Paying taxes on Bitcoin is becoming a priority for individuals in the US after the IRS announced on July 2nd, 2018 that one of their core campaigns and focuses for the year is the taxation of virtual currencies.
Because Bitcoin and other cryptocurrencies are treated as property in the eyes of the law, they are subject to capital gains and losses rules just like other forms of property — stocks, bonds, real estate etc.
This guide walks through the fundamentals and the things you need to keep in mind when paying taxes on Bitcoin.
What is a Capital Gain / Capital Loss?
A capital gain is simply the rise in value of a capital asset. In the world of Bitcoin and crypto, you incur a capital gain when you sell or trade a coin for more than you acquired it for. Just like if you sold a stock or a piece of real-estate for more than you bought it for, you owe a tax on this gain.
For example, if you purchased 0.1 Bitcoin for $1000 in April of 2018 and then sold it two months later for $2,000, you have a $1,000 capital gain. You report this gain on your tax return, and depending on what tax bracket you fall under, you will pay a certain percentage of tax on the gain. Rates fluctuate based on your tax bracket as well as depending on if it was a short term vs. a long term gain.
The frustrating part in the world of crypto is that a coin-to-coin trade, for example trading Bitcoin for ETH, is treated as a sale and is considered to be a taxable event along with cashing out to FIAT currency.
What about Capital Losses?
When you sell or trade Bitcoin or another cryptocurrency for less than you acquired it for, you incur a capital loss. This loss can be used to offset other forms of capital gains as well as regular income on your taxes. If you have big time losses, you can file these losses to save money on your tax bill. These types of tax savings can be very substantial depending on your situation. Read more about how to handle your crypto losses for tax purposes here.
Breaking it Down Further
So to calculate your capital gains and losses, you use this formula:
Fair Market Value — Cost Basis = Capital Gain / Loss
What is Cost Basis?
Cost Basis is the original value of an asset for tax purposes. In the world of crypto, your cost basis is essentially how much it cost you to acquire the coin.
What is Fair Market Value?
In the simplest sense, fair market value is just how much an asset would sell for on the open market. Again with cryptocurrency, this fair market value is how much the coin was worth in terms of US dollars at the time of the sale.
These terms can often get confusing, but the process is actually very straightforward. Let’s go through an example to make sure things are clear.
Let’s say you bought 5 Ethereum on Coinbase in January of 2018. You paid $2,000 for these ETH ($400 for each coin). After the market took a turn for the worse, you sold 3 of these ETH in July for $150 each.
Remember we need to know cost basis and fair market value to calculate your capital gain or loss.
In this example, your cost basis for the 3 ETH that you sold is $1200 (3 * 400). You sold the coins for $450 total. This is your fair market value.
Doing the math,
450–1200 = -750.
You incurred a $750 capital loss. You would file this loss on your taxes and it would save you some money on your tax bill. You would not owe taxes on the 2 ETH that you are still holding because you haven’t traded or sold them yet.
Keep in mind, coin-to-coin trades are also considered a sale for tax purposes.
So let’s say instead of selling your 3 ETH for US Dollars, you traded your 3 ETH for X amount of Bitcoin. Well in this case you still have triggered a taxable event, but now your fair market value is a little bit harder to calculate. You have to know what the value of 3 ETH was in USD at the time of trading to calculate what your loss is on the transaction.
The Elephant in the Room
This calculation of Fair Market Value for coin-to-coin trades 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 their crypto at the time of every single trade. This is information that you actually need to have to accurately file your taxes and avoid problems with the IRS. Depending on the volume of trades you have carried out, calculating gains accurately could become extremely tedious, and potentially impossible to do by hand or even with Excel if you haven’t been keeping track of Fair Market Value.
Enter Bitcoin Tax Software.
CryptoTrader.Tax is Bitcoin and cryptocurrency tax software that was developed to help traders solve this problem.
With its immense database of historical cryptocurrency prices, CryptoTrader.Tax is able to automate the entire crypto tax reporting process. As a cryptocurrency hobbyist or high volume trader, you simply need to upload all of your historical crypto trades from the exchanges that you traded on into the platform, run your tax reports, and then import these reports into TurboTax or give them to your CPA or tax professional to complete your tax return.
Paying taxes on Bitcoin isn’t fun and laws are likely to continue to shift around as the asset class evolves. Hopefully, this guide made the process a little less scary and more digestible.
For more information on how cryptocurrency is treated for tax purposes:
Use our Cryptocurrency Tax Professional Directory to find a tax specialist near you!
*This post is for informational purposes only and should not be construed as tax or investment advice. Please speak to your own tax expert, CPA or tax attorney on how you should treat taxation of digital currencies.