What the Heck Is Tax Basis? (Part 1)

Dave Lemke, CPA - March 11, 2022

You’re about to learn about tax basis from a bassist. I’ll try to cover all the bases. Are you accusing me of being confusing? Face it, you have no basis. Ok, let’s start with the basics.

In the thrilling world of accounting, your basis in an asset generally means the total amount you paid to acquire it. This is the starting point for determining your gain or loss down the road if you were to eventually sell that asset. For example, if you buy a building as an investment for $100,000 and sell it two years later for $120,000, your realized gain would be $20,000 because your basis was $100,000. Cha-ching!

Any costs to acquire an asset and any improvements you make to an asset get capitalized, which is fancy accountant code speak to say it’s added to your basis. For example, let’s say that you paid an additional $5,000 to buy new energy-efficient windows for your building. The amount you spent on the new windows would be added to your basis instead of being deducted as an expense when you paid it. Sad-face emoji because you don’t get to write it off as an expense that first year, but happy-face emoji because it offsets your gain when you eventually sell. This principle applies to any transaction costs (e.g. credit card processing fees, gas fees to stake, etc.), so they all get capitalized into your basis.

Now, a building is a single, unique asset with its own basis. But what about when you buy lots of assets that are identical, such as shares of a company’s stock, inventory for your boardwalk banana stand, or the bitcoins you acquired over the past few years? In this case, as you buy property over time and prices fluctuate, you end up having different lots of the same thing but with differing bases (that’s the plural of basis for the non-Latin majors out there).

Tax Lot Optimization – So Hot Right Now!

Where this gets interesting is that the US Tax Code actually allows taxpayers to elect which lots were sold, even if it means paying less tax. For example, say that you started buying bitcoin at the beginning of 2021 all the way through its peak in the fall of that year. If you sold some of your bitcoin at the end of the year when prices fell slightly, then you have what we call a tax-planning opportunity: a treasured moment where CPAs actually add value by optimizing the basis of your tax lots.

The default sale method is called FIFO, or first-in-first-out. This means that the oldest lots are deemed to be sold first and you chronologically eat through the newer and newer lots. The reverse of this is the LIFO method, which – you guessed it – stands for last-in-first-out. This resembles the college dorm refrigerator where the food you just bought gets eaten first and that old yogurt with a 2005 expiration date just sits in the back continuing to grow more mold. It’s not coming out until absolutely everything else is gone.

Why Tax Lot Ordering Matters

 

In our example of the 2021 bitcoin purchases and year end sale, you end up getting two very different tax answers depending on which method you pick (depicted in the diagram above). If it’s FIFO, your earliest bitcoin purchases have a lower basis and would be sold at a gain at the end of the year. However, using LIFO, the shares you purchased later in the year would create a loss. Either way you receive the same dollar amount for selling, but in one scenario you pay tax and in the other you don’t. Spiffy, right?

The options for ordering your basis aren’t limited to FIFO and LIFO. You could actually specify HIFO, that is, highest-in-first-out. Because cryptocurrency tokens have unique identifiers, you can specifically track each individual token and cherry pick the ones to sell with the highest tax basis. So if you wanted to always select your highest basis token regardless of when it was purchased and deem it to be sold first, that would be allowed. It simply comes down to your ability to identify those tokens and keep meticulous track of your tax basis lots. Luckily with the Giddy app, you’re able to do just that and maximize your after-tax income on your crypto.

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