- The HIFO (short for highest in, first out) accounting method can significantly slash an investor's tax obligation.
- When you sell your crypto, you can pick and choose the specific unit you are selling. That means a crypto holder can pick out the most expensive bitcoin they bought and use that number to determine their tax obligation.
- A higher cost basis translates to less tax on your sale, because with capital gains, the equation is your sales price minus the cost basis.
Bitcoin is down around 36% from its all-time high in November, but the dip has a good side, thanks to a quirk in the tax code that helps crypto holders shield their winnings from the IRS.
The IRS treats cryptocurrencies like property, meaning that anytime you spend, exchange, or sell your tokens, you're logging a taxable event. There's always a difference between how much you paid for your crypto, which is the cost basis, and the market value at the time you spend it. That difference can trigger capital gains taxes.
But a little-known accounting method known as HIFO — short for highest in, first out — can significantly slash an investor's tax obligation.
When you sell your crypto, you can pick and choose the specific unit you are selling. That means a crypto holder can pick out the most expensive bitcoin they bought and use that number to determine their tax obligation. A higher cost basis translates to less tax on your sale.
But the onus is on the user to keep track, so thorough bookkeeping is essential. Without detailed records of a taxpayer's transaction and cost basis, calculations to the IRS can't be substantiated.
"People rarely use it because it requires keeping good records or using crypto software," explained Shehan Chandrasekera, a CPA and head of tax strategy at crypto tax software company CoinTracker.io. "But the thing is, lots of folks now use that kind of software, which makes this kind of accounting super easy. They just don't know it exists."
The trick to HIFO accounting is keeping granular details about every crypto transaction you made for each coin you own, including when you purchased it and for how much, as well as when you sold it and the market value at that time.
But if you don't have all transaction records logged, or you're not using the right kind of software, the accounting method defaults to something called FIFO, or first in, first out.
"It's not ideal," Chandrasekera explains.
Under FIFO accounting rules, when you sell your tokens, you're selling the earliest purchased coin. If you bought your crypto before its big price run-up in 2021, your low cost basis can mean a bigger capital gains tax bill.
Then there's the wash sale rule
Pairing HIFO accounting with the wash sale rule has the potential to save taxpayers even more money, experts tell CNBC.
Because the IRS classifies digital currencies like bitcoin as property, losses on crypto holdings are treated differently than losses on stocks and mutual funds, according to Onramp Invest CEO Tyrone Ross. In particular, wash sale rules don't apply, meaning that you can sell your bitcoin and buy it right back, whereas with a stock, you would have to wait 30 days to buy it back.
This nuance in the tax code paves the way for aggressive tax-loss harvesting, where investors sell at a loss and buy back bitcoin at a lower price. Those losses can lower your tax bill or be used to offset future gains.
For instance, say a taxpayer purchases one bitcoin for $10,000 and sells it for $50,000. This individual would face $40,000 of taxable capital gains. But if this same taxpayer had previously harvested $40,000 worth of losses on earlier crypto transactions, they'd be able to offset the tax they owe.
"You want to look as poor as possible," explained Chandrasekera.
Chandrasekera says he sees people doing this on a weekly to quarterly basis, depending on their sophistication.
Quickly buying back the cryptos is another key part of the equation. If timed correctly, buying the dip enables investors to catch the ride back up, if the price of the digital coin rebounds.