Imagine having bought your first Bitcoin for $0.08 when it first started trading in July 2010 and selling that Bitcoin at its peak of over $60,000 this past April. Along with what could be called an astronomical return on investment, you would, unfortunately, also receive an astronomical tax bill. To some degree, this is a situation that millions of Americans face when they answer “Yes” to the first question of Form 1040: “At any time…did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
If your financial advisor had recommended that you invest in virtual currency, they would have joyously celebrated the good news with you. After the party was over, they would have begun talking about setting aside some of your profit for paying capital gains tax to avoid tax evasion penalties.
But how much would the IRS be entitled to? First, let’s examine how crypto capital gains and losses are taxed, at what rates your investment income is taxed (long-term capital gains tax vs. short-term capital gains tax), the IRS’s stance on crypto, legal tax deductions, what constitutes taxable events, and taxable income, and more.
How Is Cryptocurrency Taxed Today?
The Internal Revenue Service stated in 2014 that crypto should be treated as property, not a currency such as dollars or euros. This ruling significantly complicated tax reporting for individuals who own crypto.
How does crypto’s classification as property, like stocks and bonds, affect its taxation? Under the tax code, the property is generally taxed upon the sale of that asset. Note that you can hold crypto without any tax ramifications, but all (in most cases) proceeds from sales must be reported and considered for tax purposes. Taxable income is determined by comparing the proceeds from a sale to the cost basis (purchase price) in the tax year the sale occurred.
For example, if you bought a certain quantity of Bitcoin for $4,000 and later sold it for $7,500, your taxable gain would be $3,500 ($7,500 – $4,000), which you would have to report on IRS form 8949. However, if you sold that same Bitcoin for $1,000, you would realize a capital loss of $3,000, which could offset other capital gains.
In another example, let’s say that you purchased 1 Bitcoin for $500 and held it until it had risen in value to $5,000. Then you used a portion of that Bitcoin to buy $3,000 of electronics. It is not entirely obvious what you would have owed in capital gains tax, so let’s break it down. By spending $3,000 worth of Bitcoin, you essentially sold 2/3 of a Bitcoin (yes, purchasing something with Bitcoin is a sale of Bitcoin under the current tax code). The cost basis of your Bitcoin was $500, but you only spent 2/3 of your holdings, so you must calculate the cost basis on that Bitcoin, equal to $300 ($500 x 2/3). The proceeds of this sale were equal to the total purchase price of the electronics ($3,000). Therefore, the total taxable gain on this transaction was $2,700 ($3,000 – $300).
Because the IRS considers Bitcoin (and other crypto assets) property, it’s taxed accordingly. The activities detailed above are reported on IRS form 8949. This form is the scorecard that shows if a particular crypto sale resulted in a capital gain or loss.
Your Tax Rate: Long Term Capital Gains vs. Short Term Capital Gains
Let’s think positively and assume that you sell your crypto for a nice profit. Then, how much you owe in taxes will be dependent on three primary factors (according to the current tax code and capital gains tax rates):
- Your annual income (including non-crypto sources on your W-2) and tax filing status
- How long you held your crypto assets (holding period)
- The accounting method used to calculate gains
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If you’ve owned your coins for under one year before you spent or sold them, your profits would be classified as short-term capital gains on your tax return and taxed at standard income tax rates based upon your annual income.
If you’ve held onto your crypto for a year or longer, your profit (or loss) is considered long-term capital gains. As a result, that profit will be taxed at a substantially lower rate, the long-term capital gains rate, also determined by your annual income. This tax rate is typical in real estate and home sales.
If you earned crypto through mining or staking, received it as payment for goods and/or services, or as a promotion, your earnings are considered ordinary income. Therefore, the taxes owed are calculated by applying your ordinary income tax rate to the value of the crypto assets as of the time you received them.
Additionally, when you sell cryptos earned through the means described above, you will trigger another taxable event, which will require you to calculate the capital gain or loss. In this case, your cost basis will likely be equal to the value of the crypto at the time you received it.
How You Received It and How You Use It Determine If You Owe Taxes on Your Crypto
Here are some questions to determine whether or not you owe taxes on your crypto.
Did you earn crypto from mining or staking? We’ve mentioned cryptocurrency mining before; what exactly does it mean? Mining crypto uses computers to solve complex equations and record data on the blockchain (which holds sets of information). Considering this as being labor that you performed and perhaps receiving payment in crypto tokens, you’ll owe, per the IRS, income tax on the entire value of the crypto you obtained by mining.
Did you receive crypto as a reward or an airdrop? If so, it counts as taxable income.
Did you receive payment for goods and/or services in crypto? If someone pays you in cryptocurrency for services rendered, the entire amount is considered taxable income, the same as if they paid you in cash. And, it might be a double-win for the IRS if your customer used crypto that increased in value from the time they acquired it.
Did you sell cryptocurrency and realize a gain from your investment? If the ledger shows that you sold your crypto for more than you paid for it, you owe tax on that gain (short term or long term depending on how long you held the crypto), just as you would with profits from stocks or mutual funds.
Are you actively trading crypto assets in exchange for one another? Converting or exchanging crypto (for example, exchanging Bitcoin for Ethereum) means that you’ll be paying taxes on any gains you earned from the transaction. If you bought $600 worth of Bitcoin and you used it to buy $1,200 of Ethereum, you’d have a taxable gain of $600 for the profits you realized, even though it was just an exchange of one crypto for another.
These are some excellent questions to dive into deeper with your tax advisor, who can help you calculate your taxes accurately since the IRS keeps a much closer eye on cryptocurrency than ever before.
HIFO Is Your Friend
A favorable section of the tax code concerning crypto allows you to identify which coins you’re selling, as long as you have the records to back it up. In addition, selling the coins with the highest cost basis (Highest-In-First-Out, HIFO) will favorably impact (minimize your taxable gain) your capital gains tax.
Suppose you don’t have substantiating records showing each purchase and sale. In that case, you’ll have to use the FIFO (First-In-First-Out) method, which means your tax bill will likely be higher since you are not optimizing your accounting methodology.
For example, Mike bought two Bitcoin, one in 2015 for $5,000 and another for $25,000 in April 2020. He then sold one Bitcoin for $50,000 in December of 2020. Under HIFO, Mike would have had a $25,000 capital gain, but under FIFO, his capital gain would have been $45,000.
The moral of the story: keep detailed records of when and at what value of your crypto purchase to maximize your return using the HIFO accounting method.
The tax you pay on your crypto capital gains and losses can also be affected favorably by other credits, deductions, and exemptions you have for that tax year.
Lukka can do the heavy lifting for you by optimizing your taxes and books. We’ll let you know which accounting method works best for your situation by doing a side-by-side analysis of HIFO, FIFO, and one we haven’t talked about – LIFO (Last-In-First-Out). We’ll even create tax lots with specific IDs. And working with Lukka will ensure that you’ll be well-prepared in the event of an audit.
Lukka can help you manage your crypto assets on infrastructure specifically designed for the intricacies of blockchain data. We’re accelerating the adoption of blockchain technology, and we’re here to help tax professionals and savvy consumers.