Cryptocurrency has come a long way since the birth of Bitcoin in 2009.  

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 of this 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 and crypto tax guide 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 transfer between 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.

Ultimately, any transaction apart from buying, holding, or transferring cryptocurrency is considered a taxable event, and you will owe Uncle Sam some money on the transaction.  This is exactly like trading stocks. For example, if you purchased $100 of Apple stock (Apple ticker) you would not owe anything to the government on that transaction. Now let’s say a year passes, and that same amount of Apple stock that you purchased has increased to $120 in value.  Let’s say that at this same time, you also trade all of your Apple stock for Microsoft stock. This is what would be considered the ‘taxable event’ and would trigger a capital gains tax. You would owe the government a percentage of your $20 capital gain. This is the same logic that can be applied when buying Bitcoin and then trading that Bitcoin for some amount of Ripple let’s say.  The transaction of trading Bitcoin to Ripple is considered a taxable event. For those trading on cryptocurrency exchanges like Binance, this can get difficult to calculate your bitcoin taxes.

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 calculation:

(Purchase Price of Crypto + Other fees) / Quantity of Holding = Cost Basis

For example, if I invested $500 in Litecoin back in November of 2017, that would have bought me about 5.1 Litecoin.  Let’s say I also paid Coinbase a 1.49% transaction fee on the purchase. My 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 I 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 I would calculate the gain as follows:

200 – 99.50 = $100.50 Capital Gain

I 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).  On 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 I 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 I trade all of my 0.1 Bitcoin for 0.16 Ether.  How would I calculate my 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 the crypto at the time of the trade.  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. 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 will simply 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 simply 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 I’m a high-rolling day-trader who uses a bunch of different exchanges: Binance, Bitfinex, and GDAX. Let’s say, I had my fun in the crypto game and took the majority of my money, $100,000, out of the exchanges and put it back into my bank account.  The IRS can see that you put that money into your bank. Let’s say you get audited. The IRS will simply 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 simply 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.  This is a HUGE difference and could be money that you cannot afford to lose.

Thankfully, there is software that allows you to instantly and accurately calculate your capital gains tax liability by simply uploading your .csv reports from the exchanges that you use.  CryptoTrader.Tax provides a complete report of all your trades, your cost basis, and your total capital gains/loss liability in a matter of minutes.  When the IRS comes knocking, simply show them the generated report.

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.

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 of more, you qualify for a lower long-term capital gains rate.  

As you can see, the long-term rate is much lower and rewards investors if they hold, continuously, for a year or more.

So What about Capital Losses?

So 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.