By Anthony Diosdi
Cryptocurrencies are considered property in the United States for income tax purposes. Treating cryptocurrencies as property and not currency for federal income tax purposes is a departure from the rest of the world. Gain or loss is recognized and taxable, every time cryptocurrency is sold or used to purchase other virtual currency. To determine the amount of taxable gain, a cryptocurrency holder must know the basis of the cryptocurrency and the fair market value of the cryptocurrency when sold or exchanged. The fair market value of cryptocurrency is not always easy to determine. If cryptocurrency is obtained through an exchange, the fair market value of the digital asset is the amount recorded by the exchange on the date of the transaction. If a cryptocurrency transaction is not reported on a distribution ledger, the fair market value of the crypto asset is the amount the cryptocurrency was traded for on the exchange on the date and time the transaction was recorded on the ledger.
The cost basis is the amount an investor spends to acquire the cryptocurrency. This includes the purchase price, transaction fees, commissions paid, and any relevant costs. The higher an investor’s cost basis in his or her cryptocurrency, the less the investor will need to pay in taxes once cryptocurrency is sold. At first glance, calculating the cost or initial basis in cryptocurrency seems simple. When U.S. dollars are used to acquire cryptocurrency, the basis in the cryptocurrency is the amount of fiat currency used to purchase the virtual currency. This is no different than the rules for determining the basis in any capital asset. However, determining the basis in cryptocurrency quickly becomes more difficult after this initial stage in basis calculation because crypto investors often acquire a significant number of coins. As a result, an investor’s cost basis in a crypto asset often depends on his or her method of tax accounting.
Prior to the Internal Revenue Service (“IRS”) releasing their Frequently Asked Questions (“FAQs”), many believed that the tax accounting rules governing cryptocurrency for determining basis should be similar to those used for determining basis in stocks. For example, when an investor holds multiple lots or shares of the same securities with different cost basis and holding periods, the first-in, first-out (FIFO method) is typically used to determine the cost basis of stocks. However, investors in stocks are allowed to elect out of FIFO if an adequate identification is made. To do this, the investor must show that the certificates representing shares of stock were from a lot which was purchased or acquired on a certain date or for a certain price were delivered to the investor’s transferee. Unless these requirements are met, the stock sold or transferred is charged to the lot to which the certificates delivered to the transferee belong, whether or not the taxpayer intends, or instructs his broker or other agent, to sell or transfer stock from a lot purchased or acquired on a different date or for a different price.” See Treas. Reg. Section 1.1012-1(c)(2).
The IRS has provided guidance in its FAQs that permits cryptocurrency investors to use a tax accounting method known as HIFO or highest in, first out method for crypto assets that can be “specifically identified.” HIFO can significantly reduce an investor’s tax obligations when cryptocurrency is sold. This is because a crypto investor can choose the highest value of cryptocurrency being sold to determine his or her basis. A higher basis will result in the investor paying less tax on the sale of virtual currency.
The obvious issue with adequate identification is whether this concept can be applied to cryptocurrency. Cryptocurrency is often referred to as coins. The problem is there are no actual “coins;” instead, cryptocurrency is simply an entry on a distributed ledger. Fortunately for crypto investors, the IRS provided guidance in its FAQs that permit investors to select which units of cryptocurrency are sold if those units can be “specifically identified.” A cryptocurrency investor can demonstrate “specific identification of a crypto asset by documenting the specific unit’s unique digital identifier, such as a private key, public key, and address, or by records showing the transaction information for all units of a specific cryptocurrency held in a single account, wallet, or address. See IRS FAQ 40. As long as the information shows: 1) the date and time each unit was acquired; 2) the basis and fair market value of each unit at the time it was acquired; 3) 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 if, and the amount of money or the value of property received for each unit. See IRS FAQ 40.
If units of cryptocurrency cannot be specifically identified, then the FIFO method of accounting must be used. Under these rules a crypto investor will need to use the basis of the earliest purchased coin. Due to a lower basis associated with this method of tax accounting, FIFO can greatly increase a crypto investor’s tax bill.
The ability to use HIFO allows an invesor to cherry-pick the most advantageous tax treatment and it is further applicable universally across all wallets or cryptocurrency holdings and not limited to per-wallet application. See The Taxation of Cryptocurrencies, The Florida Bar Journal, Vol. 95, No. 4 July/August 2021 Pg 58 Charlotte Erdmann. The trick to HIFO tax accounting is for the crypto investor to keep detailed records about every cryptocurrency transaction made for each coin, including when it was purchased and for how much as well as when each coin was sold and the virtual asset’s market value at the time.
Overall, cryptocurrency is still an emerging asset class with a largely undefined tax framework. U.S. and foreign investors with cryptocurrency with a U.S. nexus should seek guidance from an experienced tax attorney.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on international and domestic tax planning. He advises multinational companies, closely held businesses, and individuals on a host of complicated tax matters. Anthony has authored numerous articles on international and domestic tax planning.
Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.