Cryptocurrency & Tax Law in the United States

When Bitcoin first emerged almost 11 years ago, there were people who thought it was just a phase that wasn’t going to stick. Some made a lot of money, while the skeptics remained doubting, waiting for the bubble to burst and for Bitcoin to vanish. The bubble did eventually burst, but the currency had captured a significant portion of the market and inspired a slew of other cryptocurrencies that the world can’t scrub out of existence anymore.

Now that cryptocurrencies have become a new reality for the online marketplace, they can easily be bought and sold. Although unregulated for quite some time, the United States government eventually acknowledged the increasing presence of cryptocurrencies, which are now listed on exchanges alongside other conventional currencies like Great Britain’s pound and the US dollar.

However, with this recognition came increased scrutiny and limitations, the absence of which had attracted people to cryptocurrencies in the first place. During the initial few years of their inception, due to the unregulated nature of cryptocurrencies, they were used in transactions as a means to avoid tax and prying eyes.

It was foolish of anyone to think that governments would allow crypto to operate freely for a long time. The Internal Revenue Service (IRS) has now imposed tax regulations on all instances of cryptocurrency usage within the country.

The Basics

In order to understand tax laws regarding the usage of cryptocurrencies in the US, it is important to remember a few things before we continue. First, the IRS does not recognize cryptocurrencies as “currencies” since they are neither issued nor regulated by the Central Bank. They are, instead, treated as individual property or asset.

Since cryptocurrencies are an asset, the tax rules become clearer to anyone with a basic knowledge of tax regulations. Similar to any financial asset, capital gains tax rules apply to any gains or losses that the cryptocurrency incurs.

Gains or losses are calculated the same way profit or loss is calculated on the sale or purchase of regular stock. Other important instances occur such as cost basis and a triggering event, which we will discuss in detail in a moment. These also follow the same protocol as stock transactions.

To those unfamiliar with tax regulations, coming to grips with the tax rules surrounding cryptocurrencies may seem like a complicated ordeal, so let’s break it down.

Cryptocurrency transactions, regardless of their value, need to be reported to the IRS in all instances. Individuals who fail to correctly report their income, their cryptocurrency transactions or pay the incurred tax may incur penalties and may even be subjected to criminal prosecution.

How Are Capital Gains/Losses Calculated?

In tax calculations, gains or losses on stock are calculated by working out the extent to which cost basis has increased or decreased from the time the asset was acquired up to the moment a taxable event occurs.

In mathematical terms, the Capital Gain or Loss is equal to the cryptocurrency’s Cost Basis subtracted from its Fair Market Value.

Capital Gain or Loss = Fair Market Value - Cost Basis

Bear with me, and I will explain what each component is in the above capital gain/loss equation.

Cost Basis

Cost basis is the cost that is incurred when you purchase a particular asset. In more neophytic terms, it is the amount of money the cryptocurrency was purchased for. This value of cost basis is inclusive of all exchange, brokerage and transaction fees that you may have paid at the time of purchase.

For instance, let’s assume you purchased $600 worth of a particular cryptocurrency a few years back. Those $600 got you around 4.2 units of your selected crypto. Now, further assume that you paid a transaction fee of 2% of the cost at the time of purchase. For this transaction, this is how the cost basis will be calculated:

$600 + (2% x 600) = $612 or $145.71 per unit of crypto

Taxable Event

A taxable event is any event or transaction that leads to a tax liability being incurred. For cryptocurrencies, this happens whenever a cryptocurrency is bought or sold for cash or against another cryptocurrency. It also happens whenever the cryptocurrency is used to pay for the purchase of any goods or services.

Now, we will look into this in a bit more detail and discuss all the instances that the IRS considers as taxable events:

When any cryptocurrency is traded for a conventional currency, such as the US dollar or the euro
When one cryptocurrency is traded for another form of cryptocurrency, such as Bitcoin for Litecoin (this will be done on the basis of the cryptocurrencies’ fair market value in USD at the time of transaction)
When the cryptocurrency is used to purchase any good or service (once again, the fair market value of the cryptocurrency will be calculated in USD at the time of the transaction and sales tax will also be incurred)
The following instances are not considered taxable events by the IRS:

