Bitcoin is down about 36% from its all-time high in November, but the drop has a silver lining, thanks to a quirk in the tax code that helps crypto holders shield their earnings from the IRS.
The IRS treats cryptocurrencies as property, which means that every time you spend, trade, or sell your tokens, you are recording a taxable event. There is 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 reduce an investor’s tax liability.
When you sell your crypto, you can choose the specific unit you are selling. That means a cryptocurrency holder can pick the most expensive bitcoin they bought and use that number to determine their tax liability. A higher cost base translates into less tax on your sale.
But the responsibility for keeping track rests with the user, so careful accounting is essential. Without detailed records of a taxpayer’s transaction and cost basis, IRS calculations cannot be substantiated.
“People rarely use it because it requires keeping good records or using crypto software,” explained Shehan Chandrasekera, a certified public accountant and head of tax strategy at crypto tax software company CoinTracker.io. “But the thing is, a lot of people now use that kind of software, which makes this kind of accounting very easy. They just don’t know it exists.”
The trick of HIFO accounting is keeping granular details about every crypto transaction you made for every coin you own, including when you bought it and for how much, as well as when you sold it and the market value at the time.
But if you don’t have all your transaction records on record, or if you’re not using the right kind of software, the default accounting method is something called FIFO, or first in, first out.
“It’s not ideal,” explains Chandrasekera.
Under FIFO accounting rules, when you sell your tokens, you are selling the first coin purchased. If you bought your crypto before its big price increase in 2021, its low-cost basis may mean a higher capital gains tax bill.
Then there’s the wash sale rule
Combining HIFO accounting with the dummy 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 cryptocurrency holdings are treated differently than losses on stocks and mutual funds, according to Onramp Invest CEO Tyrone Ross. Notably, the wash sale rules do not apply, meaning you can sell your bitcoin and buy it 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 reduce your tax bill or be used to offset future earnings.
For example, let’s say a taxpayer buys a 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 reaped $40,000 in losses on prior crypto transactions, he could offset the tax he owes.
“You want to look as poor as possible,” Chandrasekera explained.
Chandrasekera says he sees people doing this weekly or quarterly, depending on their sophistication.
Quickly buying back cryptocurrencies is another key part of the equation. If timed correctly, buying the dip allows investors to go back up, if the price of the digital currency rebounds.