What is Cost Basis?: How It Works & Calculation In Crypto

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Starting out with cryptocurrency taxation? Understanding the concept of cost basis is one of the first steps to correctly determine your capital gains and losses. Interestingly, employing specific cost-basis methods can also help optimize your tax position.

At its core, cost basis is the initial price you spent to acquire an asset, in this case, cryptocurrency. The formula is straightforward: subtract your cost basis from the sale price of your crypto asset to ascertain your capital gains or losses.

Though this might seem simple, the reality involves choosing from a variety of cost-basis methods for your crypto tax calculations. To add another layer of complexity, many jurisdictions have strict regulations regarding which cost-basis method is permissible and when.

However, choosing the correct cost basis method from the available options can significantly aid in reducing your crypto tax liability. But how do you decide that?

The answer varies depending on your unique circumstances. This guide will help you understand the advantages of each method using easy-to-understand examples. By the time you reach the end, you will have gained insights into which accounting method can maximize your savings during tax season.

What is a Cost Basis?

Cost basis refers to the original price paid to acquire an asset, including any fees or expenses incurred during the purchase. 

Cryptocurrencies are treated as property, so understanding the cost basis is crucial to calculating capital gains or losses.

By accurately calculating the cost basis, you can ensure proper tax reporting and compliance with the applicable regulations.

Here’s a simple formula:

• To calculate the cost basis:

Cost Basis = Fair Market Value + Purchase Fees

• To calculate capital gains/losses:

Capital Gains/Losses = Cost Basis - Sale Price

While this may look simple, it can get quickly complicated due to the frequent price fluctuation of cryptocurrencies.

Example Of Cost Basis

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Let's imagine that John purchased 2 Bitcoins on January 1, 2022. The price of one Bitcoin at the time was $3000. This means John paid $6000 (2 Bitcoins x $3000 each) for his investment.

Now, let's suppose that the transaction fee for this purchase was $200. This fee is part of John's total investment and is added to his cost basis. 

So, the total cost basis for John's 2 Bitcoins would be:

$6200 ($6000 for the Bitcoins + $200 for the transaction fee).

If John decided to sell one of his Bitcoins a year later when the price of Bitcoin had risen to $4000, he would first need to calculate his cost basis for one Bitcoin to determine his taxable gain.

In this case, the cost basis for one Bitcoin would be half of his total cost basis, or $3100 ($6200 ÷ 2). 

John would then subtract this cost basis from the sale price to find his capital gain. 

The sale of one Bitcoin for $4000 would result in a capital gain of:

$4000 - $3100 = $900

Remember that tax laws and regulations can vary depending on jurisdictions. Always consult with a tax professional or advisor for advice specific to your situation.

Methods to Calculate Cost Basis

There are different methods to calculate your cost basis. By default, most firms use Average Cost Basis for calculations, but you can choose from multiple methods including:

FIFO (First In, First Out) 

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This is one of the most widely used and straightforward cost-basis methods. In FIFO, the first asset you purchase is considered the first asset you sell. 

This method offers simplicity in accounting and has the additional advantage of spending your longest-held assets first. This can be beneficial in terms of taking advantage of lower long-term capital gains tax rates compared to short-term rates.

While FIFO provides the advantage of potentially benefiting from long-term capital gains tax discounts, it's important to note that it may result in higher gains and subsequently larger capital gains tax obligations. 

This is because long-held assets often appreciate in value over time. Thus, investors should consider the potential tax implications of FIFO when determining the most suitable cost-basis method for their investments. 

LIFO (Last In, First Out)

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In contrast to FIFO, LIFO involves using the cost basis of the most recently purchased asset rather than the first one acquired. 

While LIFO may result in higher short-term Capital Gains Tax rates, investors might still pay lower overall taxes as their recently acquired assets may not have appreciated significantly in value.

HIFO (Highest In, First Out) 

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It prioritizes selling assets based on their highest acquisition cost. This strategy aims to minimize taxable gains by selecting units with the highest cost basis for sale.

By focusing on assets with a heftier cost basis, HIFO can potentially reduce overall tax liabilities and optimize your tax position. It is important to consult with a tax professional to ensure compliance with tax regulations when utilizing the HIFO cost-basis method.

ACB (Adjusted or Average Cost Base) 

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Adjusted Cost Basis, also referred to as Average Cost Basis, involves calculating the average cost for all your acquired assets. 

To determine the cost basis using ACB, you add up the total amount paid to purchase the assets and then divide that sum by the total quantity of coins or tokens held.

This calculation allows you to arrive at an average cost per unit, providing a fair representation of the cost basis for each asset. The ACB method can be beneficial for smoothing out the impact of price fluctuations and simplifying the cost basis calculation process.

By utilizing the ACB method, you can accurately determine the cost basis for your cryptocurrency investments, aiding in tax reporting and compliance with applicable regulations.

UK Share Pooling 

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In the United Kingdom, Share Pooling, also referred to as share-matching, is a specific cost-basis method mandated by HMRC. 

This method is applicable when spending, selling, or trading cryptocurrencies, and it determines the order in which coins are considered disposed of. The Share Pooling method involves three rules:

• Same Day Rule: When you dispose and acquire tokens on the same day, you will use the average cost basis (ACB) of all the tokens purchased on that day and the average sale price to calculate your capital gains or loss.

• Bed and Breakfasting Rule: According to this, when you dispose of tokens and then acquire the same type, in the same quantity within the next 30 days, you will calculate the cost basis of the disposed of tokens using the FIFO method. 

• Section 104 Pool Rule: The s104 pool is the total of all the crypto assets that don’t fall under the same-day or 30-day rule. Under this rule, you should calculate the cost basis of a given pool of assets using the ACB method. This is then used to calculate your capital gains or losses.

