If you’ve invested in cryptocurrency over the past year, you may wonder if you owe any taxes because of this. But finding information about how to calculate cryptocurrency taxes is difficult. This article will explain how you can determine the amount you owe (if any). It will also suggest some free software that will help you make this calculation.
Identifying information and crypto taxes
You may have heard about the recent I.R.S. crackdown on Coinbase, a popular crypto exchange. Coinbase was ordered to provide identifying information for over 14,000 users. Many of these users thought they would not have to pay taxes on their crypto gains because of the anonymous nature of bitcoin and other cryptocurrencies.
However, cryptocurrency exchanges require users to produce identifying documents under “Know Your Customer” (KYC) rules. So even though bitcoin wallets are anonymous, exchanges are not. And since most crypto users buy from an exchange, this means most crypto users can easily be identified by the I.R.S.
Who owes cryptocurrency taxes?
So it’s a given that the I.R.S. can identify crypto users. But does this mean you owe taxes on your cryptocurrency? Not necessarily. Taxes are only levied on income produced using cryptocurrencies. And since most workers don’t get paid using bitcoin, users generally don’t owe taxes on their crypto holdings unless they realized a “capital gain” on their crypto holdings.
To realize a capital gain in most cases means that you bought crypto for a certain amount of money and then sold it later for a greater amount of money. If you bought crypto and never sold it, you don’t owe taxes on it. If you bought crypto and sold it for a lower price, you also don’t owe taxes on it. In general, you only owe taxes on your cryptocurrencies if you sold them for a higher price than what you bought them for.
There is also one other circumstance where you may owe a tax. If you paid for something using crypto and the dollar-value of the thing you bought was more than what you paid for the crypto used to buy it, the I.R.S. may consider this to be a barter transaction that is taxable.
For example, suppose you bought one bitcoin at a price of $6,000. The price of bitcoin then rose to $10,000. While it was at $10,000, you bought a car at a cost of 1 bitcoin. And let’s say the same car dealer sold the exact same model car to another customer for $10,000. Because you were able to buy a more valuable car than you would have had you held cash, the I.R.S. may consider the extra $4,000 to be a taxable “capital gain.” This is true even though you never actually sold your bitcoin.
How do I know much I owe?
Even if you know that you owe taxes on your cryptocurrencies, there is still the question of how to calculate the amount of tax.
There are three steps to answering this question. First, determine the amount of your capital gain by subtracting the cost of your crypto when you bought it from the amount you got when you sold it. For example, if you bought one bitcoin at $6,000 and sold it at $14,000, your capital gain is $8,000.
Second, determine the tax rate applied to this capital gain. If you held your crypto for less than a year, you must apply the regular income tax rate for your bracket. This may be anywhere from 10%-39%, depending on how high of an income you have. If you are low income, standard deductions and exemptions could even push this rate to zero.
If you have held your crypto for more than a year, you can apply the capital gains tax rate instead of the regular income tax rate. The capital gains tax rate is between 0% and 20%, depending on your income. But it is usually lower than the income tax rate.
Methods for dealing with multiple transactions
If you’ve only bought crypto one time and then sold at a later date, it should be easy to calculate your tax liability using the instructions above. However, most crypto users buy a small amount each paycheck and sell at multiple points throughout the year, then reinvest the cash from these sales into more crypto later on. This can make it hard to determine which coin was sold at which point in time. After all, cryptos bought and sold on an exchange aren’t made up of individual coins labeled with a timestamp (and even if they were, tracking down the date of each transaction would be extremely time-consuming).
This isn’t a problem just for cryptos, however. Stock, bond, and commodity traders also face this issue. And accountants have come up with a few ways to deal with it. Here are three of them:
FIFO means “First In, Last Out.” If you use the FIFO method for calculating capital gains, you assume that the first crypto coin sold out of a wallet or account is the first one that was bought. For example, if you bought 10 bitcoins in January and 10 in February, then sold 10 in March, you assume the 10 sold in March were the ones bought in January. If the price went up between January and February, you will end up with a higher tax liability using this method than with others.
LIFO means “Last In, First Out.” If you use the LIFO method for calculating capital gains, you assume that the first crypto coin sold out of a wallet or account is the last one that was bought. For example, if you bought 10 bitcoins in January and 10 in February, then sold 10 in March, you assume the 10 sold in March were the ones bought in February. If the price went up between January and February, you will end up with a lower tax liability using this method than with others.
If you use the average cost method of calculating capital gains, you take the average cost of all of your crypto purchases over the year and treat each coin as if it was bought at that cost. You do the same for all sales: calculate the average amount you made off of each sale and treat each coin as if it was sold at that cost.
Cryptocurrency tax software
Performing these calculations can be extremely complicated. You may have made 10, 20, 30, or even hundreds of trades over the course of a year. Multiple crypto brokerage accounts may have been used. You may have even sent coins back-and-forth between these accounts, further complicating the calculations.
At Path.tax, we offer free, easy-to use software that can perform all of these calculations for you. Just create an account with a username and password, then connect your crypto-brokerage accounts. Our software will calculate your capital gains using FIFO, LIFO, or average cost. A premium version with added features is coming soon. In the meantime, you can sign up for our free service here.
We hope you’ve found this explanation of cryptocurrency taxes to be helpful. If you have any questions or comments, please leave them in the comment box below. We will provide more information for cryptocurrency users in this blog in the future. In the meantime, let us know how we are doing.