The Complete Trader's Guide To Cryptocurrency Taxes
America’s cryptocurrency tax policy is confusing a lot of people. This guide breaks down everything you need to know so that you aren’t caught unprepared when tax season roles around.
In 2017, the value of cryptocurrencies increased by an average of 900% and outperformed nearly every other traditional asset class. Your friends, coworkers, television anchors, and even your great Aunt Pearl were all asking about this “mysterious” new technology that could potentially get them rich. But with all the buzz and money-making potential also came Uncle Sam demanding his fair share. This raises the question: How do you accurately report your cryptocurrency trades and investments?
Cryptocurrency is Treated as Property
According to the first and only official IRS guidance that was issued in 2014, cryptocurrencies should be treated as property for tax purposes — not currency. This means that crypto’s like Bitcoin, Ethereum, Ripple, and almost all other alt-coins must actually be treated like owning other forms of property (stocks, gold, real-estate) for tax purposes. This means that you are required by law to file your capital gains and losses realized when trading these cryptocurrencies. Failing to do so will be considered blatant tax fraud by the IRS.
So how do you calculate your crypto capital gains?
Step 1 — understand what is considered a taxable event– AKA when it is that you will actually owe money to the government for a capital gain on your cryptocurrency transactions.
The following have been taken from the official IRS guidance from 2014 as to what is considered a taxable event:
- 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; you may also end up owing sales tax)
- Giving cryptocurrency as a gift is not a taxable event (the recipient inherits the cost basis; the gift tax still applies if you exceed the gift tax exemption amount)
- A wallet-to-wallet transfer is not a taxable event (you can transferbetween exchanges or wallets without realizing capital gains and losses, so make sure to check your records against the records of your exchanges as they may count transfers as taxable events as a safe harbor)
- Buying cryptocurrency with USD is not a taxable event. You don’t realize gains until you trade, use, or sell your crypto. If you hold longer than a year you can realize long-term capital gains (which are about half the rate of short-term) if you hold less than a year you realize short-term capital gains and losses.
Step 2 — Determining your Cost Basis
Now that it is clear when you must pay taxes, it’s important to understand the exact process behind doing so. The first real step is determining the cost basis of your holdings. Essentially, cost basis is how much money you put into purchasing the 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 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 3 — Calculate your Capital Gain/Loss
The final step in determining your capital gain or loss is to merely subtract your cost basis from the sale price of your cryptocurrency.
Sale Price — 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
You would then owe a percentage of that $100.50 gain to the government.
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). One crucial piece of information that has been left out thus far is Fair Market Value. 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? Well, turns out, it 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.
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 of the trade. This is information that they actually need to have to accurately file their taxes and avoid problems with the IRS. Depending on the volume of trades they have carried out, calculating gains accurately could become extremely tedious, and potentially impossible to do by hand or even with Excel if they haven’t been keeping track of Fair Market Value. Imagine if you have done thousands of trades over the course of the year like many day-traders have…
Sadly, Uncle Sam will not empathize with your situation. If audited, the IRS can say, “Show me how you arrived at that capital gains number on your 2017 taxes.” If you have no formal report or proof of how you arrived at your capital gains number, the IRS can apply a ZERO-COST BASIS, and charge you capital gains tax on your entire holdings along with any penalties that come with inaccurate tax-filing.
What would this look like in real life? Let’s say you’re a day-trader who uses a bunch of different exchanges: Binance, Bitfinex, and GDAX. You originally invested $70,000 into the platforms to start trading. You did pretty well, but you’ve had your fun in the crypto game and took the majority of your money, $100,000, out of the exchanges and put it back into the bank. The IRS can see that you put that money into your bank. Let’s say you get audited. The IRS will say, "show me what you did with that $100,000". If you cannot prove that you actually started with $70,000 invested (ie a 70k cost basis), they can apply a zero-cost basis to your $100,000 and charge a capital gains tax on the entirety of it. Instead of just the $30,000 gain that you should be taxed on, you will be taxed a percentage of the $100,000. This is a very large difference and could be money that you cannot afford to lose.
To avoid this, it might make sense to use CryptoTrader.Tax which automates the process and provides a complete report of your trades, cost basis, and your total capital gains/loss liability in a matter of minutes. If the IRS comes knocking, simply show them the audit packet.
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. So unless you “JUST HODL”, you will likely have some short-term gains.
Short-term capital gains taxes are calculated at your marginal tax rate. Below is a table that depicts the different tax brackets that you may fall under:
To demonstrate how to navigate the marginal tax brackets, suppose you’re a single filer. You made $82,000 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 $83,000 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 $82,500 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 HODLers 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 2018:
As you can see, the long-term rate is much lower and rewards investors if they hold, continuously, for a year or more.
Filing Your Crypto Taxes
You need two forms to properly file your crypto taxes: The 8949 and the 1040 Schedule D. You will list all trades onto your 8949 along with the date of the trade, the date you acquired the crypto, the cost basis, your proceeds, and your gain or loss. Once you have listed every trade, 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.
For a detailed layout of this process, see our article about the crypto tax reporting process.
So What about Capital Losses?
Thus far, we have been strictly talking about capital gains. In an ideal world, you are a great cryptocurrency trader, and your gains on trades far out-weigh your losses. However, if your losses exceed your gains, those losses will be deducted from your taxable income for the year. However, you may only deduct up to $3,000 from your taxable income. Any capital losses in excess of $3,000 are carried forward, year after year, and applied to taxes in subsequent years until the balance reaches zero. If you did incur substantial losses in cryptocurrency trading, it would be wise to work with your CPA to make sure you are filing correctly.
What about the 1031 Like-Kind Exchange?
A lot of traders are claiming that the trading from one cryptocurrency into another is not an event that they have to pay taxes on because of the 1031 Like-Kind exchange. This law is often used in the world of real estate investing; however, under the new tax-reform law, the 1031 has been disallowed for cryptocurrency. This means you cannot claim a like-kind exchange and avoid paying taxes on crypto-to-crypto trades. You have to files these along with your other transactions.
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. The hard truth is that this is just not true. While the IRS has been slow to this point when it comes to dealing with Crypto taxes, they seem to be 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 likely only the beginning. You will see the IRS start to get very serious when it comes to traders who don’t properly file their gains. When there is this much money on the line, the big guys typically do not kid around. The same is also true even if you are only doing wallet-to-wallet transactions. 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. In the future, we will likely see software that is specifically built for automatically auditing blockchains. If you chose not to file your gains, you expose yourself 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.
Did you forget to report your crypto trades on last year’s tax return? If so, be sure to checkout our article on amending your cryptocurrency tax return.