How to Tax Crypto Gains
Updated: Apr 1, 2019
Many investors ask about the tax implications of having digital currency in their investment portfolios. Some fear the taxation of gains on cryptocurrency would be hard to wrap their heads around. Good news is that figuring out tax implications of gains on crypto assets involves the same basic methods as with conventional assets.
On March 25, 2014, the IRS issued Notice 2014–21, stating the position of IRS on taxation of cryptocurrencies: “Virtual currency is treated as property for U.S. federal tax purposes.” According to the notice: “For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars”. The IRS has yet to update their stance since 2014, so this is the best we have moving forward until they provide further guidance.
Cryptocurrency is taxed as a capital asset. Whether it is Bitcoin, Ethereum or any other digital currency, a taxpayer is required to keep track of the cost basis, transactions and proceeds from disposition to figure the gain or loss.
A taxpayer purchased 1 Bitcoin @ $ 5,000 — The price goes up to $6,000— sells 1 Bitcoin @ 6,000.
$6,000 proceeds — $5,000 cost basis = $1,000 taxable gain.
The $1,000 Gain is taxed at the applicable rates depending on the taxpayer’s tax bracket (usually 15–20%) and the type of gain (long term or short term). Below are the tax tables for both long term and short term gains.
In the past, like-to-like transfers were permitted and free from taxable gains (for example selling Ethereum for Bitcoin) thanks to a 1031 exchange loophole. Starting in 2018 however, thanks to the new tax bill passed in congress, If a taxpayer exchanges say 1 Bitcoin for the equivalent in Ethereum, that event would also be taxable, requiring the taxpayer to include the gain from conversion.
It is important to note that there is no clear guidance from the IRS in regards to taxing crypto-to-crypto trades specifically. However, the language within the new tax bill makes it clear that only real estate can be the subject of a tax-free 1031 exchange.
A taxpayer purchased 1 Bitcoin @ $ 5,000 — The price goes to $6,000 — buys 10 Ethereum with 1 Bitcoin at the current exchange rates. $6,000 current value of 1 Bitcoin converted to Ethereum— $5,000 Bitcoin cost basis = $1,000 taxable gain.
These were examples of simple transactions, but it is possible for transactions to be much more complicated. For more complex transactions where trades for partial coins or trades into multiple coins are made, the best way to go about taxation is to keep detailed transaction logs. It also becomes simpler if the taxpayer uses LIFO (Last In — First Out) or FIFO (First In — First Out) methods of transaction bookkeeping. That way it is easier to keep track of the cost basis for each trade. FIFO and LIFO refer to when the coins were purchased.
— If you purchased 5 Ethereum in June for $500 and then 5 Ethereum in August for $550, you end up with a total of 10 Ethereum. When you decide to sell 1 Ethereum in September for $600, using LIFO (Last in, First Out) the Ethereum purchased in August would be the ones used to calculate the cost basis and gains. Using LIFO, $600 current value of 1 Ethereum - $550 Ethereum cost basis = $50 taxable gain.
FIFO—Using the same example above, when you decide to sell 1 Ethereum in September for $600, using FIFO (First in, First Out) the Ethereum purchased in June would be the ones used to calculate the cost basis and gains. Using LIFO, $600 current value of 1 Ethereum - $500 Ethereum cost basis = $100 taxable gain.
As you can see, determining which bookkeeping method could change the amount of taxable gains you have. Using this example, you would pay more gains using FIFO but that will not always be the case. The biggest thing to note is that until the IRS provides guidance on which method to use, whichever method you decide to use you must use that method for all transactions.
There are other situations where crypto taxes become a bit more complicated: mining, forks, and airdrops. It is not entirely clear how to proceed with these since the IRS has yet to provide any guidance, but below are some common practices.
Mining — There are two things to consider with mining taxes. The first is how you report earnings from mining. You can report earnings as self-employment income and income tax where you can deduct expenses like equipment, electricity, and other expenses. You can also report earning as “other income”. Utilizing the second option will usually provide you with a lower tax rate but you will not be able to deduct expenses. In regards to any gains from the result of mining, the effective cost basis will be the price of the cryptoasset at the time of mining. From there you can calculate the taxable gains once sold.
Airdrops — It is recommended that the cost basis for any airdrop should be $0 at the time of the airdrop and its value on the day it is received should be taxable.
Forks — Forks are similar to airdrops. It is recommended that the cost basis for any fork should be $0 at the time of the fork and its value on the day it is received should be taxable.
Hopefully the IRS will provide further guidance before April 2019 for taxing crypto, but until then this is the best we have to work with. If you trade crypto regularly and/or have some complex transactions, we highly recommend working with a tax accountant familiar with crypto to help complete your taxes. Paying your taxes in an appropriate manner will be crucial once the IRS updates their stance. The IRS has the ability to retroactively make changes and any traders who insufficiently reported taxable gains could be charged penalties and interest on any unreported gains from previous years.
Investors must be aware that cryptocurrency transactions result in capital gains AND losses that have to be reported on Form 1040, Schedule D, Capital Gains and Losses, and on Form 8949, Sales and Other Dispositions of Capital Assets, as appropriate.
For reference, this only applies to United States taxpayers. Taxpayers from other countries may have a different set of tax laws.