The Cryptocurrency Tax Problem - Why Exchanges Can’t Provide Users With Accurate Tax Documentation

Cryptocurrency exchanges like San Francisco-based Coinbase make it easy for everyday consumers to buy and sell cryptocurrencies. 

Instead of having to interact directly with the blockchains that these digital assets are stored on, users can simply log into their preferred cryptocurrency exchange, click a few buttons, and voila! purchase their very own cryptocurrency. This is without a doubt a good thing—technology making people's lives easier.

However, by nature of the technology that these exchanges operate on (blockchain), users are also able to send bitcoin and other cryptocurrencies into their exchange accounts from locations outside of the exchange’s own network. 

For those that are unfamiliar with the world of cryptocurrency trading, an example of this would look like me buying one cryptocurrency on a separate exchange, let’s say Kraken, and then transferring it over to Coinbase so that I could cash out into US Dollars. This sort of thing happens all the time and for a variety of reasons.

Being able to send cryptocurrencies to other locations and other wallet addresses is actually core to the whole premise of crypto. It’s this easy mechanism of value transfer requiring no third party verification that makes the idea of cryptocurrency so exciting. However, this core principle is also the culprit behind the massive cryptocurrency tax problem.

Let’s Back Up… How Does the IRS Treat Cryptocurrency for Tax Purposes?

The IRS treats cryptocurrencies as property for tax purposes, not as currency. Just like with other forms of property—stocks, bonds, real estate—you incur a tax reporting liability when you sell or trade cryptocurrency for more or less than you acquired it for.

For example, if you purchased 0.1 Bitcoin for $1000 in April of 2018 and then sold it two months later for $2,000, you have a $1,000 capital gain. You report this gain on your tax return, and depending on what tax bracket you fall under, you will pay a certain percentage of tax on the gain. Rates fluctuate based on your tax bracket as well as depending on whether it was a short term vs. a long term gain.  

In order to report these gains and losses on your taxes, you need to have records of your cost basis and fair market value for each sell or trade of your cryptocurrencies at the time of sale. Cost basis is simply the amount of money you put in to acquire the asset. Fair market value is just the dollar value that you received upon sale or disposition of the asset. 

Staying with the example above, your cost basis is $1,000, and your fair market value is $2,000. You would report each of these figures along with the $1,000 gain from the transaction on your tax documents.

This process should sound familiar if you invest in or trade stocks, as it is the same reporting process that stock traders go through.

Read our 2019 Guide to Cryptocurrency Taxes for a more detailed overview.

So Why Can’t My Cryptocurrency Exchange Provide Me With Tax Reports Like My Stock Broker Does?

Here 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 (cost basis) you originally acquired these 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 likely effects over two thirds of Coinbase users which amounts to millions of people.

Cryptocurrency Exchange Taxes Wrong

In many aspects, trading cryptocurrencies can look a lot like trading stocks. However in the case of tax reporting, online brokers like Etrade or Fidelity are required to give you a 1099-B at year-end which details the necessary data for tax reporting. This data includes, yes you guessed it, cost basis and fair market value across all of your trades, something cryptocurrency exchanges by their nature cannot do.

The key difference separating a broker from a cryptocurrency exchange in this sense is the fact that you cannot send your Apple stock to an offline wallet to then go buy goods and services at your local shopping mall. Crypto is inherently different in that it is easily transferable — ultimately, it is this quality that creates a massive tax reporting headache for consumers.

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The Solution

With every problem comes an opportunity to provide a solution. 

In this case, 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.

We built exactly this at CryptoTrader.Tax.

Cryptocurrency exchanges taxes wrong

CryptoTrader.Tax is a tool for cryptocurrency traders built to solve the tax problem. It allows cryptocurrency users to aggregate all of their historical trading data by integrating with their exchanges and making it easy for users to bring everything into one platform. Once the historical data is in the system, the tax engine will auto-generate all of the necessary tax reports for cryptocurrency traders to file like the 8949.

Today, thousands of users use CryptoTrader.Tax to securely and automatically build out their required cryptocurrency tax reports. Users can take these generated reports to their own tax professionals or can simply upload them into tax software like TurboTax or TaxAct.

As of January 2018, the CryptoTrader.Tax team partnered up with Intuit’s TurboTax to make the filing process seamless and fast for traders.

In Conclusion

Whenever new industries and markets emerge, infrastructural problems always emerge alongside them. These fundamental problems need to be solved before the mass market can take advantage of certain efficiencies that new technologies bring. The world of cryptocurrency and blockchain is no different. If fundamental problems can continue being tackled one-by-one, the crypto economy will flourish.