Cryptocurrency is riding high these days. But even as more investors are taking a chance on new currencies like Bitcoin, Ethereum, and Ripple, many are still confused about how to treat it for federal income tax purposes. In 2014, the Internal Revenue Service (IRS) issued guidance to taxpayers making it clear that virtual currency will be treated as a capital asset, provided they are convertible into cash. In simple terms, this means that capital gains rules apply to any gains or losses. But taxes are rarely simple. Things can get complicated very quickly.
Here are the basics:
- For those taxpayers buying and selling cryptocurrency as an investment, calculating gains and losses are figured the same as buying and selling stock. That's true, as well, when it comes to basis, holding period and a triggering event.
- For those treating cryptocurrency like cash - spending it directly for goods or services, or using it to buy other cryptocurrencies - the individual transactions may result in a gain or a loss.
I know, the basics aren't quite so basic. Here's a deeper dive into some of the more complicated bits:
First, how do you calculate capital gains on cryptocurrency?
For tax and accounting purposes, capital gains and losses are calculated by determining how much your cost basis has gone up or down from the time you acquired the asset (in this case, cryptocurrency) until there's a taxable event.
Okay, you've already lost me. What's basis?
Basis is, at its most simple, the cost that you pay for assets. The actual cost is sometimes referred to as "cost basis" because you can make adjustments to basis over time. For example, if you add to the asset, either as a new purchase or a reinvestment, your basis is your cost plus the cost of each subsequent purchase/reinvestment.
Got it. When I trade cryptocurrency on an exchange, I pay commissions and fees. How do I treat those costs?
When you calculate your basis, you'll figure the purchase price plus any related costs, such as commissions.
You treat fees differently: If you pay investment-related fees, then you may be able to deduct the fees on your Schedule A, assuming you itemize. But that's only for 2017. The new tax reform law eliminated the deduction for 2018 through 2025 but there is a work-around: If, instead of owning cryptocurrency personally, your business owns the investments, you can deduct investment-related fees on a Schedule C (or your entity's tax form).
So what's a taxable event?
A taxable event is typically a sale or disposition of an asset. When it comes to cryptocurrency, a taxable event occurs whenever it is traded for cash or other cryptocurrency or whenever cryptocurrency is used to purchase goods or services.
There's also another potentially complicating factor. The IRS doesn't require third-party reporting for virtual currency (yet) so there's no form 1099-B or equivalent issued at the end of the tax year. Some companies like Coinbase will offer a summary of transactions which can be used to help you file your taxes but if you withdraw cryptocurrency from an exchange, the exchange can no longer track when happens. In that way, it's the same as taking money out of your bank. For that reason, cashing cryptocurrency out of an exchange or similar platform may be treated as a sale - even if you're forced to withdraw it (Remember: There's very little official guidance right now.)
And what's a holding period?
The holding period is the period of time that you own or have access to the asset - typically, the time frame between acquisition and the taxable event.
- If you hold an asset for more than one year before a taxable event, it's considered a long-term gain or loss.
- If you hold an asset for one year or less before a taxable event, it's considered a short-term gain or loss.
Ok, great. Being taxed as capital gains is a good thing, right, because those tax rates are better than normal?
Sort of. Capital gains rates can be favorable to taxpayers. For 2017 (the return that you'll file when tax season opens in January 2018), capital gains rates for long term gains (those held more than a year) range from 0% to 20%. Short-term capital gains are taxed as ordinary income, which means your marginal tax rate will apply to your short-term gains as well.
But I don't pay tax unless I actually cash out my cryptocurrency, right?
Nope. This is one of the problems. You may have a taxable event even if you don't formally cash out. Anyone using cryptocurrency to pay for goods or services must treat each purchase as a sale. Ditto for trading one cryptocurrency for another.* I know there's confusion over this treatment, but think of it like this: If you trade in your Amazon shares for Microsoft shares, that's a taxable transaction, even if you don't take cash out of your brokerage account. Same analysis.
(*Note: I'm not going to address section 1031 issues here because it's beyond the scope of this post and because it's disallowed for cryptocurrency under the new tax reform law. If you're reading this and you have no idea what section 1031 is, don't panic: It likely doesn't apply to you.)
What if I lose money?
If your realized losses exceed your realized gains, you have a capital loss for tax purposes. You can claim up to $3,000 (or $1,500 if you are married filing separately) of capital losses and the amount of your loss offsets your taxable income for the tax year. If your losses exceed those limits, you can carry the loss forward to later years subject to certain limitations and restrictions.
Realized gains and losses? What does that mean?
Cryptocurrency has been up and down over the past year. For tax purposes, you mostly care about the beginning and the end: what happens in the middle doesn't really count. For example, every time that Bitcoin takes a dive, that doesn't equal a real, or realized loss. Similarly, when it goes back up, that doesn't equal a real, or realized gain. To realize a gain or a loss for tax purposes, you have to do something with the asset. Typically, that means that you sell it or otherwise dispose of it - generally, the taxable event mentioned earlier.
Here's a quick example to help you sort out the math: Assume you invest in Bitcoin worth $1,000. Over the year, assume that the value of the Bitcoin climbs to $25,000 due to market conditions and not any additional investment on your part. You continue to hold onto it. Result? Unrealized gain, no capital gain. Now assume that the value of Bitcoin takes a hit and it falls to $500. Result? Unrealized loss, no capital loss. Finally, assume that Bitcoin climbs back to $750 and you get rid of it. Result? You have a realized capital loss of $250 ($750 selling price – $1,000 basis). You take the loss at the basis, not the high price (the $25,000 high value is meaningless for purposes of capital gain or loss) nor at the low price (the $500 low value is similarly meaningless for purposes of capital gain or loss). You want it to mean something. But it doesn’t. At least not for tax purposes.
So where do I report my gains or losses on cryptocurrency?
At tax time, you’ll report your realized gains and losses on a Schedule D, and then transfer the results to the reconciliation page on your federal form 1040. You don’t file a Schedule D if you don’t have any realized gains or losses: even if the value changes, if there's no sale or disposition, there's nothing to report.
Got it. So what if I invest in cryptocurrency outside of the United States. I know that I have to report brokerage accounts and other assets on an FBAR. Does that apply here?
Nope, you don't have to report your cryptocurrency on your FBAR. In 2014, the IRS issued a statement, saying, "The Financial Crimes Enforcement Network, which issues regulatory guidance pertaining to Reports of Foreign Bank and Financial Accounts (FBARs), is not requiring that digital (or virtual) currency accounts be reported on an FBAR at this time but may consider requiring such accounts to be reported in the future." The IRS has confirmed that position for this year.
Since I don't have to report it on an FBAR, what happens if I just don't report it all, anywhere?
The IRS has been cracking down on cryptocurrency reporting. They've made some headway into investigating potentially unreported transactions, including some initial success in legal efforts to force Coinbase to turn over customer records. It's likely not an isolated push: In the Coinbase matter, IRS Senior Revenue Agent David Utzke noted that for the 2013 through 2015 tax years, the IRS processed, on average, just under 150 million individual returns annually. Of those, approximately 84% were filed electronically. IRS matched data collected from forms 8949, Sales and Other Dispositions of Capital Assets, which were filed electronically and found that just 807 individuals reported a transaction on Form 8949 using a property description likely related to bitcoin in 2013; in 2014, that number was just 893; and in 2015, the number fell to 802. The IRS argues that those numbers indicate that taxpayers aren't reporting or paying tax on cryptocurrency transactions.
The takeaway? It's no secret that IRS is making reporting cryptocurrency a compliance priority. Stay ahead of the game by making sure your records and tax reporting are above-board.