Guide to HIFO Cost Basis for Crypto
Every time you sell, exchange or spend your crypto, a tax event is triggered. Depending on the price paid when you purchased that crypto, taxable gains or losses will be computed as the difference between the purchase price and the sale price. You can minimize your taxes owed by changing how you compute your cost basis, typically most beneficially with the HIFO accounting method.
All of this accounting can be overwhelming, so keeping it simple, this guide will teach you what cost basis is, the different types of ways to calculate cost basis, why HIFO is typically the best if you bought crypto multiple times before selling, and how to calculate your capital gains.
What does cost basis mean?
What you paid to purchase your crypto, including any exchange fees, is your cost basis. This number is important because it’s a key part of the equation used to calculate your taxes when you sell:
[price you paid] - [price you sold at] = [taxable gains, if positive]
Therefore the price you paid has a significant impact on the tax bill when you subsequently sell it.
Where things get more complicated, but advantageous to you, is when you have had multiple purchases at different price points. That leads us to different methods of accounting you can then use to calculate your cost basis.
Ways to calculate your cost basis
In simple terms, your method of accounting determines which of your purchases will first be disposed of in the event of a sale.
There are various methods that can be used such as First-In-First-Out (FIFO), Last-In-First-Out (LIFO) and Highest-In-First-Out (HIFO), among others.
To give an overview of how each method would impact your taxable crypto profits:
1. FIFO: This is a common method which works on the assumption that the first purchase will be the first to be disposed of in the event of a sale.
For instance, let’s say you had acquired 1 bitcoin on January 1st and another bitcoin on January 3rd. As per FIFO on subsequent sale, the bitcoin purchased on January 1st will first be disposed of and then the bitcoin acquired on Jan 3rd.
2. LIFO: This method disposes of the last purchase first in the event of a sale. Using this, you can reduce your tax bill if you are averaging your profitable position upwards as the price increases, since it would consider the last purchase (which is a higher price).
3. HIFO: This method disposes of the highest purchase price first in the event of a sale. When you sell, you pick out your most expensive crypto purchase and use that number to determine your taxes. A higher cost basis translates to less tax on your sale.
For example, if you bought crypto over the years including during its big price run-up in 2021 and are now selling it in the 2022 downturn, your high cost basis can mean lower taxable gains.
How to calculate HIFO
HIFO, short for Highest-In-First-Out, is a cost basis method for valuing crypto assets where the highest price paid is reduced from the sale price to arrive at the profit or loss.
Under this method of accounting, all purchases up to the date of sale are plotted in descending order based on the price paid.
HIFO example calculation
Say Jacob had made the following purchases and sales of bitcoin during the year 2021:
Step 1: Rearrange all purchases up to date of sale in descending order by price.
| Date (DD/MM/YYYY) | Price per Bitcoin ($) | Quantity | Transaction |
|---|---|---|---|
| 01-03-2021 | 15,000 | 1 | Buy |
| 01-02-2021 | 11,000 | 1 | Buy |
| 01-01-2021 | 10,000 | 1 | Buy |
| 01-04-2021 | 9,000 | 1 | Buy |
Step 2: Each sale will be reduced from the corresponding highest purchase value.
The sale of 1 bitcoin on 31-05-2021 for $20,000 will have a cost basis of $15,000 (being the highest cost paid for acquiring 1 bitcoin)
Likewise for sale of 1 bitcoin on 30-06-2021 for $20,000 will have a cost basis of $11,000 (being the highest cost paid for acquiring the next 1 bitcoin)
Gains for Jacob’s using HIFO method will be:
| Particulars | Sale 1 | Sale 2 |
|---|---|---|
| Sale Value | $20,000 | $20,000 |
| Less: Purchase Price (Using HIFO - we will consider the highest price) | $15,000 | $11,000 |
| Taxable Gains | $5,000 | $9,000 |
Note: While the IRS allows HIFO cost basis to be used as a method of accounting, it is under the condition that you maintain all of the following information:
- Date and time each unit was acquired/purchased
- The fair market value of each unit at the time it was acquired
- Date and time each unit was sold, exchanged, or otherwise disposed of
- The fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit
It is next to impossible to maintain all these documents manually. Thus, to automate these requirements you should use crypto accounting software like Bitwave to ensure compliance.
Do crypto exchanges calculate HIFO for users?
Every crypto exchange has its own set of methods for providing users with the computation of their income and tax reports.
Among major US exchanges, Coinbase is the only one to calculate crypto gains for its users using the HIFO cost basis method.
