Cost Basis Methods for Crypto Taxation [IRS Rules 2024]

<div fs-richtext-component="info-box" class="info-box"><div class="flex-info-card"><img src="https://assets-global.website-files.com/65098a145ece52db42b9c274/650c6f4cef4c34160eab4440_Info.svg" loading="eager" width="64" height="64" alt="" class="icon-info-box"><div fs-richtext-component="info-box-text" class="info-box-content"><p class="color-neutral-800">Starting January 1, 2024, the Infrastructure Investment and Jobs Act requires reporting 10,000$+ crypto transactions to the IRS. Yet, the Treasury and IRS deferred digital asset reporting until new regulations are set, promising future guidance and public input on these rules. Stay informed: IRS</p></div></div></div>

In US crypto taxation, the “cost basis”, or the asset's purchase price, is crucial for calculating capital gains or losses. Understanding and accurately determining this figure is essential for correct tax reporting.

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The Principle Behind Cost Basis

Essentially, the cost basis is your initial investment in a cryptocurrency, usually the purchase price. This foundational figure directly influences the calculation of capital gains or losses when the asset is later sold. A higher cost basis can mean lower capital gains, and thus, potentially reduced tax obligations. Conversely, a lower cost basis can lead to higher capital gains and consequently, a heftier tax bill. It's clear then, that accurately determining and tracking your cost basis plays a crucial role in your overall tax strategy, helping you make informed decisions and ensuring compliance with IRS rules.

First In, First Out (FIFO)

FIFO assumes the earliest purchased cryptocurrency units are sold first. For example, if you buy 1 Bitcoin in January at 30,000$ and another in June for 40,000$, then sell a Bitcoin in August, FIFO sets the cost basis at 30,000$.

Impact on Short-term vs. Long-term Capital Gains:
Using FIFO can move earlier purchases into the long-term capital gains category for assets held over a year, leveraging lower USA tax rates for long-term versus short-term gains.

Common Scenarios in Crypto Trading where FIFO applies: FIFO is typical in scenarios where an investor buys cryptocurrency over time and sells later. It's favored by many tax systems and software for its simplicity and the IRS's consistency preference.

Last In, First Out (LIFO)

LIFO considers the most recently purchased cryptocurrency units as the first sold. For instance, buying 1 Bitcoin in January at 30,000$ and another in June for 40,000$, then selling one in August, LIFO uses the 40,000$ cost basis from the last purchase.

Differences between FIFO and LIFO in Calculating Capital Gains/Losses: The key difference is the assets' selling order: FIFO sells the oldest first, LIFO the newest. This can affect capital gains or losses, with LIFO potentially leading to higher short-term gains in rising markets by selling more recently bought, pricier assets first.

Relevance and Application in Crypto Trading: LIFO suits scenarios with rapid price changes, fitting traders who sell recently bought assets. Yet, it may result in higher short-term gains, taxed more in the USA. Consistent LIFO application is crucial for IRS compliance.

HIFO (Highest In, First Out)

HIFO selects the highest cost cryptocurrency units for sale first. For example, if you bought Bitcoins at 20,000$, 30,000$, and 40,000$, selling one would use the $40,000 purchase as the cost basis, as it's the most expensive.

Advantages and Considerations:
HIFO can minimize capital gains taxes in rising markets by using the highest cost basis first, aiding in tax management. Yet, it demands thorough record-keeping and carries IRS uncertainty due to lack of explicit endorsement. Using HIFO may reduce taxes initially but could result in higher future taxes from a lower cost basis on remaining assets.

Specific Identification (SpecID)

SpecID allows traders to select the exact cryptocurrency units sold, based on their acquisition date and cost, offering an alternative to FIFO or LIFO.

Benefits of Using this Method, Especially in Active Trading: This method provides flexibility, enabling traders to choose specific coins to sell for optimal capital gains management. It's advantageous for holding appreciated coins longer for tax benefits while selling less appreciated ones.

