Capital Gains & Losses (Part 3)
Introduction
Hey everyone!
This is the third post of a series of informative U.S. tax posts. The goal of these posts will be to provide awareness to the current state of U.S. tax regulation. We, the authors, will attempt to write the information in an easy-to-understand format. Keep in mind, this will not solely cover cryptocurrency taxation, but all U.S. tax regulation. This being said, the early focus of these posts will cover topics closely intertwined with cryptocurrency.
In any posts relating to cryptocurrency, we will explain the current treatment as per the Internal Revenue Code (IRC) as well as sometimes touching on the proposed treatment, suggested by the American Institute of Certified Public Accountants (AICPA).
It is our hope that these posts will spark productive conversation and lead to fairer tax legislation. Remember, debating is promoted, but please remain civil! As this post is a continuation of the previous post, if you haven't already, please check out Capital Gains & Losses (Part 1) and Capital Gains & Losses (Part 2).
Throughout this series of posts, we hope to cover the following:
- Key Vocabulary for Understanding Capital Gains/Losses - Previously Covered in Part 1
- What are Capital Gains/Losses? - Previously Covered in Part 1
- What is a Carryforward/Carryback? - Previously Covered in Part 2
- What Events Initiate Gain/Loss Recognition?
- What Inventory-Costing Methods are Allowed?
Key Vocabulary
While the Key Vocabulary was already presented in Parts 1 & 2, I feel it may prove beneficial to reiterate it here to refresh your memories. The vocabulary is as follows:
- Cost Basis – The cost basis is used to establish gain and losses. The basis is the amount the property was acquired for or amount of the property previously taxed (i.e. I buy Bitcoin at $1 and sell it for $10, the $1 is my cost basis). Secondly, if Bitcoin is mined when it is worth $10, that $10 is considered ordinary income at the time the mining was completed requiring immediate tax recognition and, as a result, establishing a cost basis of $1).
- Holding Period – This is the length of time property is held.
- Long-Term Holding – This is defined by a holding time of greater than 1 year.
- Short-Term Holding – This is defined by a holding period of 1 year or less.
- Ordinary Income - Normal income from anything other than capital gains.
- First-In-First-Out (FIFO) – An inventory identification method, it assumes that the first assets purchased are the first assets sold.
- Last-In-Last-Out (LIFO) – An inventory identification method, it assumes that the last assets purchased are the first assets sold.
- Specific Identification Method – An inventory identification method, it directly identifies the asset sold, there are no assumptions. This is generally what is used for high-value, large inventory (i.e. cars).
Capital Gains Tax Recognition Events
This section may come as a surprise to some. Many believe that recognition of gains are only required when cryptocurrency is converted to U.S. dollars – this is not the case. While selling property (crypto included) for USD will, in fact, result in a recognizable gain, this is not the only event which warrants recognition.
Unfortunately, simply trading cryptocurrencies will result in recognition of gains. Thus, if one purchases a Bitcoin at $1 and at the time Bitcoin is worth $10, he or she trades the Bitcoin for another cryptocurrency, the individual is required to pay taxes on the $9 gain.
Additionally, if the appreciated asset – Bitcoin in this case – is used to purchase a good or service, the gain must be recognized. Thus, you should think of the tax consequences before you use your crypto to purchase your groceries!
What Inventory Costing Methods are Allowed?
With securities First-In-First-Out (FIFO) is the default method. However, according to the AICPA, the Internal Revenue Code (IRC) only allows for the use of the Specific Identification costing method for cryptocurrencies. This is a very cumbersome method and is nearly impossible to use with cryptocurrencies. The method requires that every sale identifies the exact asset sold and its associated cost basis and holding period. As you can imagine, if someone is performing hundreds of crypto trades a week this would be extremely hard to keep track of.
The AICPA suggested recently that the IRS allow for the use of FIFO when calculating gains for cryptocurrencies. However, there are multiple problems with the use of FIFO as it relates to cryptocurrencies – the main ones being the Double Taxation Paradox and non-preferable holding periods. But, alas, this is a topic for another day.
