is more complex, requiring more detailed records and careful consideration of the holding period of the assets. For example, under the LIFO calculation method, although your taxable income is reduced, since the asset sold is the last one you purchased, it may be subject to a higher short-term capital gains tax rate, which could actually increase your final tax payment.
2.4 Highest In First Out (HIFO)
The HIFO method assumes that the most expensive asset you purchased is the first one you sell. For example, you first bought 1 Bitcoin for $30,000, then purchased a second one for $60,000, and later bought a third one for $50,000. If you now choose to sell one Bitcoin, the cost basis will automatically be the highest purchase price (i.e., $60,000).
Advantages: The HIFO method allows you to sell the assets with the highest cost first, which can significantly reduce your capital gains and effectively lower your tax payment. If you have purchased a large number of crypto assets and the asset prices have risen substantially, the HIFO method can help you reduce your overall tax burden.
Disadvantages: For corporate investors, using the HIFO method may lead to a decrease in after-tax profits, thereby affecting the company’s financial performance. This can reduce the company’s appeal to investors or lenders who focus on book profits. Additionally, according to the latest regulations from the IRS, HIFO must be pre-selected before the transaction and cannot be applied retroactively. Due to the volatility of crypto asset values, this method introduces uncertainty to tax liabilities.
3. How to Choose the Right Cost Basis Calculation Method
Overall, different cost basis calculation methods may have varying tax implications depending on your investment strategy, trading frequency, and tax objectives. The Specific Identification (Spec-ID) method offers the greatest flexibility and accuracy but requires meticulous record-keeping. The First In First Out (FIFO) method is simple and intuitive, suitable for investors not seeking complex tax optimization, but may result in higher tax payments. The Last In First Out (LIFO) and Highest In First Out (HIFO) methods are suitable for investors who wish to reduce capital gains tax during price increases, but due to the tax rate rules for capital gains and the volatility of crypto asset values, these methods may not always be the best choice.
Each method has its advantages and limitations, and you need to make an informed choice based on your own circumstances to ensure compliance and maximize tax benefits. For this, we recommend using the professional crypto asset management and tax reporting software FinTax.
Supports multiple cost basis methods: FinTax supports various cost basis methods, including FIFO, LIFO, and HIFO, and can automatically calculate the tax impact under different methods based on your selection.
Supports multiple U.S. tax forms: FinTax supports various U.S. tax forms, including Schedule D, W-2, Schedule 1, and Form 1040. The calculation results have been verified by professional tax accountants, fully meeting your tax reporting needs.
10-minute tax reporting: You just need to link your crypto wallet and exchange to FinTax, and you can securely import all transaction data within minutes and generate detailed tax reports. FinTax helps you make the best choice and save a significant amount of tax!
