Cost Basis Methods for Crypto Taxation [IRS Rules 2024]

Explore IRS rules for 2024 on cost basis methods in crypto taxation, ensuring accurate and compliant reporting for your digital asset investments.

Expert verified
by
Mag. Georg Brameshuber

Key Takeaways

  • Understanding Cost Basis is Crucial for Crypto Tax Compliance: Calculating the cost basis, the original value of your crypto, is crucial for correct capital gains or losses reporting. It affects your tax liabilities and savings.
  • Selection of Cost Basis Method Affects Tax Outcomes: Choosing between FIFO, LIFO, HIFO, Specific Identification, or Weighted Average can change your gains or losses significantly. Picking a method that suits your trading style and goals is important for tax optimization.
  • Consistency and Accurate Record-Keeping are Key: Using your method consistently and keeping precise records are vital to prevent IRS issues. Tools like Blockpit help keep accurate, complete records for crypto tax compliance and efficiency.
Written by
Florian Wimmer
Last Updated:
February 21, 2024
Chapter 1

Understanding Cost Basis Methods

Exploring the principles and necessity of cost basis calculations.

<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.

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.

crypto cost basis formula
Cost Basis Formula
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Chapter 2

Cost Basis Methods and Their Impact

Exploring the Tax Implications and Strategies of Different Crypto Cost Basis Calculations.

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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Chapter 3

Practical Application and IRS Perspective

Putting different crypto cost basis methods into action.

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$
Examples of different cost basis method calculations
Cost Basis Example

*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. 

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Chapter 4

Your Blockpit Crypto Tax Report

Automate your tax return with the crypto tax calculator.

Optimize & File Your Crypto Taxes With Blockpit

Blockpit creates the most comprehensive crypto tax reports in PDF format. The report provides information about all your balances and transactions and can be used as proof of origin with banks or tax advisors. It contains all relevant transactions of your account in the selected tax year and shows details such as timestamp, amount, asset, costs and fees of the individual transactions.

Using Blockpit couldn’t be easier:

1. Import your transactions

Blockpit offers direct integrations for crypto exchanges, wallets and DeFi protocols. Automatically import your transactions via API integration, wallet address synchronization, or by manually uploading an Excel file. 

Discover all crypto integrations

2. Validate & Optimize

Blockpit offers smart insights and suggestions to optimize your tax report, fix issues, add missing values and to validate your transactions.

3. Generate your tax report

Generate your compliant tax report with the click of a button. Our tax engine calculates your tax report on the basis of the US tax framework.

US Blockpit Crypto Tax Report Overview
US Blockpit Crypto Tax Report Form 1040
US Blockpit Crypto Tax Report Capital Gains and Losses Summary

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FAQ

What is "cost basis" and why is it relevant for crypto taxation?

Cost basis refers to the original value of an asset for tax purposes, usually the purchase price, adjusted for stock splits, dividends, and capital distributions. It's crucial for crypto taxation as it determines the capital gain or loss when the cryptocurrency is sold.

How does choosing different cost basis methods affect my reported capital gains or losses on my tax return?

Different cost basis methods (e.g., FIFO, LIFO, HIFO) can significantly affect the reported capital gains or losses. The method chosen dictates the order in which coins are considered sold, impacting the gain or loss calculation and, consequently, the tax liability.

Are there specific cost basis methods that the IRS prefers or requires for cryptocurrency transactions?

The IRS has not specifically endorsed or prohibited particular cost basis methods for cryptocurrency. However, the default method for many tax reporting systems is FIFO (First In, First Out), given its straightforward nature and the IRS's preference for consistency in reporting.

Can I switch between cost basis methods from year to year as I report my crypto transactions?

While the IRS has not explicitly prohibited switching between methods, consistency is crucial. Continually changing methods could raise red flags and increase audit risks. It's advisable to consult with a tax professional before making such changes.

If I use software or exchange-provided reports to calculate my crypto taxes, which cost basis method do they typically use?

Most software and exchange-provided reports default to the FIFO (First In, First Out) method, but always verify the chosen method when using such tools.

Sources & References

https://www.irs.gov/taxtopics/tc703

Update Log
Disclaimer: The information provided in this article is for general information purposes only. The information was completed to the best of our knowledge and does not claim either correctness or accuracy. For detailed information on crypto regulations, we recommend contacting a certified legal advisor in the respective country.