Cryptocurrency Capital Gains and Losses 101
Understanding the tax implications of buying and selling Bitcoin and other cryptocurrencies.
If you’ve been holding cryptocurrency for a while, chances are good that you’ve made a substantial profit. And when it comes time to cash out, Uncle Sam expects a sizable chunk of that change.
But it appears that very few cryptocurrency traders are ‘fessing up. In fact, during last year’s tax filing period, one report revealed that fewer than 100 of the 250,000 people who had filed taxes through the CreditKarma service during the early part of April, had reported cryptocurrency transactions.
Whether that is due to the complexity of the effort or because these filers were hoping to dodge taxes, it seemed disproportionate to the number of people who hold cryptocurrency, which a recent survey pegged at just under 8 percent of Americans.
When currency isn’t “currency”
Even though we call it a virtual “currency,” as of now it is classified as “property” rather than “currency” under federal law. This distinction means it is subject to capital gains tax like other forms of property, such as stocks, bonds, real estate and the like, rather than foreign exchange currency principles.
For many people who are not familiar with cryptocurrency, this distinction can make taxes easier to calculate, since most investors are familiar with common capital gains principles.
As a refresher, capital gains are incurred when you sell the property for more than you paid for it, and that is the underlying principle with cryptocurrency as well.
For cryptocurrency, these events include:
- Trading cryptocurrency
- Spending cryptocurrency
- Exchanging one token for another (because you are essentially selling the first one)
- Converting to the U.S. or other currency (again, you are essentially selling it)
On the other hand, the following events need to be counted as ordinary income; in other words, they wouldn’t trigger a tax event that needs to be accounted for as capital gains taxes or losses:
- Receiving payments in virtual currency
- Air drops, which are considered ordinary income until they are sold or exchanged, in which case there would be a capital game
- Initial coin offerings
Deciphering short-term vs. long-term implications
Just like stocks, you will categorize your cryptocurrency gains or losses as short-term or long-term when you file taxes. “Short-term” capital gains are those that are held less than a year and are taxed at your normal rate. “Long-term” capital gains are taxed at a reduced rate that fluctuates according to your tax bracket. Therefore, to minimize tax events, the best strategy is to buy and hold for more than a year.
But if you have suffered losses, again, those are treated as a stock: You can deduct the loss from your capital gains. Or if you had a particularly down year, and the losses exceed your gains, you can deduct additional losses up to $3,000 annually ($1,500 if you are married and file a separate return) and carry over the rest to your next tax return.
Since it’s almost impossible to know which coin was sold or exchanged in a specific event, most owners will use First In-First Out (FIFO) as the easiest accounting methodology to determine your cost basis, but you are free to use whichever one you prefer as long as you are consistent.
The best advice—especially since determining cost basis is particularly tricky with cryptocurrency—is to seek counsel from a CPA. The worst advice? To ignore your tax implications.
Yes, The Tax Man Cometh: Why You Shouldn’t Risk Fudging Your Taxes
It can be tempting to forgo reporting your cryptocurrency gains and losses—after all, no one is sending you a 1099 form that you have to account for to the government, and you are on your own to decipher your gains/losses and cost basis, which isn’t always simple. But choosing not to self-report is a bad idea.
Just, for instance, consider the successful suit the IRS brought against Coinbase, requiring it to turn over identifying records for all customers who had bought, sold, sent or received more than $20,000 through their accounts in a single year between 2013 and 2015. The Motley Fool reports that fewer than 1,000 tax filings in those years accounted for cryptocurrency capital gains, leaving a plethora of owners open to investigation. That judgment makes it likely that the IRS will begin scrutinizing other exchanges and individual wallets to find tax scofflaws, and you don’t want to be one of them. That’s because you could face penalties, fines—and in extreme cases, even jail time if they find you have filed a false return.
The smart money is on paying what you owe now, so that amount doesn’t increase exponentially via fines, interest, and penalties in the event of an audit.
ZenLedger CEO Pat Larsen led a Facebook Live webinar on the basics of Capital Gains for Cryptocurrency with Andrew Gordon, CPA/JD. Learn everything you need to know about how crypto is taxed.
We had a long Q&A session afterwards and we're currently compiling those responses into a helpful document for you. For now, here is a link to the slide deck used.