One of the most misunderstood concepts in crypto taxes is cost basis or, simply, what you paid to acquire a crypto asset. It's a very important number because you have to know what it is to know how much you owe in taxes.

What is cost basis?

According to the Internal Revenue Code Section 1012, “The basis of property shall be the cost of such property,” which also includes the cost of any capital improvements made to the property. 

Translated into crypto terms, this means your cost basis for a token is whatever you paid in U.S. dollars to acquire it plus any associated fees (the concept of improvements doesn’t apply here since crypto is intangible and typically housed in immutable code). 

A basic example is buying 1 ETH on Coinbase for $3,000 and then transferring it to a MetaMask wallet. Your cost basis in that ether would be $3,000 + the fair value in USD of the gas fee to transfer it. Tracking the cost of a few ETH is one thing, but with crypto, taxpayers are required to track the value of each token in every transaction. You could easily end up with thousands of transactions to parse and properly label. Even if you’ve enlisted Koinly or CoinTracker to help you out, there’s still oodles of manual scrubbing to do.

There’s also another important distinction in crypto taxes: What is the character of any income you receive on the blockchain? “Character” is a whimsical term for a concept that’s infinitely more boring: Basically, was the income you earned "ordinary" or "capital"? 

Ordinary income arises from transactions like mining Bitcoin or staking ATOM. By contrast, capital gains are generated from selling, trading, swapping or spending your tokens. Crypto degens only care about cost basis because it can generate significant gains that are taxed up to 25%, depending on the holding period. And since taxes can only be paid in fiat (for now), you’re penalized with double taxation when you convert your crypto to USD to pay the liability. 

ruled that “virtual currencies” should be taxed as property in 2014. It only took the IRS nine words to declare crypto as property, but there’s nothing simple about the application of these rules in practice. Although the crypto industry has exploded and changed since 2014, the IRS is still applying rules from 1986.

How to incorporate cost basis into your tax strategy

Instead of despairing and moving to Puerto Rico to avoid capital gains altogether (although there’s caveats there as well), there are tax strategies you can employ to minimize your long- and short-term capital gains:

1. Compare the different cost basis methods

Token-tracking software make it easy to switch between the different cost basis methods so you can compare your total liability under each one. The most popular ones are: 

• FIFO (first in, first out)
• LIFO (last in, first out) 
• HIFO (highest in, first out)

These methods, all of which are IRS compliant, refer to what cost basis is used when calculating gains and losses. If you’re selling ETH in a bull market, assigning HIFO or LIFO will minimize your taxes since your cost basis will likely be higher. Choosing FIFO is more conservative and IRS-preferred (of course—more fiat for them), but your taxes will be higher since your cost basis is lower. 

Unfortunately taxpayers have to be consistent with their cost basis method, so you can’t pick whatever is most advantageous for each token. Before filing, it’s worth assessing your portfolio to see which method leads to the lowest liability.

2. Carry out tax-minimization strategies by December

Chatting about tax crypto strategies in April is quaint, but any transactions related to your strategy must be carried out by December 31 to be effective for the tax year. To take advantage of your cost basis, examine your portfolio in December to see if you have the following:

• Assets that are in a loss position (i.e., your cost basis per token is higher than the current price). The losses from selling those assets can be used to offset any gains or lead to an overall net capital loss. This net loss is capped at $3,000 per year and any excess can be carried forward indefinitely.
• Assets held greater than one year. If you’re considering selling or trading an asset, waiting until the holding period is greater than one year means any capital gains are subject to the long-term tax rates. Selling crypto assets you’ve held for less than one year are taxed at ordinary tax rates.
• Assets with a $0 cost basis. Hodling these assets will not trigger any taxable events and will ensure your taxes aren’t wrecked by a bull market.

3. Don’t forget to include your transaction fees

For anyone transacting on Ethereum pre-Merge, including your transaction fees in your cost basis is a must. This is especially relevant in the world of NFTs since minting events can often cost thousands of dollars in gas fees (i.e., my sad attempt to buy a CryptoKitty). 

Cost basis is nuanced and a headache, especially for crypto hobbyists who just want to sell a damn CryptoKitty. Complexities such as character, holding periods, methodologies and even what software to use are mini rabbit holes. It’s easy to be confused by this piece of crypto taxes, especially when the IRS has outdated and convoluted guidance. Consult your tax accountant (hopefully one with crypto expertise!) before filing and thankfully, you can always re-file an amended return if needed.