Crypto tax strategies: Understanding HIFO, FIFO and Spec ID methods

Key takeaways

• FIFO, HIFO and Spec ID (among others) are key methods to calculate crypto tax liability.
• The choice of method affects your taxable gains and overall liability.
• Record-keeping is crucial for compliance, especially for HIFO and Spec ID.
• Regulations vary by country; consult a tax professional to optimize your strategy.

Cryptocurrencies are treated differently around the world, but in most jurisdictions, your income from trading them is likely subject to capital gains tax. This is especially true in countries like the United States, United Kingdom, Germany, Australia and France, where crypto is classified as property or a taxable financial asset.

How you report your crypto gains or losses often depends on your country’s regulations, and there are various methods to calculate your tax liability. These include terms like FIFO, HIFO and specific identification, which you will learn in this article.

These terms are important to get your head around. After all, failure to report accurately could lead to penalties, audits or even legal consequences. That’s why crypto taxes matter.

Did you know? In Norway, a recent study found that approximately 88% of cryptocurrency holders failed to report their assets, leading to an estimated tax loss between $50 million and $272 million.

Basic principles of capital gains and losses in crypto

When you sell, trade or dispose of cryptocurrency, you’re likely triggering a taxable event. In the UK, His Majesty’s Revenue & Customs (HMRC) treats crypto assets as property, meaning they’re subject to capital gains tax (CGT). This applies when you:

• Sell crypto for fiat currency
• Exchange one crypto for another
• Use crypto to purchase goods or services
• Gift crypto to someone other than your spouse or civil partner.

To calculate your capital gain or loss, subtract the asset’s cost basis (what you originally paid, including transaction fees) from the disposal proceeds. If the result is positive, you’ve made a gain — if negative, a loss.

The tricky part is this: Imagine you’ve been investing in Ether (ETH) over the years. You currently hold 3 ETH — one purchased way back in 2015 for $100, another bought in 2020 for $2,000 and a third recently acquired for $3,500. Now, you decide to withdraw 1.5 ETH. How do you determine which ETH you’re selling and, more importantly, what the cost basis is for the transaction?

This is where the complexity of cryptocurrency taxation kicks in. Each ETH has a different purchase price, and calculating your capital gain or loss depends entirely on which coins are considered sold. Did you sell the oldest ETH first? The most expensive one? Or did you pick specific coins to match the withdrawal?

Methods such as FIFO, HIFO and Spec ID exist to answer this question. They provide structured approaches to calculating cost basis and determining taxable gains or losses.

Cost basis methods, explained

When it comes to filing crypto tax returns, understanding the different methods for calculating capital gains is crucial for cryptocurrency investors.

First-in, first-out (FIFO)

FIFO assumes you sell the first coins you bought. Imagine that you bought 1 ETH for $1,000 in January and another for $2,000 in March. If you sell 1 ETH in July for $3,000, FIFO assumes you’re selling the January coin, resulting in a gain of $2,000 ($3,000 - $1,000).

• Advantages: It’s simple and widely accepted by tax authorities.
• Disadvantages: In a rising market, earlier purchases may result in higher taxable gains.

Last-in, first-out (LIFO)

LIFO assumes you sell your most recently purchased coins first. For example, using the same scenario, if you sell 1 ETH in July for $3,000, LIFO assumes you’re selling the March coin. The taxable gain is $1,000 ($3,000 - $2,000).

• Advantages: It can reduce taxable gains in a volatile or rising market.
• Disadvantages: LIFO isn’t permitted for cryptocurrency taxes in many countries, as it complicates asset tracking and reporting.

Highest-in, first-out (HIFO)

HIFO prioritizes selling the most expensive coins first. Let’s suppose you bought 1 Bitcoin (BTC) for $10,000, another for $15,000 and another for $25,000. Selling 1 BTC for $35,000 using HIFO assumes the $25,000 coin was sold, leaving a $10,000 gain.

• Advantages: It minimizes gains and tax liabilities.
• Disadvantages: It requires detailed tracking and isn’t universally accepted.

Specific identification (Spec ID)

With Spec ID, you choose which asset to sell based on your purchase records. For instance, you own 5 BTC bought at varying prices. You sell 1 BTC for $40,000 and choose to sell the $30,000 BTC. Your gain is $10,000.

• Advantages: Offers flexibility to manage taxable gains.
• Disadvantages: Requires meticulous records to justify your selection.

Pooling (UK-specific method)

The UK uses a unique approach to cost basis called the pooling system. Essentially, all assets of the same type — e.g., BTC — are grouped into a single pool. The cost basis is calculated as the average cost of all holdings in the pool. Additionally, there are two rules:

• Same-day rule: If you sell and buy the same type of crypto on the same day, the cost basis for the sale is matched with the same-day purchase.
• 30-day rule: If you sell and buy the same type of crypto within 30 days, the cost basis for the sale is matched with the new purchase, overriding the pooled average.