When the cryptocurrency is sent as a gift (cost basis in this instance will go to the account of the recipient. You may still be charged a gift tax if the value of the cryptocurrency sent exceeds the gift tax exemption limit)
When the cryptocurrency is transferred from one virtual wallet to another (do note that the wallet or exchange that you are using may treat wallet transfers as taxable events, so be sure to tally your transaction records with those of the wallet or exchange)
When cryptocurrency is purchased with USD (you won’t incur any capital gains or losses until you trade or sell the cryptocurrency or use it for making a purchase. Do note that if the cryptocurrency is held for a period longer than a year, it may incur long-term capital gains)
Fair Market Value
Fair market value is simply the market value of the cryptocurrency in USD at the time it is sold, traded, or used for purchase.

These are all the basic components of a capital gains/loss calculation. I hope the calculation is much clearer now. Your cost basis (the monetary value you purchased the cryptocurrency at) subtracted from the fair market value (the monetary value you spent the cryptocurrency at) will give you the amount of capital gained or lost. This amount that you have gained is the amount the cryptocurrency tax will be incurred on. We will look at capital loss instances later.

These simple calculations can become considerably more complicated in the instance of a cryptocurrency to cryptocurrency trade which, as you may remember, is also a taxable event.

Capital Gains/Loss Calculation for Crypto to Crypto Trade

In the instance where one cryptocurrency is traded for another, you will have to find out the fair market value of the cryptocurrency that you are trading. For instance, you will have to figure out the fair market value of the Bitcoin that you are trading for Litecoin.

Let’s look at an example to make this easier to understand. Assume you purchased $200 worth of a certain cryptocurrency (crypto A) inclusive of all brokerage and transaction fees. These $200 got you 0.02 units of your required cryptocurrency. Now, assume that 6 months later, you want to trade the 0.02 units of crypto A for 0.26 units of another cryptocurrency (crypto B). How do you think the capital gains/loss calculation will be undertaken in this instance of crypto to crypto trade?

In order to calculate the capital gain or loss on the trade, you will have to determine what the fair market value of crypto A is when the trade is being made. Let’s assume that the 0.02 units of crypto A that you purchased for $200 six months ago are now worth $270 at the time of the trade. This would mean that the fair market value of crypto A is now $270.

Equipped with this information, you can now calculate the capital gain or loss. For the above example, the calculation will be like this:

$270 - $200 = $70 capital gained

For the above crypto to crypto trade, tax will be incurred on the amount of $70, which is the amount of capital gain for this transaction. This calculation needs to be repeated for all the crypto to crypto trade transactions that occurred during the year.

What Happens in the Event of a Capital Loss?

Without going into a lot of complicated detail, if you incur a capital loss (which happens when you sell or trade the cryptocurrency for less than the value you purchased it for), the amount you have lost can be used to offset capital gains from other transactions, be it transactions involving cryptocurrency or any other asset that you traded or sold.

If, during a tax year, the amount of your capital loss exceeds the amount of your capital gain, you are eligible to claim a maximum of $3000 of capital losses. The amount of loss that you incurred will offset the taxable income for that year.

What Are Short-Term and Long-Term Capital Gains?
If an individual holds the purchased cryptocurrency in their wallet for less than one year before they use, sell or trade it, these units will incur a short-term capital gains tax. Short-term gains tax for the individual is the same as their ordinary income tax rate.

Now, assume that the cryptocurrency was held in their wallet for a period of more than one year before it was traded or sold. These units will now incur a long-term capital gains tax. According to US tax law, the following are the long-term gains tax rates for ordinary tax brackets:

For people in the 10-15% tax bracket, capital gains tax rate is 0%.
For people in the 25-35% tax bracket, capital gains tax rate is 15%.
For people in the 39.6% tax bracket, capital gains tax rate is 20%.
Simply put, individuals pay less tax on the cryptocurrency if they hold it for less than one year.

Conclusion

Understanding your tax rates may be a complicated ordeal at first, but with a bit of effort, understanding and complying with these tax regulations should not be all that difficult. There are several tax automation programs that do the majority of the brunt work for you, so filing your tax returns is not as daunting a task as it may seem. As the IRS continues to expand its regulations, they will subsequently develop a more streamlined process as well. Concurrently, the penalty for people trying to circumvent these regulations will increase in parallel.

Disclaimer: Coastline17 does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.