Cryptocurrency tax policies are confusing people around the world. This guide breaks down specific crypto tax implications within the U.S., but similar issues arise in many other countries.
Cryptocurrencies like Bitcoin have gained significant popularity over the past few years and into 2020. This rise in popularity is causing governments to pay closer attention to the asset. Recently, we’ve seen the IRS release new cryptocurrency tax guidance and start sending thousands of warning letters to non-compliant cryptocurrency investors. The question everyone is asking: How is cryptocurrency handled for tax purposes?
Crypto Taxes – The Fundamentals
According to official IRS guidance, Bitcoin and other cryptocurrencies should be treated as property for tax purposes — not as currency. This is true for all cryptocurrencies such as Ethereum, Litecoin, XRP, etc.
This means that crypto must be treated like owning other forms of property such as stocks, gold, or real-estate. Just like you would with trading stocks then, you are required to report your capital gains and losses from your cryptocurrency trades on your taxes. Failing to do so is considered tax fraud in the eyes of the IRS.
How Do You Calculate Your Crypto Capital Gains/ Capital Losses?
Calculating capital gains and losses for your cryptocurrency trades is relatively straightforward, and we walk through the process below. However before doing the calculations, you need to understand taxable events.
Taxable Events for Cryptocurrency
A taxable event is simply a specific action that triggers a tax reporting liability. In other words, whenever one of these ‘taxable events’ happens, you trigger a capital gain or capital loss that needs to be reported on your tax return. It’s as simple as that. The following have been taken from the official IRS guidance from 2014 as to what is considered a taxable event in the world of crypto. If any of the below scenarios apply to you, you have a tax reporting requirement.
Trading cryptocurrency to fiat currency like the US dollar is a taxable event Trading cryptocurrency to cryptocurrency is a taxable event (you have to calculate the fair market value in USD at the time of the trade) Using cryptocurrency for goods and services is a taxable event (again, you have to calculate the fair market value in USD at the time of the trade) Earning cryptocurrency as income is a taxable event (from mining or other forms of earned cryptocurrency)
What is Not Considered a Taxable Event?
Giving cryptocurrency as a gift is not a taxable event A transfer is not a taxable event (you can transfer crypto between exchanges or wallets without realizing capital gains and losses) Buying cryptocurrency with USD is not a taxable event (you don’t realize gains until you trade, use, or sell your crypto)
Step 1 — Determine Your Cost Basis
Now that it is clear when you must report your crypto transactions, it’s important to understand the exact process behind doing so.
The first step is to determine the cost basis of your holdings.
Essentially, cost basis is how much money you put into purchasing your property. For crypto assets, it includes the purchase price plus all other costs associated with purchasing the cryptocurrency. Other costs typically include things like transaction fees and brokerage commissions from the exchanges you purchase crypto from. So to calculate your cost basis you would do the following:
(Purchase Price of Crypto + Other fees) / Quantity of Holding = Cost Basis
For example, if you invested $500 in Litecoin back in November of 2017, that would have bought you about 5.1 Litecoin. Let’s say you also paid Coinbase or Binance a 1.49% transaction fee on the purchase. Your cost basis would be calculated as such:
($500.00 + 1.49%*500)/5.1 = $99.50 per Litecoin
Step 2 — Subtract Cost Basis from Fair Market Value
The second step in determining your capital gain or loss is to merely subtract your cost basis from the sale price of your cryptocurrency. Sale price is also often referred to as the Fair Market Value. The equation below shows how to arrive at your capital gain or loss.
Fair Market Value – Cost Basis = Capital Gain/Loss
As an example, let’s say you sold exactly one Litecoin a month later because the price had doubled to $200 per coin. This would be considered a taxable event (trading crypto to FIAT currency) and you would calculate the gain as follows:
200–99.50 = $100.50 Capital Gain
$200 is the Fair Market Value in US Dollar at the time of the trade. $99.50 is your cost basis in the asset.
You then owe a percentage of this $100.50 gain to the government on your taxes.
What if I Lost Money Trading Crypto?
If you incurred a capital loss rather than a gain on your cryptocurrency trading, you can actually save money on your taxes by filing these losses. Many investors even strategically sell crypto assets which they have losses in to reduce their tax liability at the end of the year. This strategy is commonly referred to as Tax Loss Harvesting.
Determining Fair Market Value
This simple capital gains calculation gets more complicated when you consider a crypto-to-crypto trade scenario (remember this also triggers a taxable event). Let’s look at another example to gain understanding of how fair market value ties in.
Let’s say you purchase $100 worth of Bitcoin including transaction and brokerage fees. That $100 currently buys about 0.01 Bitcoin. Now let’s say two months later you trade all of your 0.1 Bitcoin for 0.16 Ether.
How would you calculate your capital gains for this coin-to-coin trade?
It all depends on what the Fair Market Value of Bitcoin was at the time of the trade.
Let’s say at the time of the trade, 0.01 Bitcoin was worth $160. This would make the Fair Market Value of 0.01 Bitcoin $160. You would then be able to calculate your capital gains based of this information:
160–100 = $60.00 capital gain
For that crypto-to-crypto trade, you would owe the government a percentage of your $60.00 gain.
The Challenge for Traders
This calculation and concept of Fair Market Value sparks a large variety of problems for crypto traders. Some traders have been trading crypto for months, possibly years, and haven’t been keeping track of the dollar value or Fair Market Value of their crypto at the time they traded it. It’s also not easy to keep track of USD values for most trades as they are mostly quoted in other cryptocurrency values, not in USD.
