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How to determine crypto gains or losses
Whether you have a gain or loss on the disposal of a digital asset depends on the value of the asset at the time of disposal measured against the cost basis of that asset.
In late 2019, the IRS issued guidance on acceptable cost-basis methods for calculating gains and losses on cryptocurrency. The IRS guidance specifically allows for only two cost-basis assignment methods:
First in First Out (FIFO)
What is FIFO (first in, first out)?
First-in, First-out (FIFO) is a method of assigning the cost basis where the oldest unit of crypto you own is sold or disposed of first.
What are the potential benefits of FIFO?
FIFO currently allows the universal pooling of assets, which makes this an easier method to apply than Specific Identification.
The IRS FAQs don’t specifically address what method is required for FIFO, so a taxpayer can use either approach – pool all their accounts together or prepare separate FIFO calculations for each wallet or account.
You can weigh your options, but if the exchange issued a Form 1099 to you, then it probably used a by-exchange approach. The same approach is likely easiest when completing your personal tax forms and could also reduce the chance of an audit because your return will match the information that the exchange provided to the IRS.
What is Specific Identification?
Taxpayers can also elect to use Specific Identification. Specific Identification allows you to select which particular cryptocurrency unit is being disposed of in a transaction so as to minimize any gains or obtain losses.
In the following example, you purchase 1 BTC at a price of $5,000 on June 1, 2023. On August 1, 2023, you purchase an additional 1 BTC at a price of $7,000. Later, you sell 1 BTC for a price of $10,000. Using Specific Identification, the taxpayer can choose to dispose of the 1 BTC with the highest cost basis first as an approach called HIFO (highest, in first out) – so as to minimize capital gains.
So instead of tracking the proceeds of the $10,000 sale for 1 BTC against the unit purchased at $5,000 on June 1, 2023, the net capital gains are matched against the unit purchased at $7,000 on August 1, 2023. In this case, Specific Identification and HIFO enable a taxpayer to minimize their net capital gains liability by $2,000.
What are the requirements for Specific Identification?
The IRS, however, has imposed requirements upon taxpayers that want to use Specific Identification.
First, a taxpayer must, “show (1) the date and time each unit was acquired, (2) your basis and the fair market value of each unit at the time it was acquired, (3) the date and time each unit was sold, exchanged, or otherwise disposed of, and (4) the fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.” In simpler terms, the IRS requires a complete set of transaction records when a taxpayer wants to use Specific Identification.
Second, the IRS guidance requires that Specific Identification be done on a per account and per wallet basis. TaxBit provides support for Specific Identification on a per account or wallet basis in order to legally minimize users’ taxes and reconcile to any Forms 1099 issued by exchanges. TaxBit automates the process by specifically identifying, by exchange, the assets with the highest cost basis for disposition to reduce taxable gains.
Although HIFO by exchange is the most common approach for optimizing taxes under the Specific Identification method, HIFO isn’t the only option. Taxpayers could choose to assign their cost basis under a different method such as Last In, First Out (LIFO), but this approach typically makes little sense because they would likely end up with a larger tax bill.