What are the differences between crypto LIFO and FIFO accounting methods? Every crypto transaction can be taxed because, according to the IRS or Internal Revenue Service, crypto coins are considered as property and therefore are subject to capital gains, and losses.
Therefore, if you want to comply with the legal and financial obligations, you will need to follow the right financial accounting methods to comply and make sure that every record of your crypto transaction is just as it is wanted.
You can use either of the two common accounting methods followed such as LIFO or Last In First Out accounting process or FIFO or First In First Out accounting technique.
In fact, proper accounting is very important in this case because it will determine how much you can save on taxes.
Sometimes, the right method of accounting can save you from paying thousands of dollars potentially on your tax return.
Typically, capital gains taxes can be calculated by using different formulas.
According to the basics of accounting, when the value of a particular crypto coin is lower at the time of sale in comparison to the cost of its purchase, you will end up incurring a capital loss.
This, the accountants can use to offset the capital gains made by you during the year.
Crypto LIFO vs FIFO Accounting Methods – The Differences
Now, all these may sound very complex to you if you do not know the differences between FIFO and LIFO accounting methods in the first place.
Yes, though these two accounting methods serve the same purpose of calculating your accumulated tax amounts there are lots of differences between them.
If you are not aware of them, this is the right place to be.
Here, in this article, you will come to know about the differences between them as well as a few other facts that will help you to choose the right accounting method for your case.
The FIFO or First In First Out is a technique wherein the crypto coins that you purchased first, when they are arranged chronologically, are sold off first.
In short, in this process, the price at which you initially bought the crypto coin is considered as the ‘Cost basis’ and is used to calculate the capital gains. This is determined by the difference between the selling price and the cost basis.
On the other hand, in the LIFO or Last In First Out method, the crypto coins that you bought last will be the first coins that you sell off.
In that case, the purchase price of the coins bought last will become the cost basis. In both the cases, if the final answer is positive, you make a capital gain and if it is negative, you incur a loss.
Features and Requirements
The FIFO accounting method is considered to be the most traditional method by most of the crypto users. The good thing about this specific technique of accounting is that you seldom need to keep a detailed record of your crypto transactions.
On the other hand, in the case of using the less traditional LIFO accounting method, just as in the case of HIFO or Highest In First Out accounting technique, you will need to keep a detailed record of all your crypto transactions, even if you are dealing with multiple crypto exchanges and wallets.
This is because you will need to sometimes provide the complete crypto trading history while reporting your taxes.
In the FIFO accounting method, it results in the highest capital gains because you are selling first the oldest coins in your crypto portfolio. This usually happens in a Bull market that usually sees the prices of the crypto coins trending up.
This means that the purchase price of a specific crypto coin will be much lower than the prevailing market price.
And, if the market experiences a bearish run or where the prices of the crypto assets are falling regularly, the FIFO accounting method minimizes your capital gains since the cost price of the crypto coin is higher than the current prices.
On the other hand, the method and outcome of LIFO are just the opposite of FIFO.
This means that in a Bull market that is trending up, this method can result in a considerably lower capital gain and, in a bear market, the outcome of LIFO is higher capital gains due to the falling prices of crypto coins.
For Investors and Traders
Though there is no specific guidance as to which particular accounting method you should use for calculating your taxable amount, for crypto investors typically both LIFO and FIFO methods can be used.
On the other hand, for the crypto traders, the choice seems to be limited. Herein ideally, the actual cost of each particular parcel is preferred, which may not be available often since multiple variants of crypto coins can be purchased at a specific point in time.
In that case, finding out which is being sold at a later point of time may not be possible or be practical and accurate.
In such a situation, the FIFO method is best suited to calculate the taxable amount more precisely. Remember, typically, an average method is not acceptable by the tax authorities.
Which is Better – Crypto LIFO or FIFO Accounting Method?
This question is quite hard to answer in simple words because it will vary according to the given condition as well as your specific trading style and preferences.
Since both these accounting methods come with different characteristics, each offers different types of benefits to the users.
The amount you paid for your crypto coin, known as the cost basis, will have a significant impact on the taxes that you eventually need to pay when you sell them off.
Therefore, it is important to know how a particular accounting method between LIFO and FIFO, or even HIFO for that matter, will affect the cost basis.
This may help you to find an easy way out to pay your taxes and at the same time apply tax saving prospects.
Ideally, the amount of tax you need to pay on your crypto transactions made during the year is decided by three specific factors such as:
- The proceeds, or the market value of the particular crypto coin at the time of making the transaction
- The cost basis, or the purchase price of the coin and
- The profit or loss, or the positive and negative differences between the two prices mentioned above.
However, it is rather unlikely that a crypto trader or investor would buy and sell all crypto coins they hold at one time.
In most cases, the users sell off their crypto holdings depending on the positions that are built up over a certain period of time.
Therefore, in such a situation, the more viable question to ask is: which will be a better accounting method for you to use for calculating the profits made or losses incurred from each crypto sale for calculating the taxable amount?
In that sense, and once again, it is the prevailing market conditions that will determine it.
For example, if the prices of the crypto coins are rising in the market, it is most likely that you will gain a lot if you use the LIFO accounting method.
This is because it will lower your capital gains and the taxable amount by a significant margin.
However, if you go for the LIFO method, just make sure that you have a proper record that contains the following information:
- The date, as well as the time of the assets, bought
- The cost basis as well as the fair market value of each of the crypto coins when you bought them
- The date and time when you sold each of the crypto coins or even exchanged them or dispose them off in any other way
- The fair market value of each crypto coin when it was sold and
- The amount of money that you received in the process or the value of the property obtained in the process.
It is only when you have all this information handy you will be able to answer all the questions asked by the IRS more confidently if in case such a situation arises.
On the other hand, if you are trading in a bearish market where the prices of crypto coins are falling continually, it is more feasible to go with the FIFO technique of accounting to calculate your taxable gains.
The good thing about the LIFO method of accounting is that it not only reduces the taxable amount and protects you from paying higher capital gains in the short term but it will also extend the holding time of your crypto coins.
Well, the FIFO method of accounting will also help you to save on your tax bills.
It is also quite a popular method of accounting used by several crypto investors mainly because it is considered to be the most conservative method for accounting.
However, you are allowed to switch from one accounting method to the other by the IRS on a year-to-year basis but there are a few things that you should keep in mind while favoring such moves. These are:
- One, frequent flipping back and forth between the two different accounting methods can result in some errors in your calculation. This may, in turn, result in a lot of questions asked by the IRS and delay in completing your tax obligations.
- Two, switching from one accounting method to the other may also raise the suspicion of the IRS and lead to a strict scrutiny and investigation.
Therefore, the best thing to do to avoid such issues and consequences is to consult your accountant or tax professional.
They will be able to find out whether or not you actually need a switchover and what is needed to be done to make such a switch and save your tax reports from being red flagged.
Therefore, in the end, it can be summarized that the FIFO cost basis refers to that particular situation wherein the same order of buying and selling of crypto coins is followed. In other words, the oldest crypto coins are sold first.
On the other hand, the LIFO cost basis refers to the practice where the coins are sold in the opposite way as FIFO. This means that the coins that are acquired most recently are sold first.
Therefore, each of these two accounting methods, FIFO and LIFO, can produce a tax outcome that is wildly different and that is why you will need to choose the right method. Otherwise, it may expose you to a higher level of risks and taxes.
If you want to minimize the tax amount on your crypto coins as much as possible, you will need to use the right method among FIFO and LIFO to calculate the amount and file your taxes. This article and in-depth tax guides will help you a lot.