In order to curb the rise of illegal money-making, the U.S. government has stepped in with the Internal Revenue Service (IRS). For a very long time, centralized agencies and regulatory authorities have been in the unknown as to how cryptocurrency should be taxed.
However, the IRS, issued a Notice 2014-21 which stated that cryptocurrency should be taxed similar to ‘property’ and not treated as currency, even though it may seem like one. But the next big question was how should crypto be taxed? What are the various accounting methods?
In this article, we’ll learn how to calculate LIFO and FIFO and also calculate capital gains using a FIFO and LIFO calculator.
Calculation Of Crypto Taxes
As mentioned above, cryptocurrency is taxable and the various clauses laid down by the IRS make it clear as to which transactions should be taxed as capital gains, which ones as income taxes, and which ones are non-taxable events.
When it comes to capital gains taxable events, there are various accounting methods that can be used to calculate your capital gains, namely:
- FIFO (First-In-First-Out)
- LIFO (Last-In-First-Out)
- HIFO (Highest-In-First-Out)
The Generally Accepted Accounting Principles (GAAP) in the United States allows tax calculation agencies and software to choose between LIFO and FIFO accounting methods.
What Is LIFO Accounting Method?
LIFO is short for Last-In-First-Out. Using this method, the coins that you acquired last, will be the first ones that you sell.
When calculating gains using LIFO, in a bull market (the crypto market is heading up and the cost basis is lower than the fair market value), you’ll incur smaller gains and in a bear market (prices are dropping and the cost basis is higher than fair market value) you can have larger gains.
Many times, the LIFO calculation is considered a better accounting method than FIFO because of inflation, when the cost of assets is on a rise.
How To Calculate LIFO
Determine the cost of your most recently acquired coins in order to calculate the capital gains or losses for the calculation of your crypto taxes. The formula for calculating using LIFO is:
Capital Gains = Selling Price of recent assets – Cost Basis of the same assets
For better understanding, we’ve illustrated an example in the FIFO and LIFO calculator sections.
What Is FIFO Accounting Method?
FIFO is short for First-In-First-Out. Unlike the LIFO method, the coins that you acquired first, will be the first ones that you sell when calculating with FIFO.
FIFO is essentially the reverse of LIFO accounting. When the crypto market is heading up (bull market) and the cost basis is lower than the fair market value, FIFO accounting methods can often lead to the most capital gains. On the other hand, in a market where prices are dropping (bear market) and the cost basis is higher than fair market value, FIFO can limit your gains.
How To Calculate FIFO
Determine the cost of the coins that you’ve acquired first, in order to calculate the capital gains or losses for the calculation of your crypto taxes. The formula for calculating taxes using FIFO is the same as LIFO:
Capital Gains = Selling Price of first assets – Cost Basis of the same assets
To understand this better, let’s take a look at an example of a FIFO and LIFO calculator.
Example: FIFO and LIFO Calculator
Here’s the scenario: In July 2021 you had bought 1 ETH for $2,200. Then in October, you bought 1 ETH for $4,500. Following this, you sold half of your ETH holdings in November at $6,000. So what are your capital gains? This is where the accounting methods come in.
| Transaction No. | Date | Activity | Amount (in $) |
|---|---|---|---|
| Txn #1 | July 2021 | Bought 1 ETH | $2,200 |
| Txn #2 | October 2021 | Bought 1 ETH | $4,500 |
| Txn #3 | November 2021 | Sold 1 ETH | $6,000 |
Using LIFO and FIFO methods will give you different outcomes. Let’s understand how.
If we apply FIFO to this example, we’ll have the tokens that were acquired first, also sold first. So, $2,200 will be your cost basis or purchase price (Txn #1). Now your selling price (Txn #3) will remain the same at $6,000. So, according to the formula given above,
Capital Gains = Selling Price of first assets – Cost Basis of the same assets
Capital Gains = $6,000 – $ 2,200 = $3,800
Thus, $3,800 is the capital gain when calculated in FIFO.
Now if we apply LIFO to the same example, we’ll have the tokens that were acquired last, sold-out first. So, $4,500 will be your cost basis or purchase price (Txn #2). Your selling price (Txn #3) will remain the same at $6,000. So, according to the formula given above,
Capital Gains = Selling Price of recent assets – Cost Basis of the same assets
Capital Gains = $6,000 – $4,500 = $1,500
Thus, $1,500 is the capital gain when calculated in LIFO.
The Bottom Line: Which Is Better LIFO Or FIFO?
In the absence of inflation, both LIFO and FIFO give the same outcomes. However, if inflation is substantial, the accounting system you choose might have a significant impact on your taxes.
FIFO is considered the most traditional method of accounting, but LIFO can help you save a lot on your taxes. Whichever accounting method you choose, make sure you’ve studied the market scenario and then calculate your taxes.
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Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide tax, legal or financial advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