To know more details, refer to our Share Pooling in UK guide.

Specification Identification (Spec ID)

It allows you to use the actual cost basis of the specific asset you have sold. This method is particularly convenient to track with digital assets like cryptocurrencies due to the availability of transaction (TXN) numbers.

A potential drawback of the Spec ID method arises when trading at high volumes and not using cryptocurrency tax software. Calculating the cost basis for every disposal manually can be time-consuming and labor-intensive.

Despite this, using the Spec ID method offers the most accurate way to report your actual capital gains and losses compared to other cost-basis methods. Note that this cost-basis method is only allowed in the USA.

Comparison of Capital Gain/Loss with Each Cost Basis Method

Let's say you have purchased the following Bitcoin (BTC) over a period of time:

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Now, let's calculate the capital gain using different cost-basis methods:

• FIFO (First-In, First-Out):

Under FIFO, the BTC sold would be from the first purchase on January 1st, 2021. The cost basis for the BTC is $3000. The proceeds from the sale is $4000. 

Capital Gain = $4000 - $3000 = $1000.

• LIFO (Last-In, First-Out):

With LIFO, the BTC sold would be from the most recent purchase on August 1st, 2022. The cost basis for this BTC is $7000. The proceeds from the sale remain $4000. 

Capital Loss = $7000 - $4000 = $3000

You incur a capital loss using the LIFO method instead of realizing a capital gain utilizing FIFO. You can use these realized losses to offset your overall gains and save taxes.

• HIFO:

Using HIFO, the BTC sold would be from the highest-cost basis assets first. In this case, the BTC sold would be from the August 1st, 2022 purchase, with a cost basis of $7000. The proceeds from the sale are $4000. 

Capital Loss = $7000 - $4000 = $3000.

You realize a loss of $3000 on your BTC sale.

• ACB

To calculate the average cost basis, we divide the total amount paid for the BTC purchased ($3000 + $3000 + $5000 + $7000) by the total quantity held (2 + 1 + 1). 

The average cost basis per BTC is ($3000 + $3000 + $5000 + $7000) / 4 = $4500.

Since you sold 1 BTC, the proceeds from the sale is $4000.

Capital Loss = $4500 - $4000 = $500.

You realize a capital loss of $500.

• Specific Identification:

In this method, you can choose the specific BTC you are selling. Let's assume you sell the BTC purchased on January 1st, 2021 with a cost basis of $3000. The sale proceeds remain $4000

Capital Gain = $4000 - $3000 = $1000.

• Share Pooling

Here, we would need specific dates of acquisition and disposal. In this case, the BTC sold would be from the August 1st, 2022 purchase, with a cost basis of $7000. The proceeds from the sale are $4000. 

Capital Loss = $7000 - $4000 = $3000.

So, Which Cost Basis Method Should You Choose?

With various cost basis methods available for calculating capital gains and losses, the choice of method can significantly impact your Capital Gains Tax bill. 

In some countries like the UK, the government has laid out specific cost-basis methods that should be followed while calculating taxes.

In other countries where you have the option to select the cost basis method, it is important to choose the one that optimizes your tax position. Consider your objectives, whether to minimize tax liabilities or maximize tax benefits.

Evaluate the level of recordkeeping required for each method and the frequency of your trading activities. If you are unsure, always consult a tax professional or utilize a crypto tax software to help you choose the most suitable cost-basis method for your cryptocurrency investments.

Find The Best Cost Basis For Your Investments

Manually calculating the cost basis for cryptocurrency transactions for determining your capital gains and losses can quickly turn complex. Each transaction must be accurately recorded along with all the specific details to ensure correct tax calculations. 

This process can be time-consuming and prone to errors leading to potential tax discrepancies and legal issues.

This is where a dedicated cryptocurrency tax software like Kryptos can be a game-changer. KryptoSkatt streamlines the entire process, automating the calculation of cost basis, and tracking capital gains and losses. 

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The software intelligently chooses the most suitable cost basis method according to the specific jurisdiction and transaction type, ensuring accurate tax calculations tailored to your’s unique needs. 

Want to calculate your cost basis for your crypto investments? Get Started Today.

FAQs

1. Can I change my cost basis method for cryptocurrency transactions?

No, once you have chosen a cost-basis method, it is generally expected that you use it consistently for all your cryptocurrency transactions. While you can change the method, it will impact on your overall calculations.

2. Do I need to report every cryptocurrency transaction on my tax return?

Yes, the IRS requires you to report all taxable cryptocurrency transactions on your tax return, regardless of the amount.

3. What happens if I cannot determine the cost basis of my cryptocurrency?

If you cannot determine the cost basis of your cryptocurrency, the IRS assumes a cost basis of zero, resulting in the entire proceeds being treated as taxable income.

4. Is cryptocurrency taxed differently than traditional investments?

Yes, cryptocurrency is subject to specific tax rules, and the IRS treats it as property for tax purposes rather than currency. This can have implications for capital gains tax rates and reporting requirements.

5. Can I deduct cryptocurrency losses on my tax return?

Yes, you can deduct cryptocurrency losses on your tax return, subject to certain limitations and restrictions. Losses can offset capital gains and potentially reduce your overall tax liability.

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All content on Kryptos serves general informational purposes only. It's not intended to replace any professional advice from licensed accountants, attorneys, or certified financial and tax professionals. The information is completed to the best of our knowledge and we at Kryptos do not claim either correctness or accuracy of the same. Before taking any tax position / stance, you should always consider seeking independent legal, financial, taxation or other advice from the professionals. Kryptos is not liable for any loss caused from the use of, or by placing reliance on, the information on this website. Kryptos disclaims any responsibility for the accuracy or adequacy of any positions taken by you in your tax returns. Thank you for being part of our community, and we're excited to continue guiding you on your crypto journey!