Challenges and Considerations in Tracking Specific Crypto Coins or Tokens: SpecID requires meticulous documentation of each coin's purchase details and transaction fees, complicating record-keeping in high-volume trading. Digital wallets and crypto tax software can help track these details, but accuracy is crucial for IRS compliance.

Weighted Average Cost (or simply Average Cost)

This method calculates a cryptocurrency's average cost by dividing the total spent by the number of units owned. For example, buying one Bitcoin at 30,000$ and another at 40,000$ results in an average cost of 35,000$ per Bitcoin upon sale.

Situations Where this Method is Advantageous or Challenging: The Weighted Average Cost method simplifies tracking by averaging the cost basis, ideal for regular, consistent purchases. It's less suited to volatile markets, lacking the precision in selecting specific lots for sale that SpecID offers. Once selected for a cryptocurrency, the IRS mandates consistency with this method, prohibiting switching between methods for that asset.

Choosing the Right Cost Basis Method: Factors to Consider

When determining the most suitable cost basis method for your crypto transactions, a strategic approach is essential. Here are some guiding principles to make an informed decision.

Evaluating Individual Trading Habits and Frequency

Your trading behavior plays a pivotal role in selecting a cost basis method. If you're an active trader making frequent trades, methods like HIFO might offer tax advantages. Conversely, occasional traders might find FIFO or LIFO more straightforward and apt for their needs.

Assessing Potential Tax Implications of Each Method

Delve into how each method might affect your tax liabilities. For instance, using HIFO in a generally rising market can minimize your short-term tax burden, but it's essential to anticipate how it might impact future transactions. Consider both short-term and long-term capital gains rates when assessing.

The Importance of Consistency Once a Method is Chosen

‍The IRS places a significant emphasis on consistency. Once you choose a cost basis method, it's vital to stick with it to avoid complications or potential red flags. Switching between methods from year to year can lead to complexities and increase the risk of errors or misreporting.

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Example Calculation of Cost Basis Methods

Let’s see the following example on different cost basis methods and change how you  calculate tax and your resulting gains and losses.

• October 2023: Buy of 1 BTC for 30,000$
• December 2023: Buy of 2 BTC for 40,000$
• June 2024: Buy of 1 BTC for 60,000$
• December 2024: Sell of 1 BTC for 45,000$

*For the Weighted Average:

You've spent a total of 170,000$ for 4 BTC before the sale, which gives an average cost of 42,500$ per BTC. But since the BTC bought in June 2024 was not part of the ones sold, we need to adjust the weighted average. 

[(1 BTC x 30,000$) + (2 BTC x 40,000$)] / 3 BTC = 43,333$ as the average for the first 3 BTCs bought.

Now, with the sale at the end of 2024, using FIFO, you'll report a gain of 15,000$. Using LIFO or HIFO, you'll report a loss of 15,000$. With the Weighted Average method, you'll report a gain of 1,667$.

IRS's Perspective on Cost Basis Methods

The Internal Revenue Service (IRS) categorizes cryptocurrency as property, which means it's subject to capital gains and losses rules similar to other forms of property like stocks or real estate. However, the IRS has not specifically endorsed or prohibited particular cost basis methods for cryptocurrency. Instead, the emphasis is on consistency and accuracy.

Documentation and Record-Keeping Requirements‍

Taxpayers are expected to maintain detailed records of their cryptocurrency transactions. This includes dates of acquisition and sale, amounts, costs, sales proceeds, and any other pertinent information. In scenarios where specific identification is used, meticulous tracking of each unit's acquisition and subsequent disposition is crucial. Specialized crypto tax tools like Blockpit can help with that.

Potential Consequences of Misreporting or Inconsistency‍

Inaccurate reporting or inconsistency in the chosen cost basis method can result in penalties and interest on any unpaid tax. The IRS is increasing its scrutiny of cryptocurrency transactions, and discrepancies might trigger audits. Properly calculating and reporting gains or losses is essential to avoid potential legal and financial repercussions.