Cost Basis Methods for Crypto Taxation (FIFO, LIFO, WAC & HIFO)

gm accountants 👋

If this is your first year using digital assets and you’re unfamiliar with cost basis methods, don’t fret it.

Tracking the cost basis of your crypto transactions is the gateway into crypto taxation, as it will allow you to have an understanding of the ‘capital gains tax’ and ‘realized gains/losses’ (or capital gains/losses) every time you dispose (i.e sell/trade/swap) a crypto asset. 

If your business is contemplating or already using cryptocurrencies to run its operations, this article will provide you with an understanding of the most popular cost basis methods used and its implications on your financial reporting. 

More specifically this article will cover:

• Crypto Taxes 101 
• Introduction to Crypto Cost Basis Methods - FIFO, LIFO, WAC, HIFO
• Comparing Cost Basis Methods in a Bull Market v/s Bear Market 
• How to Choose the Right Cost Basis Method

Let’s dive right in.

🧐 Crypto Taxes 101

Whenever you dispose of a crypto asset, i.e sell, trade, swap, there will be a difference between the current market value of the asset and its cost price. 

Definition: The cost price is known as the ‘cost basis’ and is the price you pay to acquire the crypto asset. 

The gas fees incurred can either be expensed in the P&L or capitalized and included in the cost basis price. For example, if Bob & Alice LLC purchased ETH for $1,200 and incurred $10 gas fees, in the case of capitalizing gas fees, the cost basis of that transaction would be $1,210. Increasing your cost basis means that the capital gains will be lower. 

The proceeds of the sale are how much you received for disposing of your crypto asset. Typically, this is the fair market value of your crypto-asset at the time of disposal, less the gas fees.

Definition: The capital gains or losses is the difference between the proceeds of sale and the cost basis of the crypto asset. 

• If you sell your crypto for more than you paid, you'll have a capital gain, which is subject to capital gains tax.
• Conversely, if the value of your crypto has decreased since the purchase, you'll incur a capital loss, which can offset capital gains for the year, reducing your overall tax burden.

Capital gains or losses are only realized upon disposal of the digital asset (i.e if no disposal, no capital gains or losses are incurred)

Now what happens if your business is acquiring digital assets continuously and how to keep track of the cost basis? In this case, it’s recommended to categorize each purchase into a lot. 

Definition: A lot refers to the individual purchase of digital assets. Each time you purchase new digital assets, it creates a new lot with its own cost basis and purchase date.

There are different cost basis methods—FIFO, LIFO, WAC, and HIFO—and depending on the method of choice, the financial outcomes will be different. The cost basis method essentially determines the order in which you dispose of your digital assets.

🙌 Template for Crypto Cost Basis 

For this article, we have provided you with a Cost Basis Template which compares the purchase and disposal of digital assets during a bull market v/s bear market. (feel free to create a copy and amend figures if needed)

📈Bull Market 

These were the following purchases:

• 8/1/2023: 10 ETH @ $2,022 each (Total Cost: $20,220)
• 8/15/2023: 5 ETH @ $2,368.80 each (Total Cost: $11,844)
• 8/31/2023: 25 ETH @ $2,488.96 each (Total Cost: $62,224)
• 9/28/2023: 32 ETH @ $2,851.72 each (Total Cost: $91,255)
• 10/31/2023: 18 ETH @ $3,077.78 each (Total Cost: $55,250)
• 11/5/2023: 7 ETH @ $3,364.29 each (Total Cost: $23,550)

The total cost basis was $264,343.00, and total ETH tokens purchased was 97.

📉Bear Market 

These were the following purchases:

• 8/1/2023: 10 ETH @ $3124 each (Total Cost: $31,240)
• 8/15/2023: 5 ETH @ $2976 each (Total Cost: $14,880)
• 8/31/2023: 25 ETH @ $2591.20 each (Total Cost: $64,780)
• 9/28/2023: 32 ETH @ $2119.375 each (Total Cost: $67,820)
• 10/31/2023: 18 ETH @ $1975 each (Total Cost: $35,550)
• 11/5/2023: 7 ETH @ $1935.71 each (Total Cost: $13,550)

The total cost basis was $227,820.00, and total ETH tokens purchased was 97.

Note: The ETH prices do not reflect actual historical market prices.

1️⃣ FIFO (First In, First Out) Explained

FIFO is one of the most commonly used accounting methods. It assumes that the first assets you purchase are the first ones sold.

This method is straightforward and often results in higher capital gains in a bull market since older, cheaper assets are sold first.

📈Bull Market 

In our example, we disposed ETH 52 tokens at a market price of $3,400.00

Total Cost Basis Disposed = $20,220 (ETH 10) + $11,844 (ETH 5) + $62,224 (ETH 35) + $34,220.64 (Remaining ETH12/ Total ETH32 * $91,255.00) = $128,508.63

Realized Gain = Proceeds of $176,800.00 - Total Cost Basis Disposed $128,508.63 = $48,291.38

📉Bear Market 

In our example, we disposed ETH 52 tokens at a market price of $1,830.00

Total Cost Basis Disposed = $31,240 (ETH 10) + $14,880 (ETH 5) + $64,780 (ETH 25) + $25,432.50 (Remaining ETH12/Total ETH32 * $67,820.00) = $136,332.50

Realized (Loss) = Proceeds of $95,160.00 - Total Cost Basis Disposed $136,332.50 = ($41,172.50)

2️⃣ LIFO (Last In, First Out) Explained

LIFO assumes that the most recently acquired assets are sold first. This method can reduce taxable income (i.e realized gain) during market downturns, since the newer, lower priced assets are sold first.

