The tax calculations required for cryptocurrency investments heighten your return’s complexity, and often lead taxpayers to make mistakes during the filing process.
For crypto users who use multiple exchanges or wallets, understanding how the IRS treats cost basis assignment is important. Things can get confusing quickly.
Miles Fuller is head of government solutions for TaxBit, a provider of tax and accounting services focused on digital assets.
The IRS classifies cryptocurrency as virtual currency, which is property for tax purposes. This classification means the agency treats crypto as a capital asset in almost all cases. Taxes on capital assets are straightforward.
This article is part of CoinDesk’s Tax Week
When you sell a capital asset for fiat currency or exchange it for other property or for services, you take the amount received for that transaction and reduce it by the amount you paid for the asset. Your original purchase price is known as cost basis.
If the proceeds of a crypto transaction exceed the cost, you have a capital gain. Likewise, if the inverse is true, you have a capital loss.
If you hold the asset for under 12 months, it will be treated as a short-term capital gain; if you hold the asset for over 12 months, it will be treated as a long-term capital gain.
How is cost basis calculated?
A common question that arises during a crypto transaction – whether involving a single asset or multiple assets – is “How do I calculate the cost basis?” When you sell property, existing tax regulations require you to apply the cost basis of that specific property against the proceeds received to calculate your gain or loss. However, this isn’t possible for fungible property like crypto because it lacks a specific identifier for each unit specifically tracking when the unit was purchased and when that same unit was sold.
In October 2019, the IRS posted FAQs on its website that explain how to approach cost basis calculations for cryptocurrency. FAQs 39, 40 and 41 address cryptocurrency cost basis.
The IRS takes a similar approach to cryptocurrency cost basis as traditional equities and allows two methods for calculating cost basis when disposing of virtual currency:
First-in, First-Out (FIFO)
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 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.
This new legislation will likely result in IRS regulations that mirror current rules for stocks. Each crypto exchange will be reporting proceeds and basis for sales on its own platform. The FIFO approach is likely to shift toward a by-exchange basis because that’s the information that will be provided.
What are the potential cons of FIFO?
While FIFO may be easier to apply, it doesn’t always provide the best tax result. The oldest units you own may have lower cost basis, which could result in larger capital gains.
What is specific identification?
Specific Identification permits a taxpayer to identify which units of crypto are being sold in a particular transaction. Under Specific Identification, a taxpayer can elect to dispose of higher cost basis assets first, which allows for greater tax optimization, but the IRS imposes additional requirements to use this method.
Note that IRS FAQ 40 explicitly requires a taxpayer using Specific Identification to have “records showing the transaction information for all units of a specific virtual currency … held in a single account, wallet, or address.”
You can’t use Specific Identification with cost basis and sale proceeds for crypto from different wallets or exchanges. You can only use Specific Identification with transactions from the same wallet or exchange.
Additionally, to use Specific Identification, you must have complete records including the:
Date and time each unit was acquired
Cost basis and value of each unit when it was acquired
Date and time each unit was sold or disposed of
Value of each unit when it was sold or disposed of
What are the potential benefits of specific identification?
While FIFO may be the default by some providers, Specific Identification offers many possible tax advantages to the taxpayer. Most importantly, it provides flexibility that can help minimize taxes in both the current year and long term.
Assume the purchase price of your longest-held units of a particular cryptocurrency is much lower than units you just acquired. If you applied FIFO to a sale of these units, you would likely report a gain for tax purposes.
Conversely, if you use Specific Identification on a by-exchange basis, you could select and sell the units with the highest cost basis regardless of acquisition date, which could reduce the gain or even result in a loss.
For example, let’s say a taxpayer sells BTC for $10,000. You can see the difference when FIFO and Specification Identification methods are applied to the transaction:
Under FIFO, the cost basis is $3,000 and results in a $7,000 capital gain.
Under Specific Identification – using Highest In, First Out (HIFO) by exchange – the cost basis is $12,000 and results in a $2,000 capital loss.
What are the potential cons of specific identification?
Because Specific Identification is an election, failure to do the proper calculation or maintain complete records could result in an IRS audit where you’ll potentially need to redo the calculation using FIFO.
If you’re considering using Specific Identification to achieve tax optimization, you should ensure that whoever is doing the tax calculation – you, your preparer or any software provider – is applying Specific Identification on a per account or wallet basis.
How do you make a specific identification election?
Unlike the regulations governing stocks, the IRS Cryptocurrency FAQs don’t provide specific instructions on when to elect Specific Identification or how to do it. Unlike equities, some exchanges don’t even allow a Specific Identification election within their platform.
If the exchange doesn’t allow the election, you’ll need to complete it manually or use crypto tax software. TaxBit allows for the proper use of Specific Identification by using a by-exchange approach and properly identifying assets that were transferred between platforms.