Many crypto traders were faced with unexpectedly high tax bills after the run-up of bitcoin and other alt coins. To minimize taxes on crypto trading, investors have been looking at different accounting options. The choice of accounting method indeed can make thousands of dollars of difference in your tax bill.
Some methods are preferred by the IRS, while others are more uncharted territory.
Crypto transactions are taxed as capital gains
Although the IRS increasingly targets crypto traders with unpaid taxes, it has not issued guidance on crypto taxation since 2014. There the IRS classified crypto currencies as property and not as currency. (If a taxpayer received crypto as payment for services or goods, it must be included in the gross income. Read our overview of crypto taxation here.)
Virtual currency transactions can result in gains or losses, which are taxed like other property transactions. For property transactions, the IRS allows the specific identification accounting method. While specific identification is possible with assets like stocks, it requires “adequate identification” of the asset sold.
Coins are not documented like stocks and mutual funds. Instead they are entries in a distributed ledger. This makes it doubtful that “adequate identification” on any specific coin can be made.
Therefore, tax accountants recommend another accounting method, the First-In, First-Out or FIFO method.
Benefits of FIFO for crypto trades
First-In, First-Out or FIFO is the most conservative accounting method and default rule for tracking securities. Tax accountants recommend FIFO for crypto transactions to reduce the risk of underpayment.
The FIFO principle is very straightforward. It makes sense for assets held long term because of the lower long-term capital gains tax rate. For capital gains that don’t qualify yet as long-term gain, FIFO however may result in higher current tax bills. This is the scenario many crypto currency investors are facing.
Can you use LIFO instead of FIFO for crypto tax?
Many crypto traders would instead like to use the LIFO method, Last-In, First-Out. LIFO accounting could yield significant tax savings for short-term gains. But it’s not without risk.
The IRS Notice 2014-21 mentioned above provides no guidance on which valuation method is acceptable. IRS has had ample time since then to release more specific guidance on crypto taxation. Even the new tax law signed into effect in December 2017 does not clarify acceptable accounting methods for crypto currencies. So it seems that LIFO may be allowed.
However, the use of LIFO, at least for stock sales, requires that adequate identification can be made. This is difficult, if not impossible, for most crypto trades. You could argue, and some do, that requirements for stock sales don’t apply to crypto currencies. If the IRS agrees with that or not is still unknown.
Should you use LIFO for cryptocurrency tax?
The use of LIFO instead of FIFO seems possible at this time, in the absence of specific guidance from the IRS. But as you can see, there is risk involved.
If the IRS disagrees with the use of LIFO for crypto trades, you may face additional taxes plus penalties.
Like-kind exchange tax loophole closed
Like-kind exchange allows for deferring capital gains when exchanging of one property for a similar property if the exchange meets certain requirements.
Previously, aggressive crypto investors applied this to cryptocurrency transactions. However, it was a grey area with significant risk. The new tax law clarified like-kind exchanges and now limits those to real property.
Which accounting method should you use for crypto taxation?
The safest approach to account for crypto currency transactions on your tax return is using FIFO. FIFO is the default method, if adequate identification cannot be made.
A slightly less conservative approach is to apply FIFO on a per wallet basis. You could do this if you bought into separate wallets and never mixed assets between wallets.
LIFO is not completely off the table and would lower the tax bill for many investors in the short term. But the lack of current guidance does not mean that the IRS agrees.
If you should use FIFO or LIFO also depends on your appetite for risk. The last IRS guidance on this topic has been retroactive. It is not unlikely that any new guidance will also be retroactive for the tax year.
As always, when it comes to tax, get advice from an experienced tax accountant.Schedule a crypto tax consultation now