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How HIFO Accounting Reduces IRS Bill

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How HIFO Accounting Reduces IRS Bill

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Bitcoin is down about 36% from its all-time high in November, but there’s an upside to the decline, thanks to a quirk in the tax code that helps crypto holders protect their earnings from the IRS.

The IRS treats cryptocurrencies as property, which means that every time you spend, trade, or sell your tokens, you register a taxable event. There is always a difference between the amount you paid for your crypto, which is the cost basis, and the market value at the time you spend it. This 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 selling your crypto, you can choose the specific unit you are selling. This means that a crypto holder can choose the most expensive bitcoin they purchased and use that number to determine their tax liability. A higher cost base translates to less tax on your sale.

But it’s the user’s responsibility to keep track, so thorough 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 encryption software,” explained Shehan Chandrasekera, CPA and head of tax strategy at crypto tax software company CoinTracker.io. “But the thing is, a lot of people are now using this type of software, which makes this type of accounting super easy. They just don’t know it exists.”

The trick to HIFO accounting is to keep 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 market value at that time.

But if you haven’t saved all the transaction records or 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,” says Chandrasekera.

According to FIFO accounting rules, when you sell your tokens, you sell the first coin purchased. If you bought your crypto before its 2021 price spike, your low cost base may mean a bigger capital gains tax bill.

Then there’s the wash sale rule

Pairing HIFO accounting with the wash 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 crypto holdings are treated differently than losses on stocks and mutual funds, according to Tyrone Ross, CEO of Onramp Invest. In particular, wash-sell rules do not apply, meaning you can sell your bitcoin and redeem it immediately, whereas with a stock you will have to wait 30 days to redeem it.

This nuance in the tax code sets the stage for aggressive tax loss harvesting, where investors sell at a loss and buy back bitcoin at a lower price. These losses can reduce your tax bill or be used to offset future gains.

For example, suppose a taxpayer buys bitcoin for $10,000 and resells it for $50,000. This person would face $40,000 in taxable capital gains. But if that same taxpayer had already reaped $40,000 in losses from previous crypto transactions, they would be able to offset the tax they owe.

“You want to look as poor as possible,” Chandrasekera explained.

Chandrasekera says he sees people doing this on a weekly to quarterly basis, depending on their sophistication.

Quickly redeeming cryptos is another key part of the equation. If timed correctly, buying the dip allows investors to catch up, if the price of the digital coin rebounds.

How HIFO Accounting Reduces IRS Bill

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