Example: You buy 1 BTC for 10,000 British pounds and another for 20,000 pounds. The pool’s average cost basis is 15,000 pounds per BTC. If you sell 1 BTC for 25,000 pounds, your gain is 10,000 pounds. However, if you repurchase 1 BTC for 18,000 pounds within 30 days, the sale is matched with this purchase, and the gain becomes 7,000 pounds (25,000 - 18,000).

• Advantages: It ensures consistent reporting and prevents manipulation of taxable gains using wash sales.
• Disadvantages: It limits flexibility and requires careful tracking of transactions under the same-day and 30-day rules. 

The flexibility to select a cost basis method for cryptocurrency taxes depends heavily on the regulations of your country.

In the United States, the Internal Revenue Service offers freedom to use methods like FIFO, HIFO or Specific Identification (Spec ID). However, this flexibility comes with the requirement to maintain detailed records. For instance, you must document dates of purchase and sale, amounts, costs and prices for each transaction. If you can’t match specific assets to transactions — e.g., for Spec ID — the IRS defaults you to FIFO, although this scheme has recently been challenged.

As you’ve seen, in the United Kingdom, the approach is much stricter. Taxpayers must use a pooling system, where all crypto of the same type is averaged into a single cost basis. Additionally, same-day and 30-day matching rules prevent taxpayers from manipulating gains or losses by exploiting market fluctuations. These rules override alternative methods like LIFO or HIFO, making them inapplicable in the UK.

In Australia, taxpayers can use FIFO or Spec ID, provided they maintain meticulous records. Similar to the US, if adequate documentation isn’t provided, authorities may default to FIFO, which is simpler but can result in higher tax liabilities in a rising market.

The LIFO method is rarely allowed for cryptocurrency taxes in most jurisdictions, as:

• LIFO can complicate tax reporting because it assumes you’re selling the newest assets first, which may not align with how transactions occur in practice.
• Allowing LIFO could incentivize taxpayers to minimize taxable gains in rising markets. For example, selling recently purchased, higher-cost crypto during a bull market can significantly lower reported gains, even if the taxpayer still holds older, low-cost crypto.
• LIFO requires tracking every purchase in reverse order and matching it to sales, which can create significant complications in maintaining accurate records.

Did you know? Most jurisdictions allow only one cost-basis method to be applied per tax year. Once you commit to a method, switching mid-year is generally not permitted without special approval.

Choosing the right method for your situation

Here’s how to determine the best fit for your situation:

Understand your tax obligations

Start by reviewing the tax rules in your country. For instance, if you’re in the UK, you’ll likely use the pooling system, whereas US taxpayers can choose between FIFO, HIFO or Spec ID. Ensure your preferred method is legally permitted where you live.

Consider your trading activity

• Occasional investors: If you rarely trade, FIFO is a simple and widely accepted choice. It requires less documentation and is easy to apply.
• Frequent traders: For active traders, methods like HIFO or Spec ID can help minimize taxable gains, especially in volatile markets, but these methods require meticulous record-keeping.

Evaluate tax implications

Each method affects your tax liability differently. Here’s how:

• FIFO may result in higher taxes in rising markets, as it uses older, lower-cost assets for calculations.
• HIFO can lower your gains by prioritizing higher-cost assets, reducing your taxable income.
• Spec ID offers the most flexibility, allowing you to match sales to specific purchases strategically.

Plan ahead

Once you select a method, you’ll typically need to stick with it for the entire tax year. Plan your strategy early to align with your financial goals and simplify reporting.

Did you know? For high-frequency traders or those with complex portfolios, consulting a tax professional is highly recommended. They can help ensure compliance with local rules, optimize your strategy, and reduce the risk of audits or penalties.

Best practices for record-keeping

Here are some helpful tips on how to ensure accurate record-keeping.

1. Track every transaction: Maintain detailed records of all crypto purchases, sales, trades and other taxable events. For each transaction, include the date and time, the type of transaction (buy, sell, trade, etc.), the amount of cryptocurrency involved, the value in your local currency at the time of the transaction, and transaction fees incurred.
2. Use crypto tax software: Several tools like Koinly can automatically track your transactions, calculate gains and losses, and generate tax reports. They’re especially helpful for active traders with high transaction volumes.
3. Consolidate your accounts: If you trade across multiple exchanges or wallets, ensure you gather all transaction data in one place. This helps avoid missing any taxable events.
4. Save supporting documents: Keep receipts, screenshots or transaction confirmations for each trade or purchase. These can serve as proof in case of audits or disputes.
5. Update regularly: Don’t wait until tax season to organize your records. Update your transaction logs regularly to avoid last-minute stress.
6. Be mindful of local rules: Some countries, like the UK, have specific rules, such as the same-day or 30-day matching rules. Ensure your records account for these to avoid errors in reporting.
7. Store your records securely: Use both digital and physical backups to prevent data loss. Store records for the period required by your local tax authority — often five to seven years.

As a final thought, remember that being crypto-tax efficient pays. That said, by staying compliant, you’re not only avoiding penalties and audits but also creating a solid foundation for long-term financial success.

Happy crypto gains tax reporting! 

Written by Bradley Peak