Crypto Accounting for Beginners

Calculating Gains and Losses

 

For those trading on a centralised exchange, most platforms allow you to download a complete record of all purchases and sales, which eliminates the need for manual note-taking. However, if you trade on a DEX (decentralised exchange), you may not have access to downloadable transaction data. In this case, you’ll need to find alternative methods to keep accurate records of your trades.

Your next task is to make sense of all this transaction data, particularly by calculating the changes in value of your crypto assets over time. Let’s look at some key accounting principles and how they apply to crypto transactions.

Cost Basis

Ah, our old friend, cost basis. It sounds simple: how much did you pay for your crypto? But this seemingly straightforward question is often filled with complexity and confusion.

Without getting too much into the weeds, the cost of your asset includes all the purchases you’ve made of that asset. It's rarely the case that you'll buy cryptocurrency in a single transaction. More often, you’ll make several purchases over time, each at a different price.

All of these purchases must be considered when you eventually sell your crypto. They also come into play if you use one cryptocurrency to buy another. Even though this might look like a buy transaction, you're effectively using one crypto asset to purchase another—meaning, for tax purposes, it’s treated as a sale of your original crypto asset.

Additionally, it's common not to sell your entire portfolio in a single transaction. Instead, you might sell portions over time, each with its own cost-basis implications.

In this case another accounting principle is applied; Which one of your purchases is used to value your crypto sold?

Inventory Valuation Methods

There are a few common methods for determining this but the principle is that we use a consistent method of choosing which of the purchases you used in the past to determine the value of your crypto asset. Your country may dictate a particular method or you may be able to choose one to suit your needs. Here are some popular choices:

• FIFO (First-In, First-Out):

The earliest purchased crypto is considered sold first. This method can result in higher taxable gains during a bull market, as older purchases may have lower cost bases.

• LIFO (Last-In, First-Out):

The most recent purchases are considered sold first. This approach may reduce taxable gains in a rising market by using higher cost basis values from recent purchases.

• HIFO (Highest-In, First-Out):

The units with the highest cost basis are considered sold first. This strategy can minimize gains, as it prioritizes selling the most expensive purchases first.

• LOFO (Lowest-In, First-Out):

This method uses the units with the lowest cost basis first. It often results in higher gains because it prioritizes the least expensive purchases, which may be beneficial if you're looking to maximize gains in specific tax situations.

• Specific Identification:

If you meticulously track each unit of crypto, you can specify which purchases are sold. This requires detailed records but offers the most flexibility and potential tax savings.

• Average Cost:

This method calculates the average cost of all units purchased to determine the cost basis when a portion is sold. To find the average cost, add up the total cost of all your purchases and divide by the total number of units. This approach simplifies the tracking of individual purchases and spreads out the cost basis across all transactions, providing a more balanced view of gains and losses over time.

• Bed-and-Breakfast Rules

In some jurisdictions, such as the UK and Australia, Bed and Breakfast rules (also known as anti-wash-sale rules) apply to prevent tax avoidance through rapid repurchase of sold assets. For example, if you sell a cryptocurrency to realize a loss and then repurchase the same cryptocurrency within a set period (often 30 days), the loss cannot be claimed for tax purposes. Instead, the new purchase adjusts the cost basis for future sales.

These rules are essential to keep in mind, especially if you actively trade, as they prevent "wash sales" where investors sell assets at a loss and repurchase them shortly after, aiming to claim a tax loss while still holding the asset.

Holding Periods

It's important to note that the length of time you hold an asset before selling it significantly impacts your tax obligations, as it determines eligibility for a capital gains discount. In some countries, if you hold an asset for over 12 months, you may qualify for a reduced tax rate on any gains from the sale, potentially saving you money on taxes.

Fair Market Value

To determine your cost basis, you need a way to accurately value your crypto assets. Sometimes this is straightforward, but often it’s more complex. Unlike traditional markets, there is no central authority providing standardised valuations for crypto assets. Cryptocurrencies are frequently traded on multiple exchanges, each potentially offering a different price. Additionally, many of the thousands of coins and tokens out there are traded on decentralised exchanges or through private transactions, which can complicate establishing a clear market value.

For widely traded assets like Bitcoin and Ethereum, valuation is relatively easy, as prices are readily available across major exchanges. But what happens if you trade Ethereum for a meme coin like PEPE, and later make a substantial profit when selling PEPE for USD?

In this case, your original purchase of PEPE wasn’t made in USD, so you’ll need to find a way to determine its value in USD at the time of acquisition to accurately calculate your gains. This can involve checking the FMV of Ethereum at the time of the PEPE trade or using third-party tools that aggregate price data from multiple exchanges to approximate a fair market value.

The accounting principle of Fair Market Value is crucial in these situations, especially for cryptocurrency, where the sheer volume of assets and the challenge of valuing less popular ones make accurate reporting essential.

Realised vs Unrealised Gains or Losses

Even if you haven't sold your crypto, it’s still a good idea to track the financial position of your current assets.

One reason is that you may need to report the balances of your crypto holdings to your tax office.

Another reason is strategic. If one of your holdings is "underwater" (i.e., valued below its cost basis), you can choose to sell it before the end of the financial year to offset any gains made that year. This approach, known as tax loss harvesting, can reduce your tax liability.

However, be mindful of repurchasing restrictions. In some jurisdictions, such as Australia, you must wait a specific period (30 days) before buying back the asset. Failing to do so may disqualify your loss claim.

Also, exercise caution when swapping one cryptocurrency for another. Although you’re purchasing a new asset, this transaction is typically recognised as a taxable event, and you may be liable to pay tax on any gains realised in the swap.