Cryptocurrency is a relatively new concept, and when dabbling in the world of Bitcoin most investors aren’t thinking about taxes. With the IRS continuing to refine the compliance laws around cryptocurrency though, it is important to understand the rules of crypto tax.
This article will be part of a two part series. We will cover high level tax implications, compliance rules, as well as specific forms you will need to fill out to stay on top of everything in the United States. ***See here for part 2.***
In September of 2021, the IRS started to send out letters 6174 and 6173 as warning to suspected cryptocurrency holders, similar to what they did in August 2019.
If you received a 6147 cryptocurrency letter and you reported everything correct, you do not need to respond. This letter is simply an informational letter and requires no action.
If you received a 6173 cryptocurrency letter, you are required to send a response letter by the date specified within.
Crypto taxes basics
What is cryptocurrency?
Cryptocurrencies, such as Bitcoin, are digital currencies not backed by real assets or tangible securities. They are traded between consenting parties with no broker and tracked on digital ledgers.
How do I go about owning cryptocurrency?
You could end up owning cryptocurrency in a multitude of ways.
- You could buy cryptocurrency on an exchange such as Coinbase, Kraken, Gemini, Coinmama, Binance or Changelly.
- You could buy independently from someone you know.
- You may receive cryptocurrency as a gift from a friend or relative
- You may receive cryptocurrency as part of an incentive/pay from a firm you work at
Is investing in cryptocurrency legal?
Yes. All around the United States investing in cryptocurrency is completely legal. You must consider all tax implications when investing, though, to ensure you stay compliant with the ever changing rules.
When do you owe taxes on cryptocurrency?
Trading crypto for fiat
Selling crypto for a fiat currency, such as the US dollar, is a taxable event. You don’t owe taxes on the entire amount that you received in the fiat currency, though. See below on how to calculate your taxable income.
Trading crypto for other cryptocurrencies
Trading one cryptocurrency for another is treated by the IRS as a disposal of asset, and is therefore a taxable event.
For example, let’s assume you bought some Bitcoin for $200. This asset then appreciates to $400, and you use this new value to buy $400 worth of Litecoin. You will then have a capital gain of $200 from this transfer.
Buying goods/services with crypto
Buying goods and services with crypto is considered a taxable event. Just like the above example, if, instead of buying Litecoin for $400 you bought a new monitor, you’d incur a capital gain of $200.
Earning crypto income
Earning crypto income through mining operations is considered a form of personal income and is therefore subject to income tax.
If you buy a cryptocurrency and simply hold the currency in a wallet, you do not have to declare anything or pay any taxes on this amount. You will only have to pay taxes if you realize the gain or loss and trade it for something else.
Wallet to wallet transfers
Similar to above, if you move your Bitcoin into another wallet that is also owned by you, you do not dispose of your Bitcoin and therefore do not trigger a taxable event.
I received a Crypto currency as a gift – is this a taxable event?
If you received cryptocurrency as a gift, this is usually not a taxable event. The only time that you must report it is if the transfer exceeds the gift tax allowance. (See our article on gift tax)
You will, however, need to report the cryptocurrency once you have realized a gain or loss on it.
Calculating your cryptocurrency taxation
So, now we understand when we do and do not need to pay taxes on cryptocurrency. Using this information, let’s look at how to calculate your cryptocurrency taxation.
Cryptocurrency capital gains are calculated in the same manner as stocks and shares. The formula is as follows:
Fair Market Value – Cost Basis = Capital Gain/Loss
What is fair market value?
Fair market value is the price an asset would sell on the open market. So, if you’ve sold 0.02 LiteCoin for $500, the fair market value would be $500.
What is cost basis?
Cost basis represents the amount of money you put into purchasing your property. Essentially how much you bought it for. It also includes any other costs associated with the purchasing of your cryptocurrency.
Let’s use our above example where we sold LiteCoin for $500. Assuming we bought it for $300, and spent $3 on the exchange fees, our cost basis would be $303.
Using our formula; $500 – $303 = $197
$197 would be our capital gain.
This is relatively straight forward – but this assumes you only make one transaction, which is generally not the case for many investors who are trading a number of transactions in a given tax year.
So, how do we calculate more complex gains & losses?
Understanding accounting methods for calculations
There are a number of different accounting methods you can use to determine your capital gains when it comes to multiple transactions. They include;
- FIFO: First In First Out
- LIFO: Last In First Out
- HIFO: Highest In First Out
This can get quite technical, but let’s dive into a simpler example where we will use the FIFO method.
During the year, the following transactions occur on Coinbase:
- 31/01/21 – Buy 1 Bitcoin for $28,000
- 17/03/21 – Buy 1.5 Bitcoin for $70,000
- 10/04/21 – Buy 0.5 Bitcoin for $29,000
- 14/04/21 – Selling 0.5 Bitcoin for $32,000
As we’ve discussed, the taxable event occurred when Bitcoin was sold for fiat currency on 14/04/21.
The question is, what is the cost basis for the 0.5 Bitcoin that has been sold, when it has been bought for three different prices throughout the year.
If we use the FIFO method, we would take the initial transaction of 1 Bitcoin for $28,000 as our cost basis. As we only sold 0.5, we would take half of the cost – $14,000.
Therefore, our capital gain is: $32,000 – $14,000 = $18,000.
LIFO and HIFO work in a similar way, whereby in LIFO you’d use the latest in, 10/04/2021 for $29,000.
Why is this important?
Understanding this concept is important as it can significantly change the amount of capital gains that is being declared in a given year. In our above example, or capital gains declared could be $18,000 or $3,000, depending on whether FIFO or LIFO is used.
How do I keep track of everything?
Exchanges are generally not great at keeping detailed records of all of your transactions, because cryptocurrency moves at such a high pace it is important to keep detailed accounts of every transaction you make.
You can do this the old school way on an excel spreadsheet, or you could use a software such as CryptoTrader that allows for reporting from multiple different exchanges and methods.
How is Crypto income taxed?
Crypto transactions that are classified as income (see above for a full breakdown), are generally taxed according to your personal income tax bracket. You can find an outline of the current tax brackets here.
It is generally considered last, so first take into account your personal earnings that you have made outside of your trading.
See part two of our post to learn more about how much tax you’ll have to pay on your short term capital gains versus long term capital gains, and how to report cryptocurrency taxes. We’ll also delve into DeFi taxes and NFT taxes.
If you are unsure on which rules apply to you, or would simply like to talk to a professional about it to ensure you are staying compliant, get in touch with us here at Cerebral Tax Advisors.