FTX US and Binance US do not provide any tax reports, rather they provide the trading, deposits and withdrawal statements. These statements will have to be imported into crypto tax software to compute the gains using the HIFO cost basis method.
Advantages of using HIFO
To recap, since HIFO captures the highest price paid when computing gains, the advantages are:
Replaces the default method of selling the oldest first
The HIFO cost basis method is a significant tool that gives users the benefit of choosing to dispose of their crypto purchased at the highest price first irrespective of when it was purchased. This enables users to withstand highly volatile markets.
Otherwise the default accounting method is FIFO, which disposes of the older (first in) ones first.
Reduces overall gains
When compared to the other cost basis methods of FIFO and LIFO, following the HIFO method significantly reduces your overall taxable gains.
To understand the advantages even more clearly, here’s an example of how much taxable gains would be paid using different cost basis methods.
Say Jacob made the following purchases and sales of bitcoin in 2021:
| Date (DD/MM/YYYY) | Price per Bitcoin ($) | Quantity | Transaction |
|---|---|---|---|
| 01-01-2021 | 10,000 | 1 | Buy |
| 01-02-2021 | 11,000 | 1 | Buy |
| 01-03-2021 | 15,000 | 1 | Buy |
| 01-04-2021 | 9,000 | 1 | Buy |
| 31-05-2021 | 20,000 | 1 | Sell |
| 30-06-2021 | 20,000 | 1 | Sell |
His gains would vary based on whether he used FIFO, LIFO or HIFO cost basis.
Taxable gains as per FIFO
We will reduce the first purchase from the first sale. In other words, what was acquired first will be the one sold first.
| Particulars | Sale 1 | Sale 2 |
|---|---|---|
| Sale Value | $20,000 | $20,000 |
| Less: Purchase Price (Using FIFO - we will consider first purchase price) | $10,000 | $11,000 |
| Taxable Gains | $10,000 | $9,000 |
As per FIFO, we have a cumulative gain of $19,000.
Taxable gains as per LIFO
We will reduce the last purchase from the first sale. In other words, under LIFO we assume that the last purchase will be sold first.
| Particulars | Sale 1 | Sale 2 |
|---|---|---|
| Sale Value | $20,000 | $20,000 |
| Less: Purchase Price (Using LIFO - we will consider last purchase price) | $9,000 | $15,000 |
| Taxable Gains | $11,000 | $5,000 |
As per LIFO, we have a cumulative gain of $16,000.
Taxable gains as per HIFO
We will reduce the highest purchase price from the first sale. In other words, under HIFO we assume that the highest price we paid for purchasing will be disposed of first.
| Particulars | Sale 1 | Sale 2 |
|---|---|---|
| Sale Value | $20,000 | $20,000 |
| Less: Purchase Price (Using HIFO - We will consider highest price) | $15,000 | $11,000 |
| Taxable Gains | $5,000 | $9,000 |
As per HIFO, we have a cumulative gain of $14,000.
To conclude, using the HIFO cost basis, our taxable gains were $14,000 the least of the three methods followed.
Disadvantages of using HIFO
Although HIFO has a significant impact on taxable gains, it also has its own set of disadvantages owing to the compliance requirements.
Documentation
As mentioned earlier, you have to maintain documentation as required by the IRS. These requirements are exhaustive and even a small mistake can mean a switch to the default method to FIFO.
It’s best to use crypto accounting software to automate and remain compliant with these requirements to avoid any lapses.
Limitation on Losses
Since the HIFO cost basis considers the highest cost when computing gains, it’s possible that there can be a net capital loss during the year. The IRS does allow you to set off capital losses up to $3,000, in excess of which is rolled over to future years.
Therefore, in case there is no future taxable income or you are in the tax-free income bracket, HIFO may not be of much use.
Conclusion
HIFO cost basis is a crucial tool in an investor’s arsenal which can have a significant impact on the tax bill due. Accurate recordkeeping will be crucial, however, so it pays to use automated accounting software like Bitwave to produce gain/loss reports to and ensure complete compliance with the IRS requirements. Request a demo now.
Disclaimer: The information provided in this blog post is for general informational purposes only and should not be construed as tax, accounting, or financial advice. The content is not intended to address the specific needs of any individual or organization, and readers are encouraged to consult with a qualified tax, accounting, or financial professional before making any decisions based on the information provided. The author and the publisher of this blog post disclaim any liability, loss, or risk incurred as a consequence, directly or indirectly, of the use or application of any of the contents herein.
