ELI5 —Part 1: Crypto Taxation
This article is for you if you…
- …want to understand how your crypto assets are measured
- …didn’t study business administration or accounting and have never heard about Fifo or Lifo
- …want to get a better understanding of inventory methods
- …DID study business administration but fell asleep during accounting 101
The Fundamental Truth of Taxation
If you want to know how much you owe in taxes, there are really only two parameters that matter:
- How much money you own relative to the last time you filed taxes
- Your tax rate
While this seems easy enough, both of those parameters have a whole megillah of buts, ifs and whiles to consider. There are libraries filled with books about definitions of “money”, “tax rate” or even the meaning of “the last time you filed taxes”.
In this article, we are going to talk about the different ways to determine the most important parameter (your taxable income).
Lesson one: Inventory
In the crypto world, taxable income is not as clear cut as one would think. Especially when you don’t buy and sell everything at once. If you only invest once (at t=0), don’t do any trades and liquidate at the end (t=n), the calculation is fairly simple. Taxable income then becomes the difference between the money you invested in t=0 and the money you took out in t=n.
Depending on whether you’ve made gains or losses, you either have to pay taxes on your gains, or you can deduct them from your taxable income.
But if you want to buy and sell different assets at different times, this calculation becomes much harder.
In order to correctly determine your income, you can borrow methods from classical inventory such as FIFO and LIFO. We have created a much more in-depth article about FIFO and LIFO here, feel free to check it out.
The acronym stands for “first in, first out”. Whatever assets you have bought first get spent first. An obvious use of FIFO is the way lines of people in a supermarket usually work. The people first in line get served first.
That way, the time between buy and sell is always the longest possible. This is especially useful if you have a holding period after which crypto assets do not count towards your taxable income. In Germany for example, if you hold a currency for more than one year, gains do not count towards your taxable income.
Especially with the consideration of holding periods, FIFO accounting can be very favorable for investors as older investments might have lower tax rates than newer ones.
LIFO is the polar opposite of FIFO, meaning “Last in, first out”. This works like a stack of pancakes, where the last one you put on the pile gets eaten first.
This inventory method is great if you are looking to extend the holding duration of your earlier investments.
FIFO and LIFO in Action
Imagine you bought 100 Bitcoin at $1 each and then you bought another 1 Bitcoin at $10,000. Not taking holding periods into account, if you now wanted to sell 1 Bitcoin at the current price of $3,500, you could either realize a gain of $3,499 that you would have to pay taxes for using FIFO (because you are selling one of the early 100 Bitcoins), or a loss of $6,500 using LIFO (because you are selling the last Bitcoin), that you could deduct from your investment income.
Which inventory method is the right one for you of course depends on your specific situation. Accointing can give you a much better overview on your current status and give you a much better understanding of your current gains and losses.
With its tax optimizer, Accointing can also propose different scenarios for your portfolio depending on what your current requirements are.
For an in depth explanation and example of LIFO and FIFO click here.