Cost Basis Methods: Your Complete Crypto Guide

Navigating the intricacies of cost basis calculation is vital for crypto accounting. Without it, Web3 organizations cannot determine the capital gains or losses for digital assets held on their balance sheet. 

There are several methods to calculate cost basis for cryptocurrencies. These approaches hinge on the jurisdiction, the flux of the market, and the composition of the investment portfolio. Organizations should be choosing the most tax-advantageous method permitted in their jurisdiction. The vast majority of organizations in the space use the FIFO method.

In this guide, we will explore the following topics to help optimize this accounting workflow:

1. Cost basis and its role in calculating crypto capital gains and losses

2. Different cost basis methods, their potential benefits and disadvantages, and their application in various jurisdictions

3. Specific identification and cost basis-related documentation requirements

4. How to save time with automatic capital gains/losses calculation

What is Cost Basis in Crypto?

Cost basis is the original purchase price of an asset plus any fees or commissions related to its acquisition. This value forms the cornerstone for tax calculations and is pivotal in determining potential capital gains or losses upon the sale of the asset.

It is a crucial factor in tax matters as it is used to calculate capital gains or losses for financial assets. Cost basis must also be considered for impairment testing and used in the crypto tax reconciliation.

Here’s a simple example of the steps needed to calculate cost basis:

1. Take the current market value of a cryptocurrency.

2. Add the respective fees of the acquisition to the asset's purchase price. This value is the cost basis of your asset.

3. To estimate unrealized capital gains or losses (assuming the asset hasn’t been sold), subtract the cost basis from the asset's current market value.

Note: If a company is utilizing the revaluation method they would need to set specified intervals to conduct impairment testing to account for potential declines in the asset's market value.

For instance, your Web3 organization acquired 1 BTC for a $30,000 purchase price last month. You executed the trade on a DEX with a 0.1% trading fee ($30). Due to its on-chain nature, you also paid $70 in gas costs for your transaction. The cost basis becomes $30,100 ($30,000 + $30 + $70). 

If Bitcoin's current market value is $40,000, you would subtract the cost basis ($30,100) from this amount, yielding a capital gain of $9,900.

To avoid unwanted crypto tax audits, you would need to report these capital gains if you were to sell this BTC, as it would trigger a tax event. In the US, an organization can report capital gains via Form 8949 and Form 1040 Schedule D while in the UK, they can file a corporate tax return via the CT600 form or online. By diligently reporting these gains, you ensure your organization stays in full compliance with tax regulations, avoiding potential penalties and complications.

Which Cost Basis Method Should You Apply in Crypto?

Organizations may use different cost basis methods to calculate their crypto capital gains or losses based on their location. For instance, jurisdictions such as the US and Australia grant taxpayers the flexibility to select from various cost basis methods. On the other hand, countries like the UK, Canada, France, and several others prescribe a singular cost basis approach.

There are four primary cost basis methods in crypto accounting, each presenting its unique set of features, advantages, and challenges. One method can significantly reduce your tax liabilities, while a different method may lead to considerable tax burdens.

1. First In, First Out (FIFO)

FIFO is one of the most commonly used cost basis methods in both traditional and crypto finance. It is supported in several jurisdictions, including the US, UK, Australia, Germany, Austria, Norway, and Switzerland. FIFO is a simple method of calculating capital gains, where the first crypto asset you acquire is the first one to be sold.

For example, let's assume that your Web3 organization has 2 BTC on its balance sheet. 

The first BTC was purchased for $60,000 at the peak of the bull market in October 2021, while you acquired the second BTC for $17,000 a few days after FTX's bankruptcy in November 2022. 

If the current market price for Bitcoin is $25,000, you would realize a $35,000 capital loss by selling the first BTC using FIFO. In contrast, selling the newly-acquired Bitcoin would result in an $8,000 capital gain.

As illustrated in the above example, FIFO effectively reduces capital gains amid bear market conditions. Moreover, by holding your assets for more than a year, you can leverage the method to realize long-term capital gains tax discounts.The discount can be quite substantial. 

For example, the highest short-term capital gains tax rate in the US (37%) is nearly twice that of the highest long-term capital gains tax rate (20%).

However, FIFO may not be the optimal choice for your organization if market prices have surged significantly since you acquired your first assets. In that case, you could be subject to a higher capital gains tax than with other cost basis methods.

2. Last In, First Out (LIFO)

LIFO operates in the opposite manner to FIFO; it implies selling the most recently acquired cryptocurrency. 

For instance, if you purchased 1 BTC during the bear market in November 2018 for $4,000 and another 1 BTC for $28,000 in March 2023, you would realize a $21,000 capital gain with FIFO if Bitcoin's current market value is $25,000. However, with LIFO, you can sell the second BTC and realize a $3,000 capital loss instead.

Organizations can benefit from LIFO when the market is rising, as the newest digital assets on their balance sheets were acquired at the highest cost basis. In contrast, LIFO performs poorly in a bear market, making FIFO the better choice.

As organizations dispose of their recently-acquired assets with LIFO, they are often subject to short-term capital gains rates. Besides paying taxes at a higher rate, they could face more volatility-related risks with short-term investments.

Finally, LIFO is not as widely-accepted as FIFO. In fact, only a few jurisdictions such as the US and Australia allow LIFO as a cost basis method.

3. Average Cost Basis (ACB)

Unlike LIFO and FIFO, Average Cost Basis (ACB) is a method of calculating capital gains and losses that doesn’t rely on the date of purchase. Instead, it uses the average cost basis of all the assets on an organization's balance sheets.

To calculate ACB, you add up the purchase price of all units of the same digital asset including fees and commissions. Next, divide that value by the total number of investments.

