You might have come across the terms FIFO, LIFO, and HIFO when reading about cryptocurrency tax calculations. These terms are sometimes also referred to as different cost basis methods. Every time you sell a coin or token, for example selling BTC and receiving USD or INR in return, you have to determine which coins from your holdings are actually being sold to work out your capital gains correctly.
If this sounds complicated, there is no need to worry as we will in this article explain everything in detail using easily understandable terms.
Every time you sell, trade, or purchase any goods or services with a cryptocurrency, you need to calculate the capital gains for that transaction. The general formula for calculating capital gains is:
capital gains = selling price – purchase price
The selling price is simply the value of what you sold (disposed of) at the time of the transaction or the value of what you received. The purchase price (acquisition cost) is what you originally paid when you acquired the coins in the past, also referred to as the cost basis.
The general rule is that you can add any associated transaction costs to the cost basis. In the cryptocurrency world, this is usually any fees you paid which is typically between 0.1-2% on popular exchanges today.
FIFO Cost Basis
FIFO is short for “First-In, First-Out”, which means that we are selling the coins in the same order as they were acquired. In other words, we are always selling the oldest coins first.
LIFO Cost Basis
LIFO is short for “Last-In, First-Out”, which in practice means that we are selling the coins in the opposite order as done using FIFO. In other words, we are always selling the most recently acquired coins first.
HIFO Cost Basis
HIFO is short for “Highest-In, First-Out” and works exactly as it sounds by selling coins from highest to lowest cost basis value (purchase price).
This means that the HIFO cost basis method will minimize the total capital gains as much as possible by minimizing the realized gain for each transaction. Keep in mind it will also lead to the largest realized losses so you might end up with a net capital loss that can be used to offset other income. This method is NOT allowed by Income Tax Department of India so cannot be used to file your taxes in India.
Choosing the Right Method
Let’s first look at a few key differences so that we understand the general implications a bit better.
Since we are selling the oldest coins first, FIFO can often lead to the highest capital gains in a market that is trending up (bull market), and where the initial purchase price is lower than current prices. On the other hand, in a bear market where prices are declining, FIFO can minimize your capital gains if the initial purchase price is higher than current prices.
Basically the opposite as FIFO: it can lead to significantly lower capital gains in a bull market that is trending up, and higher capital gains in a bear market with declining prices.
This will always lead to the lowest possible capital gains since each transaction considers the highest cost basis available.
Now, you might think that choosing HIFO is the obvious decision to reduce your taxes as much as possible, but it’s actually not that simple.
First, you need to consider which cost basis method you are actually allowed to use in your country. As mentioned above, This method is NOT allowed by Income Tax Department of India so cannot be used to file your taxes in India.
In the US, you are allowed to use any method available as long as you can specifically identify which unit of cryptocurrency is being sold. This is also often referred to as Specific Identification and is very beneficial for cryptocurrency traders and investors in the US, and such provides them with great opportunities for tax saving.
But keep in mind that in the INDIA, the amount of tax you pay is also decided by how long you held (or owned) a capital asset. Short term gains from capital asset owned less than one year are taxed at a higher rate than assets owned for more than six months.
As it should be clear now, cryptocurrency tax calculations can be quite complicated, and terms like FIFO and LIFO can definitely confuse a lot of people. There are several different methods that can be used to calculate capital gains, and the three methods discussed in this article are the most widely used around the world today including the US. Which method results in the lowest possible tax burden depends on many factors, so it may be a good idea to do separate calculations for the different methods before submitting the tax return.
The most important thing to do is to keep track of all transactions you have on different exchanges and wallets. If you have more than 20-30 transactions it will be very difficult (in fact, almost impossible) to do it yourself and that's where we come into the picture. Please schedule a consultation to discuss your accounting and taxation needs.
The contents of this article are for information purposes only and do not constitute an advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point of time and prepared with due accuracy & reliability. Readers are requested to check and refer relevant provisions of statute, latest judicial pronouncements, circulars, clarifications etc before acting on the basis of the above write up. The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that we are not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof. CA Mitesh and Associates is Mumbai's leading Cryptocurrency Taxation Firm which is committed to helping people navigate complex tax laws and banking regulations. Our main aim is to assist the individuals with applicable laws & regulations compliance and providing support at each & every level to make sure that they stay compliant and grow continuously. For any query, help or feedback you may get in touch here - Appointment with CA
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