Warren Buffett famously surveyed his employees in 2007 and found that his 17.7% margin tax rate was significantly lower than the office average 32.9% tax rate. Of course, the billionaire has a lower tax rate because most of his income comes from dividends and capital gains rather than ordinary income – and those have a much lower tax rate.
Let's take a closer look at capital gains, how to compute them, and how the IRS taxes these gains.
Capital gains taxes can significantly impact after-tax returns – here's what you need to know to reduce your tax burden.
What Are Capital Gains?
Capital gains are the profits you make from selling or trading a capital asset. Generally, capital assets include any investment or personal property, from stocks and bonds to automobiles and home furnishings. And despite what their name suggests, the IRS considers cryptocurrencies "property" for tax purposes.
Capital gains are taxable when you "realize" them. In most cases, you "realize" a gain or loss when you sell or transfer property. However, you don't owe tax on "unrealized" gains as you hold your property, which creates some interesting tax loopholes, such as refinancing real estate or taking out loans against appreciated stock to avoid realizing a gain.
These rules can be a little confusing when applied to cryptocurrencies. For instance, if you buy a cup of coffee with Bitcoin, you realize a capital gain on the sale of that Bitcoin. And, if you trade Ethereum for the next big alt-coin, you realize a capital gain on the Ethereum – even if the alt-coin goes to zero and you never make any cash profits.
Calculating Capital Gains
A capital gain or loss typically equals the value you receive minus the cost basis (how much you paid for it). So, for example, if you paid $1,000 for Ethereum and sold it for $2,500, your capital gain is $1,500. But again, these simple rules can quickly become complex when dealing with cryptocurrencies.
Suppose you buy 2 ETH, spend 1 ETH, buy 3 more ETH, and then sell 1 ETH. What's the cost basis for the last ETH that you sold? Would it be the price you paid for the original 2 ETH or the price you paid when you later bought 3 ETH? And worse, what happens if you make the two purchases on different exchanges?
The answer is: It depends. Most investors use the first-in, first-out (FIFO) accounting method to calculate their cost basis. So, for example, you'd use the first ETH purchase as the cost in our model above. However, you can also use last-in, first-out (LIFO), or even highest-in, first-out (HIFO) to compute the capital gain.
Regardless of how you calculate your capital gain, you must incorporate transactions across wallets and exchanges. Unfortunately, exchanges cannot provide accurate cost basis information if you use multiple accounts. After all, they cannot know how much you paid for Bitcoin or Ethereum on a different exchange.
ZenLedger and other crypto tax software can help solve these challenges by aggregating transactions across different exchanges and wallets. That way, you don't have to spend hours merging CSV files and matching up buy and sell transactions to compute your cost basis – you have all the information you need at your fingertips.
Finally, it's worth noting you can deduct certain expenses from your capital gain. In particular, you can subtract gas or other transaction fees from the value you receive from a sale, lowering your capital gain. Since Ethereum gas fees remain lofty, these deductions can significantly affect your tax liability.
Paying Taxes on Capital Gains
The amount of tax you pay on capital gains depends on several factors. For example, long-term capital gains are subject to lower tax rates than short-term capital gains. And, of course, the amount of tax you pay depends on your income and capital gains tax brackets. Those that earn less and hold assets longer qualify for the lowest tax rates.
Short-term Capital Gains
Long-term Capital Gains
As these tables make clear, short-term capital gains taxes are always lower than long-term capital gains taxes. The savings are particularly significant for high earners that realize a 17% savings relative to the top income bracket.
Unfortunately, the lack of clear guidance from the IRS on some crypto-specific issues also creates some gray areas. For example, non-fungible tokens (NFTs) representing digital art may be subject to the higher collectibles tax rate. Interest income from decentralized finance (DeFi) may also classify as ordinary income.
You can minimize your capital gains taxes by holding assets for more than one year, selling during lower-income years, and taking advantage of tax-loss harvesting opportunities. The latter strategy involves selling crypto assets at a loss to realize the loss in the current year and using that loss to offset other capital gains.
The Bottom Line
Capital gains reflect the difference between the amount you paid for a piece of property and its current market value. When you sell or transfer property, you realize these capital gains and may owe capital gains taxes on the profit. The amount of tax depends on your income, holding time, and several other factors.
If you'd like to reduce your tax burden, ZenLedger can help aggregate transactions across wallets and exchanges, compute your overall capital gain or loss, and auto-populate the IRS forms you need to file each year.