For example, if your Web3 organization purchased 5 BTC at different prices, the ACB would be the total purchase price divided by 5 (fees and commissions included):

• 1 BTC for $10,000

• 1 BTC for $20,000

• 1 BTC for $30,000

• 1 BTC for $40,000

• 1 BTC for $50,000

Based on the above, the calculation would look like this:

• $150,000 ($10,000 + $20,000 + $30,000 + $40,000 + $50,000) / 5 = $30,000

If we take $25,000 as the current Bitcoin price, the Average Cost Basis of $30,000 would amount to a $5,000 capital loss on all your assets.

Suppose you sell 3 BTC out of the 5 BTC total on your organization's balance sheets:

• With the ACB method, you would realize a $15,000 capital loss. 

• If you used LIFO, it would account for a $45,000 ($25,000 + $15,000 + $5,000) capital loss. 

• However, you would have a capital gain of $15,000 ($15,000 + $5,000 - $5,000) with FIFO.

ACB can be considered a well-balanced cost basis method for Web3 organizations. While it may not always be the most efficient way to calculate capital gains and losses (like in a bull market), it may safeguard your project from being subject to LIFO's or FIFO's tax extremes.

That said, ACB is supported in only a few jurisdictions, such as Canada, France, and the UK and there are some notable differences in the ACB application within each:

• United Kingdom: In the UK, ACB is accompanied by a specific set of rules called share pooling. The same-day, bed and breakfasting, and section 104 rules are designed to prevent unrealistic views of capital gains or losses from short-term investments.

• France: Weighted Average Acquisition Price (PMPA) is the default cost basis method in this country. It is similar to ACB but with a key difference. PMPA uses the number of asset units acquired at each price level to weight the average cost in calculating capital gains and losses. On the other hand, ACB calculates the cost basis for a digital asset based on the total number of investments and their average cost.

• Canada: Canadian-based Web3 organizations must use Adjusted Cost Basis instead of Average Cost Basis for capital gains/losses calculations. The two methods are similar but Canadian organizations must also apply the superficial loss rule in conjunction with Adjusted Cost Basis to prevent wash sales.

4. Highest In, First Out (HIFO)

Highest In, First Out (HIFO) is a cost basis method that sells the assets with the highest purchase price first to determine capital gains or losses.

To use this method, all the digital assets on an organization's balance sheet must be collected and listed in descending order based on their purchase price.

For example, let's consider an organization that acquired the following digital assets in 2022 with the given cost basis:

• 2 BTC at $20,000 in January

• 5 BTC at $15,000 in May

• 3 BTC at $30,000 in October

• 1 BTC at $25,000 in November

• 2 BTC at $35,000 in December

Sorting these assets in descending order based on their cost basis, without considering the dates, we get:

• 2 BTC at $35,000

• 3 BTC at $30,000

• 1 BTC at $25,000

• 2 BTC at $20,000

• 5 BTC at $15,000

Assuming a current Bitcoin price of $25,000, selling 7 BTC from the organization's balance sheet would result in a capital loss of $30,000.

When compared with other cost basis, you would realize:

• $60,000 capital gains with FIFO

• $25,000 capital losses with LIFO

• No gains or losses with ACB

Based on the above example, HIFO could be the most efficient approach for Web3 organizations to minimize their capital gains or maximize losses. However, it's important to note that HIFO is only allowed in a few jurisdictions, such as the US and Australia.

Spec ID and Documentation Requirements

Organizations may face various documentation requirements based on the cost basis method they choose to calculate their crypto assets' capital gains or losses.

In the US, organizations must rely on specific identification (Spec ID) if they utilize a cost basis method other than the default FIFO. With Spec ID, taxpayers can identify the exact digital asset unit to be disposed of in a specific transaction and its respective cost basis. As a result, this makes tracking the cost basis of each digital asset unit in a Web3 organization's balance sheet much easier.

Specific identification is especially important because it enables US businesses to apply HIFO or LIFO to calculate cost basis. This offers more options to optimize capital gains or losses. This can be especially useful when FIFO would otherwise create a high tax bill for organizations.

However, the IRS requires Web3 organizations to document specific details for each digital asset unit, including:

1. Date and time of acquisition

2. Value at the time of acquisition

3. Cost basis

4. Date and time of disposal

5. Value at the time of disposal

It’s worth noting that the IRS only allows Web3 organizations to utilize specific identification with digital assets held in a single account, wallet, or address.

This means that it is not possible to optimize capital gains and losses with this technique across an entire balance sheet. Instead, organizations must employ a Spec ID-based cost basis method for each CEX and CeFi account, crypto wallet, and blockchain address to comply with IRS regulations.

An exception could occur when all project assets are held in a single wallet. However, this carries a high risk, as a security incident compromising the entire balance sheet of a Web3 organization could transpire.

How to Automatically Calculate Capital Gains/Losses

Cost basis is a critical component in calculating capital gains or losses in the cryptocurrency space. However, with several choices available, selecting the right cost basis method is crucial for optimizing taxes in your Web3 organization.

But unless you limit yourself to FIFO, your project may have to fulfill various documentation requirements.

Given the volatile nature of crypto, accurately managing a vast number of transactions and assigning the correct market values at the time of trade is essential for precise, compliant calculations.

Thankfully, Integral offers a solution that streamlines your accounting workflows. In our Policy Center, financial operators can select their preferred cost basis method (FIFO, LIFO, ACB, or HIFO). Once the method is selected, organizations can generate and export their comprehensive Cost Basis Report automatically.  Integral also provides a range of compliant and detailed reports, including closing positions, realized gains and losses, and profit & loss statements.

Take control of your digital assets with Integral – Enterprise-grade accounting that puts you in control.

Book a demo with our team, and we'll show you how quickly it can be done.