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How HIFO accounting reduces IRS bill

Bitcoin is down about 36% from its all-time high in November, but the drop has a good side, thanks to the evasiveness of tax law that helps crypto holders protect their earnings from the IRS.

The IRS treats cryptocurrencies like property, which means that any time you spend, exchange or sell your tokens, you register a taxable event. There is always a difference between how much you paid for your cryptocurrency, which is the cost basis, and the market value at the time you spent it. This difference can result in 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 you sell your cryptocurrency, you can pick and choose the specific unit you are selling. This means that the holder of the cryptocurrency can choose the most expensive bitcoin they have purchased and use this number to determine their tax liability. A higher cost basis translates to lower taxes on your sales.

But the onus is on the user to follow through, so thorough bookkeeping is essential. Without detailed records of the taxpayer’s transaction and cost basis, the accounts cannot be proven to the IRS.

“People rarely use it because it requires keeping good records or using encryption software,” explained Sheehan Chandrasekera, a certified public accountant and head of tax strategy at crypto tax software company CoinTracker.io. “But the thing is, a lot of people are now using this kind of software, which makes this kind of accounting very easy. They don’t even know it exists.”

The trick with HIFO accounting is to keep accurate details about every crypto transaction you made for every coin you own, including when and how much you bought it, as well as when you sold it and the market value at that time.

But if you don’t have all transaction records on file, or if you’re not using the right kind of software, the accounting method defaults to something called FIFO, or what’s first.

“It’s not perfect,” Chandrasekera explains.

Under the first-in-first-out accounting rules, when you sell your tokens, you sell the first coin purchased. If you buy cryptocurrency before its price spikes in 2021, the lower cost basis could mean an increase in your capital gains tax bill.

Then there is the laundry sale rule

Experts tell CNBC that pairing HIFO accounting with a laundry sale rule has the potential to save taxpayers more money.

Since the IRS classifies digital currencies like bitcoin as property, losses in cryptocurrency holdings are treated differently than losses in stocks and mutual funds, according to Onramp Invest CEO Tyrone Ross. In particular, the rules of selling wash do not apply, which means that you can sell your bitcoins and buy them back, while with stocks, you have to wait 30 days to buy them back.

This nuance in the tax code paves the way for aggressive tax losses, as investors sell at a loss and buy back bitcoin at a lower price. These losses can lower your tax bill or use them to offset future gains.

For example, suppose a taxpayer buys 1 bitcoin for $10,000 and sells it for $50,000. This individual will face $40,000 in taxable capital gains. But if the same taxpayer previously reaped $40,000 in losses in previous crypto transactions, they will be able to recoup 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 how developed they are.

Buying back cryptocurrencies quickly is another essential part of the equation. If timed correctly, buying dips enables investors to bounce back, if the price of the digital currency rebounds.

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