Capital gains on cryptocurrency: FIFO, LIFO, or Specific Identification?

I regularly receive inquiries from around the country regarding how gains and losses on cryptocurrency transactions are taxed. Unfortunately, to date, IRS guidance has been limited to Notice 2014-21, which, while it doesn’t tell us a whole lot, does make the following clear:

1. For tax purposes, cryptocurrency is property, not currency.
2. Unless you are in the business of selling cryptocurrency, the gain or loss from any sale of cryptocurrency is capital gain or loss, similar to stocks, bonds, and mutual funds.

Point 2 as caused a lot of confusion. When a Taxpayer sells a stock, bond, or mutual fund, assuming all of his shares being sold are identical, he has several options regarding gain or loss, the most common of which are:

1. He can record the transactions on a “first in, first out” basis (FIFO). This means if I own 100 shares of MSFT, and I sell 10, the 10 I sell are deemed to be the first 10 I purchased.
2. He can record the transactions on a “last in, first out” basis (LIFO). This means if I own 100 shares of MSFT, and I sell 10, the 10 I sell are deemed to be the last 10 I purchased.
3. He can record the transactions on a “specific identification” basis. This means if I own 100 shares of MSFT and sell 10, I specifically identify to my broker which 10 shares I wish to sell.

When selling a portion of a given holding of a cryptocurrency, many have applied these same rules. It would seem to make logical sense, since if Notice 2014-21 treats cryptocurrency like stocks and bonds, shouldn’t all the same rules apply? Unfortunately, this analysis ignores the text of the Treasury Regulations which authorize these methods of gain and loss.

Treas. Reg. 1.1012-1(a) sets forth the general rule for determining cost basis in a sale:

In general, the basis of property is the cost thereof. The cost is the amount paid for such property in cash or other property.

That seems innocuous enough, but if I own 10 Bitcoin and sell 1, it doesn’t help me determine the basis of the 1 sold (as opposed to the 9 I retain). Reading further in the regulation, we see where the concept of FIFO, LIFO, and specific identification come from:

Except as provided in paragraph (e)(2) of this section (dealing with stock for which the average basis method is permitted), if a taxpayer sells or transfers shares of stock in a corporation that the taxpayer purchased or acquired on different dates or at different prices and the taxpayer does not adequately identify the lot from which the stock is sold or transferred, the stock sold or transferred is charged against the earliest lot the taxpayer purchased or acquired to determine the basis and holding period of the stock. If the earliest lot purchased or acquired is held in a stock certificate that represents multiple lots of stock, and the taxpayer does not adequately identify the lot from which the stock is sold or transferred, the stock sold or transferred is charged against the earliest lot included in the certificate.

Treas. Reg. 1.1012-1(c)(1).

In plain English, that paragraph means that by default, when I sell stock, I have to use FIFO. The only exception is if I can make an “adequate identification”. An adequate identification is:

An adequate identification is made if it is shown that certificates representing shares of stock from a lot which was purchased or acquired on a certain date or for a certain price were delivered to the taxpayer’s transferee… Where the stock is left in the custody of a broker or other agent, an adequate identification is made if—(a) At the time of the sale or transfer, the taxpayer specifies to such broker or other agent having custody of the stock the particular stock to be sold or transferred, and (b) Within a reasonable time thereafter, confirmation of such specification is set forth in a written document from such broker or other agent…. I[I]n the case of a sale or transfer of a book-entry security…, pursuant to a written instruction by the taxpayer, a specification by the taxpayer of the unique lot number which he has assigned to the lot which contains the securities being sold or transferred shall constitute specification as required by such subparagraph.

Treas. Reg. 1.1012-1(c)(2)-(4).

It’s doubtful that an “adequate identification” could ever be made with respect to cryptocurrency. Using Bitcoin as an example, there is no actual “Bitcoin”, just entries in a distributed ledger regarding (infinitely divisible) amounts held by various parties. Bitcoin itself is an abstraction without any sort of lot number. Without an adequate identification, the only permissible method is FIFO.

Further, it’s unclear whether this regulation applies to cryptocurrency at all. Notice that the regulation itself on its face refers to “stock”, not property in general. [Later sections of the regulation specifically apply it to bonds and mutual funds.] Cryptocurrency isn’t stock, a bond, or a mutual fund, so it’s unclear that this regulation can be relied upon in any event.

In the absence of further guidance, what should a Taxpayer do? There are three basic approaches:

1. Use FIFO universally. This is the most conservative method, as FIFO is generally the least pro-Taxpayer of the methods. It’s hard to see the IRS issuing future guidance that would be less advantageous than FIFO. This is personally my approach.
2. Use FIFO on a per-wallet basis. This is less conservative than pure FIFO. The idea here is that you can segregate your cryptocurrency bought at separate times in separate wallets, assuming it was never previously mixed. This would seem to make it “adequately identifiable”. When selling part of a wallet, you’d be using FIFO within the wallet. You still have the issue of whether Treas. Reg. 1.1012-1(c) is applicable at  all, since cryptocurrency isn’t “stock”. To gain any certainty, the IRS would have to issue a revised Treas. Reg. 1.1012-1(c) clarifying that cryptocurrency is treated as stock for purposes of the regulation.
3. Use LIFO or specific identification. This is the most aggressive manoeuvre, as you’re betting both that the regulation applies, and if it does apply, that cryptocurrency is an asset which can be adequately identified.

It’s important to note that the IRS likes to be retroactive when it issues guidance. For instance, Notice 2014-21, which classified cryptocurrency as property rather than currency, was issued in 2014, but still applied to transactions taking place before 2014. Future guidance on the FIFO, LIFO, specific identification issue would likely also be retroactive to prior filed returns. This is why I typically recommend the most conservative approach of universal FIFO.

IMPORTANT: Information provided is for educational purposes only and does not constitute legal advice. Readers should consult with a tax professional.

Jeff Vandrew Jr is the founder of Vandrew LLC,  a New Jersey estate planning firm that assists clients with cryptocurrency estate planning issues.