However, due to the aforementioned problems with FIFO, I believe that the best method would be Last-in-First-Out (LIFO). LIFO requires the investor to use the cost basis and the holding period of the most recently purchased token to calculate the gain on sale.
To better explain how FIFO, Specific Identification, and LIFO work, I will provide another example below:
Case Facts:
- Bitcoin 1 was purchased on 1/1/2018 at $1
- Bitcoin 2 was purchased on 7/1/2018 at $4
- Bitcoin 3 was purchased on 9/1/2018 at $8
- Bitcoin 2 was sold on 10/10/2018 for $40
Case Questions & Answers:
- What is the holding period of the asset, the basis, and the gain from sale in the instance First-in-First-Out was utilized?
- Holding Period = 10 months; Short-Term
- Explanation - The first asset purchased (Bitcoin 1) is considered to be the first one sold. As a result, we need to establish the holding period based on when Bitcoin 1 was purchased - 1/1/2018. Since the asset was then sold in October, the holding period is 10 months. 10 months is less than a year, thus it is considered Short-Term and subject to ordinary income rates.
- Basis = $1
- Explanation - The first asset purchased (Bitcoin 1) is considered to be the first one sold. As a result, we need to establish the basis using the purchase price of Bitcoin 1 - $1.
- Gain = $39 ($40 - $1)
- Explanation - We already established the basis in the step above ($1). All that is left is to subtract the basis from the sales price ($40). Thus, the gain is $39.
- Holding Period = 10 months; Short-Term
- What is the holding period of the asset, the basis, and the gain from sale in the instance Specific Identification was utilized?
- Holding Period = 3 months; Short-Term
- Explanation - The exact asset sold (Bitcoin 2) is used to establish the holding period. As a result, the holding period is based upon when Bitcoin 2 was purchased - 7/2/2018. Since the asset was then sold in October, the holding period is 3 months. 3 months is less than a year, thus it is considered Short-Term and subject to ordinary income rates.
- Basis = $4
- Explanation - The basis must be established using the exact asset sold (Bitcoin 2). As a result, we need to establish the basis using the purchase price of Bitcoin 2 - $4.
- Gain = $36 ($40 - $4)
- Explanation - We already established the basis in the step above ($4). All that is left is to subtract the basis from the sales price ($40). Thus, the gain is $36.
- Holding Period = 3 months; Short-Term
- What is the holding period of the asset, the basis, and the gain from sale in the instance Last-in-First-Out was utilized?
- Holding Period = 1 month; Short-Term
- Explanation - The last asset purchased (Bitcoin 3) is considered to be the first one sold. As a result, we need to establish the holding period based on when Bitcoin 3 was purchased - 9/1/2018. Since the asset was then sold in October, the holding period is 1 months. 1 month is less than a year, thus it is considered Short-Term and subject to ordinary income rates.
- Basis = $8 (The LAST asset purchased is the first sold)
- Explanation - The last asset purchased (Bitcoin 3) is considered to be the first one sold. As a result, we need to establish the basis using the purchase price of Bitcoin 3 - $8.
- Gain = $32 ($40 - $8)
- Explanation - We already established the basis in the step above ($8). All that is left is to subtract the basis from the sales price ($40). Thus, the gain is $32.
- Holding Period = 1 month; Short-Term
Conclusion
This concludes Part 3 of the Capital Gains/Losses series and, in effect, the entire Capital Gains/Losses series. Hopefully this series was able to shed some light on the treatment of capital gain/loss treatment in the United States. Before we can advocate for change, we must first understand what we are changing!
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About the Author
I hold a Master’s degree in Accounting with a concentration in Information Management. This degree has given me years of exposure to topics, as it relates to the USA, such as: financial reporting, financial statement audits, information systems audits, tax regulation, business law, and overall general business knowledge. Shortly after obtaining my degree I worked for a large public accounting firm for about a year, focusing on IT audits, only deciding to leave to put more focus on cryptocurrency.
While I am not technically a Certified Public Accountant (CPA), I have met the educational requirements and passed all four sections of the CPA on the first try; the only requirement left is to obtain the required experience hours, which I am extremely close to. All of this being said, I can safely say that I am well versed in business knowledge and am more than capable of learning business related concepts.
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