This Fair Market Value information is needed for traders to accurately file their taxes and avoid problems with the IRS. Depending on the volume of trades they have carried out, calculating gains could become extremely tedious, and potentially impossible to do by hand if you haven’t been keeping track of Fair Market Value. Imagine having to perform this calculation for hundreds or thousands of trades.
Because of this challenge, a lot of cryptocurrency users are turning to crypto tax software to automate the entire tax reporting process.
How Do I Actually File My Crypto Taxes?
To properly file and report your crypto transactions, you need IRS form 8949 and 1040 Schedule D.
List all cryptocurrency trades and sells onto Form 8949 (pictured below) along with the date you acquired the crypto, the date sold or traded, your proceeds (Fair Market Value), your cost basis, and your gain or loss. Once you have each trade listed, total them up at the bottom, and transfer this amount to your 1040 Schedule D. Include both of these forms with your yearly tax return.
Short-Term vs. Long-Term Capital Gains:
One thing that has yet to be touched on is the actual rate of your capital gains tax. That is because this rate is dependent upon a number of factors. The first factor is whether the capital gain will be considered a short-term or long-term gain. The most common rate in the world of cryptocurrency is the short-term capital gain which occurs when you hold a cryptocurrency for less than a year and sell the cryptocurrency at more than your cost basis.
Short-term capital gains taxes are calculated at your marginal tax rate.
Crypto taxes capital gains
To demonstrate how to navigate the marginal tax brackets, suppose you’re a single filer. You made $85,025 during the tax year, and you purchased Bitcoin six months ago for $5,000 including fees and commissions. Yesterday, you sold Bitcoin for $6,000, a gain of $1,000.
The $1000 raises your income to $86,025 for the year. Based on the marginal tax rate table, the first $500 of your gain is taxed at the 22% rate, generating $110 in taxes. The remaining $500 is taxed at 24% as it exceeds the $85,525 threshold. This generates $120 in taxes. In total, the $1000 capital gain would generate $230 in taxes for the year. This is the amount that you owe the government.
Long-Term Capital Gains:
For all of the holders out there, if you held your cryptocurrency for a year or more, you qualify for a lower long-term capital gains rate. The table below details the tax brackets for long term capital gains:
Crypto long term capital gains
As you can see, the long-term rate is much lower and rewards investors if they hold, continuously, for a year or more.
If you mine cryptocurrency, you will incur two separate taxable events. The first is as income from the USD value of the coins you mined, and the second is the capital gain or loss you incur when you sell or trade your mined coins.
You report this income differently depending on whether or not you mined the crypto as a hobby or as a business entity.
Crypto Loans, Margin Trading, and DeFi
Cryptocurrency lending platforms and other DeFi services have exploded in popularity within the crypto landscape. Receiving interest income from a crypto loan or similar service is treated as a form of taxable income – similar to mining or staking rewards. This type of income should be reported under the “other income” section of line 21 of Schedule 1 — Additional Income and Adjustments to Income — as part of your income tax return.
Why Can’t My Cryptocurrency Exchanges Provide Me With Accurate Tax Reports?
This is where the big problem exists.
Because users are constantly transferring crypto into and out of exchanges, the exchange has no way of knowing how, when, where, or at what cost basis you originally acquired your cryptocurrencies. It only sees that they appear in your account.
The second you transfer crypto into or out of an exchange, that exchange loses the ability to give you an accurate report detailing the cost basis and fair market value of your cryptocurrencies, both of which are mandatory components for tax reporting.
As you can see pictured below, Coinbase themselves explains to their users how their generated tax reports won’t be accurate if any of the below scenarios took place. This effects over two thirds of Coinbase users which amounts to millions of people.
1099 Information Reporting
Another side effect of the “cryptocurrency tax problem” is that cryptocurrency exchanges struggle to give accurate and useful 1099’s to their users. 1099’s of all types serve the same general purpose: to provide information to the Internal Revenue Service (IRS) about certain types of income from non-employment-related sources.
Many exchanges have decided to issue 1099-K because the industry leader, Coinbase, issues this form to users who meet certain thresholds. Unfortunately, this form is completely useless for taxpayers who are trying to report their cryptocurrency gains and losses.
The solution to the “cryptocurrency tax problem” hinges on aggregating all of your cryptocurrency data making up your buys, sells, trades, air drops, forks, mined coins, exchanges, swaps, and received cryptocurrencies into one platform so that you can build out an accurate tax profile containing all necessary data.
What About Other Countries?
Similar to the U.S., countries all over the world have started taking action and enforcing cryptocurrency capital gains and losses taxes. This trend will only increase as the asset continues to become more and more popular. While the tax rules are very similar to the U.S., small differences do exist.
What Happens if I Don’t Pay My Crypto Taxes?
A lot of traders are convinced that because of the anonymous, decentralized nature of Blockchain and crypto transactions, that there is no way for the government to see or know that they are making money trading/buying/selling cryptocurrency. This is not true.
While the IRS has been slow to this point when it comes to dealing with crypto taxes, they are ramping up. The IRS win against Coinbase, which required the popular exchange to turn over records for individuals who have $20,000 or more in any transaction (buy/sell/ or receive), is the beginning.
The Blockchain is a distributed public ledger, meaning anyone can view the ledger at anytime. Figuring out an individual’s activities on that ledger essentially comes down to associating a wallet address with a name. Choosing not to report your crypto transactions is a risky decision that exposes you to tax fraud to which the IRS can enforce a number of penalties, including criminal prosecution, five years in prison, along with a fine of up to $250,000.