When dealing with digital assets, understanding how to calculate gains and losses is crucial. The IRS has issued guidance on acceptable cost-basis methods for cryptocurrency, specifically allowing two methods: First in First Out (FIFO) and Specific Identification.
FIFO (First in, First Out) Method
FIFO is a method where the oldest unit of crypto you own is sold or disposed of first.
Potential Benefits of FIFO:
- Allows universal pooling of assets, making it easier to apply than Specific Identification.
- Taxpayers can pool all their accounts together or prepare separate FIFO calculations for each wallet or account.
- If the exchange issued a Form 1099, using the same approach as the exchange could reduce the chance of an audit.
Specific Identification Method
Specific Identification allows selecting which particular cryptocurrency unit is being disposed of to minimize gains or obtain losses.
- Purchase 1 BTC at $5,000 on June 1, 2023.
- Purchase 1 BTC at $7,000 on August 1, 2023.
- Sell 1 BTC for $10,000.
- Using Specific Identification, dispose of the 1 BTC with the highest cost basis first (HIFO) to minimize capital gains.
- Minimize net capital gains liability by $2,000.
Requirements for Specific Identification:
- A complete set of transaction records, including the date, time, basis, fair market value of each unit acquired, and sold.
- Specific Identification must be done on a per account and per wallet basis.
Options for Specific Identification:
- HIFO by exchange is the most common approach to reduce taxable gains.
- Other options like Last In, First Out (LIFO) could be used but may result in a larger tax bill.
Understanding the cost-basis methods for calculating gains and losses on cryptocurrency is essential for compliance with IRS regulations. Both FIFO and Specific Identification have their benefits and requirements. Tools like TaxBit can automate the process, specifically identifying assets with the highest cost basis for disposition to reduce taxable gains.