The Complete 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. Everyone was 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.
So how do you calculate your crypto capital gains/ capital losses?
Step 1 — understand what is considered a taxable event
A taxable event is simply a specific action that triggers a tax liability. Whenever a taxable event occurs, you trigger a gain or loss that needs to be reported on your taxes. The following have been taken from the official IRS guidance from 2014 as to what is and what is not considered a taxable event in the world of crypto:
- 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 — Determine 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 on your taxes.
What if I lost money trading crypto?
If you incurred a capital loss rather than a gain on your cryptocurrency trading (like most traders in 2018) you can actually save money on your taxes by filing these losses. Read more about the tax loss harvesting process here.
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.
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 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 (not just your gains) along with any penalties that come with inaccurate tax-filing.
Because of this challenge, a lot of cryptocurrency users are turning to crypto tax software to automate the entire tax reporting process.
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. 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 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 2018:
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.
Checkout our article for a complete breakdown of how to report your mined cryptocurrency on your taxes.
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 mostly been talking about capital gains. In an ideal world, you are a great cryptocurrency trader, and your gains far out-weigh your losses. However, if your losses exceed your gains, those losses will reduce your taxabls income. Many traders had substantial losses in 2018, and they are saving money on their tax bill by reporting these losses. Please read our detailed guide on the topic to learn how you can save money by filing your losses.
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.
Crypto Tax Software
CryptoTrader.Tax is software built for cryptocurrency traders to solve the tax problem. It allows cryptocurrency users to aggregate all of their historical trading data by integrating with 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.
As of January 2018, the CryptoTrader.Tax team partnered up with Intuit’s TurboTax to make the filing process seamless and fast for traders.
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. 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.
*This post is for informational purposes only and should not be construed as tax or investment advice. Please speak to your own tax expert, CPA or tax attorney on how you should treat taxation of digital currencies.
Want to automate the entire crypto tax reporting process? Sign up for CryptoTrader.Tax today. We exist to make your life easier!