What is Cost Basis and Why is it important?
Cost basis is a crucial concept in crypto accounting as it is used to calculate the capital gain or loss when selling a crypto asset. To accurately calculate cost basis, it is important to keep track of all purchases and transactions made with a particular crypto asset.
When you sell a crypto asset, you need to calculate your capital gain or loss. To do this, you need to know your cost basis – the original purchase price when you acquired the crypto asset. Your cost basis includes the purchase price of the asset and any fees or commissions paid to acquire the asset.
The formula for calculating the gain/loss is:
Sale price (Fair Market Value) – Cost = Gain/Loss.
One of the challenges of calculating cost basis is dealing with multiple units of a crypto asset that were purchased at different times and prices. Several different methods can be used to calculate cost basis in these situations including:
First In First Out (FIFO)
Last In First Out (LIFO)
Highest In First Out (HIFO)
Weighted Average Cost (WAC)
Let’s take a look at each method.
FIFO (First in First Out): The FIFO method is the most intuitive of the bunch. You simply treat the units of a crypto asset acquired first as being sold first.
LIFO (Last in First Out): The LIFO method disposes of the latest units purchased first.
HIFO (Highest in First Out): The HIFO method takes the highest unit cost first, and is used to maximise initial capital losses (and therefore minimise tax).
WAC (Weighted Average Cost): The weighted average cost basis is a bit more complicated to calculate but it can be useful in some situations. Essentially, it takes into account all of the different purchase prices and weights them according to how many units were purchased at each price.
Here is an example. Let's say you purchased 1 BTC for $10,000 on January 1st, another 1 BTC for $15,000 on February 1st, and yet another 1 BTC for $20,000 on March 1st. Now, let's say you decided to sell 2 BTC on April 1st for $30,000 each.
It's important to note that there are tax advantages for showing a larger capital loss, but there are also legal ramifications for minimising capital gain. It's important to consult with a tax professional to determine the best method for your situation and ensure compliance with tax laws.
Accurately calculating cost basis is also important for keeping track of your crypto portfolio's performance. By knowing the cost basis of each asset, you can easily track your profit or loss and make informed decisions about when to buy, hold or sell. This is especially important for traders who are actively buying and selling different crypto assets.
In addition, cost basis is also important for tracking any taxes that may be owed on the sale of a crypto asset. In most countries, the capital gain or loss resulting from the sale of a crypto asset is subject to tax. By accurately calculating cost basis, you can ensure that you are accurately reporting any taxes owed and avoid any potential issues with the tax authorities.
In conclusion, cost basis is a crucial concept in crypto accounting as it is used to calculate the capital gains or losses on crypto assets. Additionally, cost basis is important for tracking the performance of your crypto portfolio and accurately reporting any taxes owed. By keeping accurate records and understanding the concept of cost basis, you can make informed decisions about managing your crypto assets and stay compliant with tax laws.
Want a consultation to understand how you can automate your cost basis and bookkeeping?
Book a demo with Mensari. Our team has built a crypto accounting tool for web3 organisations & NFT projects, streamlining day-to-day bookkeeping and accounting and directly linking with your on-chain wallets.