Know These Accounting Methods Before Filing Your Crypto Taxes
This guest blog post was provided by Token Tax.
How tracking your buy and sell trades as tax lots can reduce your tax bill
Common Cryptocurrency Tax Accounting Methods Explained
The Internal Revenue Service (IRS) allows individuals to use any accounting method for filing their crypto taxes in the United States. Just as important as it is to understand different algorithmic trading strategies to increase your profits, understanding different accounting methods decreases your tax bill on those profits.
To understand how to calculate your crypto taxes, you need to consider that the IRS treats crypto as property. You are taxed on your net profit, which is the sell price minus the buy price and fees (known as the capital gain/loss) for each trade.
For example, say you traded Bitcoin four times:
Buy: 1 BTC at USD 4,000
Buy: 1 BTC at USD 6,000
Buy: 1 BTC at USD 8,000
Sell: 1 BTC at USD 10,000
Your First In First Out (FIFO) accounting method would be calculated as the USD 10,000 sell minus the USD 4,000 buy for a taxable gain of USD 6,000.
Your Last In First Out (LIFO) accounting method would be calculated as the USD 10,000 sell minus the USD 8,000 buy for a taxable gain of USD 2,000.
Using Specific Identification, however, would allow you to pick the most beneficial buy cost, which in this example is the USD 10,000 - USD 8,000 = USD 2,000 taxable gain.
For more examples, please read our accounting article detailing FIFO, LIFO and specific identification minimization.
IRS crypto tax accounting guidance allows for specific identification
The IRS provided clarification in 2019 that individuals can use specific identification for filing their bitcoin taxes. Specifically, IRS Virtual Currency Question and Answer 38 explains that you can use specific identification accounting to calculate your net capital gain or loss (i.e., your sale price net your purchase price for each crypto trade) on which you are taxed.
IRS Virtual Currency Question and Answer 39 explains that you need to provide records of the date and time of each buy and sell trade, as well as each buy cost and sell price in order to specifically identify your tax lots. IRS Virtual Currency Question and Answer 40 explains that you should use the FIFO accounting method if you are not tracking your tax lots.
International Crypto Tax Considerations
Be mindful that if you are filing your crypto taxes outside the United States, your tax authority may have different accounting guidance. For example, you need to use the average cost accounting method for your U.K. crypto taxes under guidance from Her Majesty's Revenue and Customs (HMRC). Canadian crypto tax guidelines also require adjusted cost basis, or average cost.
Challenges of doing your own accounting
Imagine you tried to calculate your capital gains taxes in Excel for your trading algorithm this past year. You would need to export your transaction history and sort it over time by each cryptocurrency.
Then, you would need to track each cost basis and pair it with trades such that you have the lowest overall gain. Remember that there are also lower taxes on long term trades, so you need to account for the trade hold duration greater than a year in picking your best tax lots.
Certainly, you could do this for a few trades in a year, but it becomes increasingly difficult for more complex trade strategies that may involve thousands of transactions.
Benefits of using crypto tax software
Crypto tax software automates all the above challenges, saving you time and tedious spreadsheet gymnastics. Many software packages can seamlessly load your transaction history and automatically track cost basis for record-keeping. Typically, you can automatically calculate FIFO and LIFO accounting methods. Many software packages also allow you to save money on taxes with crypto tax-loss harvesting.
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