Many banks charge arbitrary fees to process payments. For instance, Visa and MasterCard charge processing fees for each transaction to cover the cost of transferring funds from a card holder's bank account to a merchant's bank account. The profitability of these companies suggest that their fees are higher than the true cost of the funds transfer.
Cryptocurrencies are designed to lower transaction fees by maximizing efficiency, but many cryptocurrency transactions remain more expensive than with conventional payment processors — particularly for consumers. For example, Bitcoin transactions still cost about $1.00 each to execute, which is a high cost for casual spending on small goods or services.
Let's take a closer look at how transaction fees are calculated, compare various cryptocurrencies and exchanges, and explore how to avoid paying transaction fees.
What Are Transaction Fees?
The best way to understand cryptocurrency transaction fees is to explore the underlying mechanics of cryptocurrencies.
Cryptocurrencies rely on blockchain technology to record and verify transactions. Each time a transaction occurs, it must be verified by cryptocurrency miners before it's added to the blockchain. The verification process involves using computing resources to solve a cryptographic problem, and the reward for verifying the transaction is a new cryptocurrency coin.
If the output of the transaction is less than its input value, the difference is the transaction fee that is added to the incentive value of the block containing the transaction. Transaction fees are offered to incentive miners rather than charged by miners to process transactions, which means periods of high demand can result in higher transaction fees.
Transaction fees become the only incentive to process transactions once all coins have been mined — at least in the case of Bitcoin. However, these fees are based on convenience rather than necessity. Those willing to accept longer transaction times may pay less in transaction fees, although there's certainly a minimum threshold that must be passed.
Transaction Fees from Exchanges
Cryptocurrency exchanges charge maker and taker fees to people that buy and sell through the exchange.
Maker fees are derived from the term "market maker", which is someone that creates liquidity in a market. For example, a trader might place a limit order that creates an order in an order book, and therefore creates liquidity. The downside is that these transactions aren't immediately executed, and depending on the price, may never be executed.
Taker fees are charged from those that take liquidity away from the market via immediate buy or sell orders. Since you're not creating liquidity, these fees are usually higher than maker fees. The goal is to incentivize people to place limit orders that help create a more orderly and predictable market than one where everyone immediately buys and sells.
Some exchanges also charge deposit fees for converting cash into cryptocurrency, as well as various transfer fees. For instance, an international wire transfer may involve a modest fee to process since the exchange must pay a commercial bank to accept and process the transfer. As a result, the all-in fees charged to traders tend to vary between exchanges.
How to Avoid Transaction Fees
Several cryptocurrencies are lowering or eliminating transaction fees by changing the validation process.
The best way to reduce transaction costs is to increase transaction speeds. For instance, Bitcoin's introduction of SegWit increased the number of transactions in each block. Ripple and other cryptocurrencies have taken similar measures to speed up transactions, which inherently results in lower overall transaction fees.
Other companies are looking to build networks that would operate outside of the blockchain to rapidly process transactions and separately reconcile them. For instance, the Lightning Network creates a smart contract between two users that's secured with initial capital deposited on the blockchain. Any disputes are automatically settled.
Exchange fees are also easy to minimize by shopping around for the best exchange to suit your needs — or even avoiding exchanges altogether. In addition, it's much cheaper to fund accounts with domestic ACH transfers rather than trying to use credit cards or international wire transfers. ACH funding is free on exchanges like Coinbase Pro.
Tax Implications of Fees
The good news is that some transaction fees are tax deductible since cryptocurrencies are treated as property in the U.S.
The cost of acquiring cryptocurrency is fully deductible under IRS tax law. If you pay a $1.00 network fee and $20.00 in exchange fees, you can deduct the full $21.00 from any capital gains that you may realize from the transaction. These deductions can help offset your capital gains taxes or even your ordinary income if capital losses are higher than gains.
The only grey area is transfer fees, since they're not directly related to the cost of acquiring cryptocurrencies. In these cases, the most conservative option is to ignore these costs. The good news is that these costs tend to be much lower than network and exchange fees anyway, so they won't have such a large impact on your total tax exposure.
ZenLedger makes it easy to aggregate cryptocurrency transactions across exchanges and automatically calculate your capital gain or loss. You don't have to worry about calculating the cost basis or recording the fees associated with each transaction since these figures are automatically computed on ZenLedger to generate pre-filled IRS forms.
The Bottom Line
Transaction fees can have a significant impact on your overall capital gains or losses, so it's important to understand what they are and how to minimize them. While it's not always possible to avoid these fees, there are several easy steps that you can take to mitigate the costs and avoid overpaying.
Many cryptocurrencies are also exploring ways to minimize transaction fees on a fundamental level by dramatically increasing processing speeds. Over time, these efforts could make transaction fees lower than conventional merchant processing or broker transaction fees.
ZenLedger makes it easy to account for these fees and other factors when tax season rolls around. By automating the process, you can ensure that there aren't any errors or misunderstandings that could trigger an audit, as well as generate an audit trail in case something happens.