Bitcoin is down about 36% from its all-time high in November, but tax habits that help crypto holders protect their profits from the IRS have a positive side to the decline.
The IRS treats cryptocurrencies like property. That is, whenever you use, redeem or sell a token, you are recording the taxable events. There is always a difference between the amount paid for cryptocurrencies, which depends on the cost, and the market value when they are used. The difference can cause capital gains taxes.
However, a less well-known accounting method known as HIFO (short for High In, First Out) can significantly reduce investors’ tax liabilities.
When you sell your crypto, you can pick and choose the specific unit you’re selling. This means that cryptocurrency holders can choose the most expensive bitcoin they have purchased and use this number to determine their tax liability. A higher cost base results in lower taxes on your sales.
However, comprehensive bookkeeping is necessary because the user is responsible for tracking. Without detailed taxpayer transactions and cost-based records, the account cannot be proven to the IRS.
“People rarely use it because they need to keep good records and use encryption software,” said CoinTracker.io, chief accountant and chief strategy officer at the crypto tax software company. Sheehan Chandrasekera explained. “But now that so many people are using this type of software, this type of accounting is very easy. They just don’t know it exists.”
The secret to HIFO accounting is to keep details about all cryptocurrency transactions that take place for each coin you own. This includes the time and quantity of purchase, the time of sale and the market value at that time.
However, if not all transaction records are logged, or if you are not using the appropriate type of software, the accounting method defaults to what is called the first in, first out method, or the first in, first out method.
“It’s not perfect,” Chandra Sekera explains.
According to FIFO accounting rules, when you sell tokens, you sell the coins you bought as soon as possible. If you buy cryptocurrency before it hits high prices in 2021, the lower cost base can increase capital gains tax charges.
Next, there are the rules of selling laundry
Experts tell CNBC that taxpayers can save more money by combining HIFO accounting with sales rules.
According to Tyrone Ross, CEO of Onramp Invest, the IRS classifies cryptocurrencies like Bitcoin as assets, so losses from holding cryptocurrencies are treated differently from losses from stocks and mutual funds. In particular, the rules for selling laundry do not apply. This means that you can sell and buy back Bitcoin instantly, but if it is available, you have to wait 30 days before buying it again.
This nuance in the tax code paves the way for aggressive tax losses, as investors sell at losses and buy back bitcoins at low prices. These losses can be used to reduce tax charges or offset future profits.
For example, suppose a taxpayer buys 1 bitcoin for $10,000 and sells it for $50,000. This individual will face a taxable capital gain of $40,000. But if the same taxpayer previously reaped a loss of $40,000 in a previous crypto transaction, they can recoup the taxes they incur.
“You want to look as poor as possible,” Chandra Sekera explained.
Chandra Sekera says she sees people do this from a week to quarterly, depending on how developed they are.
Buying back cryptocurrencies quickly is another important part of the equation. If the timing is right, buying a dip can help investors reclaim the ride quality if the crypto price rebounds.