📈Bull Market 

In our example, we disposed ETH 52 tokens at a market price of $3,400.00

Total Cost Basis Disposed =  $23,550 (ETH 7) + $55,250 (ETH 18) + $76,996.41 (Remaining ETH27/Total ETH32 * $91,255.00) = $155,796.41

Realized Gain = Proceeds of $176,800.00 - Total Cost Basis Disposed $155,796.41 = $21,003.59

📉Bear Market 

In our example, we disposed ETH 52 tokens at a market price of $1,830.00

Total Cost Basis Disposed =  $13,550 (ETH 7) + $35,550 (ETH 18) + $57,223.13 (Remaining ETH 27/Total ETH32) = $106,323.13

Realized (Loss) = Proceeds of $95,160.00 - Total Cost Basis Disposed $106,323.13 = ($11,163.13)

3️⃣ WAC (Weighted Average Cost) Explained

Weighted Averate Cost (WAC) averages the cost of all assets to determine the cost basis for sales. Here you add up the purchase price of all tokens of the same crypto asset and divide by the total number of tokens purchased. This method smooths out price fluctuations and simplifies record-keeping.

📈Bull Market 

In our example, we disposed ETH 52 tokens at a market price of $3,400.00

The average cost per unit = $264,343.00 / ETH 97 = $2,725.19

Total Cost Basis Disposed = $141,709.65 ($2,725.19 * ETH 52)

Realized Gain = Proceeds of $176,800.00 - Total Cost Basis Disposed $141,709.65 = $35,090.35

📉Bear Market 

In our example, we disposed ETH 52 tokens at a market price of $1,830.00

The average cost per unit = $227,820.00 / ETH 97 = $2,348.66

Total Cost Basis Disposed =  $122,130.31 ($2,348.66 * ETH 52)

Realized (Loss) = Proceeds of $95,160.00 - Total Cost Basis Disposed $122,130.31 = ($26,970.31)

4️⃣ HIFO (Highest In, First Out) Explained

HIFO prioritizes the sale of the highest-cost assets first. This strategy can minimize taxable gains in a rising market, providing potential tax advantages. HIFO is not explicitly allowed by tax authorities in many jurisdictions since it minimizes capital gains tax. 

📈Bull Market 

In our example, we disposed ETH 52 tokens at a market price of $3,400.00

Total Cost Basis Disposed = $31,240 (ETH 10) + $14,880 (ETH 5) + $64,780 (ETH 25) + $25,432.50 (Remaining ETH12/Total ETH32 * $67,820.00) = $136,332.50

Realized Gain = Proceeds of $176,800.00 - Total Cost Basis Disposed $155,796.41 = $21,003.59 (Same result as under LIFO Bull)

📉Bear Market 

In our example, we disposed ETH 52 tokens at a market price of $1,830.00

Total Cost Basis Disposed =  $23,550 + $55,250 + $76,996.41 = $155,796.41

Realized (Loss) = Proceeds of $95,160.00 - Total Cost Basis Disposed $136,332.50 = ($41,172.50) (Same result as under FIFO Bear)

🥊 Comparing Cost Basis Methods in a Bull Market v/s Bear Market 

Below chart analyzes the differences in realized gain or loss in a bull market against a bear market, as per our above example.

📈Bull Market 

• FIFO increases the realized gain by selling earlier and cheapest cost units first.
• LIFO and HIFO minimize the realized gain by selling last and higher cost units first.
• WAC provides a middle ground, balancing the gain between the extremes of FIFO and LIFO/HIFO.

📉Bear Market 

• FIFO and HIFO resulted in the highest realized loss because the cost basis of the earliest and highest cost ETH purchases were used.
• LIFO resulted in the lowest realized loss because the cost basis of the most recent and lower cost ETH purchases were used.
• WAC again provides a middle ground, averaging out the costs and resulting in a moderate realized loss.

Please refer to our Cost Basis Template for a comparison of ‘Closing Cost Basis Balance’ and ‘Total Cost Basis Disposed’.

🎯 How to Choose the Right Cost Basis Method

Choosing the best cost basis method depends on your trading strategy, market conditions, and country specific tax regulations. Note that you’re not allowed to change the accounting method at every reporting period, and if you do decide to change, you must do so retroactively. 

Here are some tips:

• Market Conditions: 

In a bull market, LIFO or HIFO can reduce taxable gains. In a bear market, FIFO might be more beneficial as the initial purchase price is higher than current prices.

• Regulatory Compliance: 

Ensure the method chosen is allowed in your jurisdiction. Most jurisdictions allow the FIFO method, including the US, Australia, Singapore, Switzerland, France and Germany.

• Short-Term vs. Long-Term Gains

If you hold the asset for more than a year, you may qualify for long-term capital gains tax rates, which are typically lower than short-term rates.

• Use a crypto sub-ledger

Allows to track digital asset transactions and automatically calculate the cost basis for various assets on multiple chains. Using sub-ledgers, you can compare and choose the preferred cost basis method based on what is most advantageous for you.

• Consult a Professional: 

Consider consulting a local tax professional to optimize your approach based on your specific circumstances. Some of our local partners are; 

• 🇺🇲US - Hash Basis LLP
• 🇬🇧UK - Harris&Trotter LLP
• 🇨🇭Switzerland - Detof 
• 🇨🇦Canada - Convoy Finance
• 🇦🇺Australia - ElectraFi

👋 Wrapping Up  

In this guide, you have learnt how to navigate through choosing the different cost basis methods for your crypto transactions to help optimize your tax planning and financial reporting. 

If you want to learn more about crypto taxation for DeFi including liquidity providing, staking, NFT taxes and how to use tax loss harvesting, you can join our next cohort of the Crypto Accounting Academy.