You invested in some cryptocurrency in 2019.
And for tax purposes, that means you have officially made the jump from a simple to a more complicated tax return.
To add to the complexity, you will now be required to explain your cryptocurrency activity to the federal government for the first time when filling out your federal tax forms this year.
Chances are good that you may choose to use one of the various online calculation services when you decide to calculate your cryptocurrency gains.At that point, you will need to answer which method you want to use to do your crypto reporting (FIFO, LIFO, etc.) when calculating your cryptocurrency gains.
This article will explain how to pick the best method for reporting your cryptocurrencies and why.
What is the best way to calculate my cryptocurrency capital gain?
You may be wondering if you choose to calculate using the FIFO (“first in first out”) method during one year, must you continue using this same method each preceding year?
The short answer is no.
Some crypto-traders think FIFO is the only way to calculate capital gain and wonder if it is legal to use methods other than FIFO.
And, what about other methods like the Average Basis Method? Is that an option to be considered?
What The IRS Has Said About Cryptocurrency Reporting
The IRS issued guidance on the method for calculating cryptocurrencies in October 2019 in their FAQ about virtual currency.
In the IRS virtual currency FAQ question 38, they permit the use of “specific instruction” after the trade has occurred.
They said, “You may choose which units of virtual currency are deemed to be sold, exchanged, or otherwise disposed of if you can specifically identify which unit or units of virtual currency are involved in the transaction and substantiate your basis in those units.”
This instruction means you can choose which coin is sold “after the fact” as long as you can track which units were sold and what you originally paid for them.
You don’t even need a method for choosing as long as you account for every sale.
With that said:
- FIFO is okay.
- LIFO is okay.
- Cherry-picking is okay.
Previously, IRS guidance was determined by IRS regulations, which required the first units to be purchased to be the first units sold. This method is known as FIFO, or “first in first out”.
Why did the IRS loosen their cryptocurrency regulations?
The answer is the principle of Conservation of Gain. This principle says that regardless of the method used, the cumulative gain over the long haul is still the same.
This principle follows from the numeric properties of arithmetic that you learned in high school algebra.
Consider this example:
- In January of year one, I buy one Coin1 for $1000
- In July of year one, I buy another Coin1 for $2000
- In year two, I sell one Coin1 for an equivalent amount of Coin2 for $10,000
- In year three, I sell my remaining Coin1 for $3000, and all the Coin2 for $4000.
First note that the total investment of $3000 in year one is ultimately sold in year three for $7000, or a total gain of $4000.
This $4000 is the gain that is conserved.
Does it matter which Coin1 is traded in year two?
The FIFO method says the first one. The LIFO method would pick the second one.
Does it change the amount gained?
The answer is yes in the first year, but not in the long run.
In the example of FIFO and LIFO below, the total gain over the two years is still the same, $4,000.
What is the real crypto calculation issue?
The real issue between FIFO, LIFO, and other methods is how much gain is eligible for reduced long-term capital gains rate. An asset qualifies for long-term gain if it is held for over a year. The long-term gain rate for most people is 15% versus short-term gain taxed at marginal tax rates of 22-35%.
What about Like-Kind Exchange?
Like-kind exchange (LKE), tax code section 1031, was a valid treatment for cryptocurrency until 2018 when the law was limited to just real estate. Many traders and tax professionals feared that the IRS would allow LKE treatment for crypto-to-crypto trades.
In our example, the gain on the trade from Coin1 to Coin2 is deferred until traded for cash in year 3. The total gain is still the same, $4000. Therefore, LKE was just another method like FIFO and LIFO. No gain is lost. The gain is conserved. This is why the IRS isn’t distressed by the use of LKE on crypto-to-crypto gains before 2018.
Changing methods is allowed.
Because of the principle of conservation of gain, a trader is free to use any method he wants each year. You are free to use FIFO in 2018 and LIFO in 2019. This assumes that the LIFO calculation is based on the FIFO results of the prior year FIFO. As far as IRS FAQ Question 38 is concerned, it is all “specific identification.”
Bulletproof Tax Tip! I recommend using whichever method generates the lowest tax liability for the specific year. Some crypto gain calculation services offer an “optimized” or “minimized” method, which prefers long-term over short-term gains when possible. I encourage using these methods.
What about using the Average Basis method?
Other countries use various permutations of the average basis method. It is also allowed for dividend reinvestment plans in the U.S. The average basis method does not violate the principle of conservation of gain.
However, it is not permitted by the tax regulations or the FAQ. There must be a specific identification for calculating the cost basis on every trade. Averaging doesn’t do this.
No calculation method is based in reality.
Regardless of which way you choose, none are anchored in the reality of what was traded by the exchange.
Presently, exchanges trade whichever coin they want irrespective of the coin’s cost basis or purchase date.
The crypto gain calculation services calculate the gain without consideration of what happened on the blockchain.
We’re talking taxes here, so make sure not to muddle the tax conversation with reality.
The current situation of calculating capital gains using exchange transaction records becomes increasingly painful every year.
What is the future of cryptocurrency gain taxation?
The tax planners at the Treasury Department, IRS, and Congress understand that treating cryptos like other assets is inadequate treatment. They know that a new asset class is needed.
Blockchain, smart contracts, and decentralized finance are continuing to transform the financial asset world. I doubt that Congress will approve a new asset class for several years as the innovation continues.
I believe that the IRS will have to adopt an average basis method for crypto assets because it is the only method structured for the long haul with the most connection to reality. Some have proposed a mark-to-market method for annual taxation, but this defeats the purpose of incenting long-term gains through lower tax rates.
We Love Complicated Crypto Tax Returns
At Donnelly Tax Law, we love complicated crypto tax returns. We’re also experienced and qualified at using these various methods for cryptocurrency reporting, including like-kind exchange for 2017 tax year amendments.
Schedule a tax consultation with us today:
And benefit from powerful do-it-yourself resources for filing and amending your taxes.
Clinton J. Donnelly is recognized as a U.S. income tax expert on reporting cryptocurrencies. He is an Enrolled Agent with an advanced law degree in international financial regulation including taxation.
He is the author of four books on cryptocurrency taxation. He is one of the few U.S. tax experts who has actually defended crypto currency calculations including like-kind exchange during an IRS audit. His firm offers tax preparation & tax amnesty services for crypto owners. Clinton can be reached at http://donnellytaxlaw.com