Many crypto traders face massive tax bills for 2017. Which accounting method they apply could change their tax bills by tens of thousands of dollars.
Specific identification vs. FIFO
The IRS wants the “specific identification” (SI) accounting method used on property transactions, which applies to crypto. SI requires “adequate identification” of units sold, but most crypto traders cannot comply with these formal IRS regulations.
Many crypto traders and accountants use the alternative “first in first out” (FIFO) accounting method. FIFO is reliable and practical. A side benefit of FIFO is longer holding periods with potential qualification for long-term capital gains tax at 0%, 15% and 20% graduated rates.
But FIFO likely raised tax bills for many crypto traders in 2017, because coin prices rose dramatically during the year. Selling coins purchased at lower prices (cost basis), increased 2017 capital gains. Many traders held significant amounts of crypto at year-end, embedded with higher cost-basis. If these traders complied with SI adequate identification rules, they might have reduced capital gains income by choosing higher-cost lots for sale.
Special IRS rule for securities
Thomson Reuters tax publishers explains the FIFO rule as follows:
Except for stock for which the average basis method is available (i.e., mutual fund shares), if a taxpayer sells or transfers corporate stock that the taxpayer purchased or acquired on different dates or at different prices, and the taxpayer doesn’t adequately identify the lot from which the stock is sold or transferred, the stock sold or transferred is charged against the earliest lot purchased or acquired to determine the basis and holding period of the stock.
An adequate identification is made if the taxpayer, ‘at the time of the sale or transfer,’ specifies what particular shares are to be sold or transferred and, within a reasonable time after that, the broker or other agent confirms the specification in a written document. In this event, the taxpayer’s instruction prevails even though delivery was actually made from a different lot. Stock identified under this rule is considered to be the stock sold or transferred by the taxpayer, even if stock certificates from a different lot are actually delivered to the taxpayer’s transferee. For this purpose, an adequate identification of stock is made at the time of sale, transfer, delivery or distribution if the identification is made no later than the earlier of the settlement date or the time for settlement required by Rule 15c6-1 under the Securities Exchange Act of 1934. A standing order or instruction for the specific identification of stock is treated as an adequate identification made at the time of sale, transfer, delivery or distribution.”
The tax court and IRS relaxed SI rules in some cases, but more stringent IRS regulations remain the law. In Concord Instruments Corp, (1994) TC Memo 1994-248, per Thomson Reuters,
Taxpayer had maintained cost records of each lot of stock that was purchased, the date of purchase and the price per share. T’s accountant used these records to prepare T’s income tax returns. To compute the gain from T’s stock sales, the specific identification method was used and the highest cost shares were treated as sold first. The court concluded that Taxpayer had sufficiently identified the stock sold to avoid the FIFO method of reporting the gains.”
The tax court allowed oral communication by the trader to the broker and the court relaxed the broker rules for providing contemporaneously written confirmation.
With high-speed trading on coin exchanges, it seems nearly impossible to comply with adequate identification rules for the SI accounting method. Crypto traders don’t use brokers; they trade online over coin exchanges without any communication between trader and exchange. Would the IRS consider this situation to be compliant with SI adequate identification rules? Maybe not.
New York tax attorney Roger D. Lorence says: “Given how longstanding this regulation is, I would describe it as having in effect the force of law. The legal effect is to create a rebuttable presumption of its correctness; the presumption is overcome only upon the showing of strong proof. Unless the cryptocurrency trader has contemporaneous records showing specific identification, if they are in the US Tax Court, they would be held to FIFO.”
AICPA weighs in
In June 2016, the AICPA asked the IRS if crypto traders could use FIFO as an alternative accounting method. (See Comments on Notice 2014-21: Virtual Currency Guidance.)
Allow an alternative treatment under section 1012 (e.g., first in first out (FIFO)). The treatment of convertible virtual currency as noncash property means that any time virtual currency is used to acquire goods or services, a barter transaction takes place, and the parties need to know the fair market value (FMV) of the currency on that day. The party exchanging the virtual currency for the goods or services will need to also track the basis of all of his or her currency to determine if a gain or loss has occurred and whether it is a short-term or long-term transaction. This determination involves a significant amount of recordkeeping, even if the transaction is valued at under $10.
Currently, there are no alternative tracking methods provided for such transactions (other than for securities under Treas. Reg. § 1.1012-1(c)). Therefore, taxpayers are required to specifically identify which virtual currency lot was used for each transaction in order to properly determine the gain or loss for that particular transaction. In many cases, it is impossible for a taxpayer to track which specific virtual currency was used for a particular transaction.”
Example of specific identification
A crypto trader bought 20 Bitcoins before 2017 at low prices. He bought 30 more Bitcoins between January and June 2017 at materially higher rates. In July 2017, he transferred the 30 Bitcoins purchased in 2017 to a coin exchange. He kept the original 20 in his wallet off-exchange. He adequately identified the 30 newer units for the trading. He used and complied with SI, and it saved him thousands of dollars in capital gains taxes compared to using FIFO.
Choosing an option in a trade accounting program to cherry pick the highest cost basis for lowering capital gains after the fact is probably not acceptable to the IRS. “Last in first out” (LIFO) is also expected not acceptable.