Cryptocurrency Tax Explained – How to Calculate Capital Gains Tax
- In 2014, the U.S. Internal Revenue Service categorized all forms of cryptocurrency as property.
- By being classified as property, capital gains tax applies whenever cryptocurrency profits are realized
- A 2017 amendment to the U.S. tax code, makes capital gains tax applicable whenever digital assets are traded for like amounts of other cryptocurrencies
Capital Gains Tax & Cryptocurrency Explained
Tax on cryptocurrency is a contentious subject. Cryptocurrency purists consider taxation antithetical to everything coins like Bitcoin stand for. Others argue that taxation helps better legitimize cryptocurrency. However, even for those willing to pay, calculating capital gains tax is far from straightforward.
How to Calculate Tax on Cryptocurrency
In principle, calculating capital gains tax on cryptocurrency is simple.
Capital gains tax applies to cryptocurrency whenever investors realize profits. When cryptocurrency is traded for fiat cash, (or other assets) tax, therefore, applies to the difference between original coin prices and coin prices when liquidated.
Short & Long-Term Capital Gains Tax and When Each Applies
Capital gains tax in the U.S. is calculated on a long and short-term sliding scale. For cryptocurrency, users who cash out, spend, or trade cryptocurrency less than a year after investing, short-term capital gains rates apply. Conversely, after 12-months, long-term capital gains rates apply.
Short-Term Capital Gains Tax
Short-term capital gains tax is equivocal to a person’s regular income tax rate. If you pay 10%, 15%, 25% (or higher) income tax, the same rate will apply when trading and transacting cryptocurrency.
To demonstrate, let’s say that someone buys 1 BTC today and uses 0.0023 BTC to buy a pizza tomorrow. In this example, this person would be required to pay between 10% and 39.6%, on any difference between the price of 0.0023 BTC today and the value of the same 0.0023 BTC tomorrow.
Long-Term Capital Gains Tax
Long-term capital gains tax rates start at lower rates of 0%, 15%, and 20%. This being the case, it is always advantageous to hold digital assets for 12-months or more. More importantly, in cases where couples and individuals fall into lower income tax brackets (10% & 12%), long-term capital gains tax starts at zero.
Where Things Get Complicated
For the most part, people who hold cryptocurrency long-term, don’t need to worry too much about capital gains tax. However, several key factors still need taking into consideration.
- Capital gains tax applies even when converting coins into other forms of cryptocurrency
- As soon as a trade or exchange takes place, newly purchased coins will become subject to short-term capital gains tax rates
- In cases where investors hold an amount of digital currency for a year or more, but at some point receive more of the same currency, short-term capital gains will apply to new coin amounts.
- Capital gains tax on cryptocurrency always needs to be paid in accordance with coin market values at the time a transaction is processed
Cryptocurrency Capital Gains Tax Nightmares
Understanding when capital gains applies, is of paramount importance.
Let’s say that someone with a gross income of $38,601 bought 1 BTC for $2,000 in May 2017. Now let’s assume that this person traded their BTC for LTC in January 2018. At a then Bitcoin price of $20,000, this individual would be required to pay $2,400 in capital gains tax in April, despite making a significant trading loss.
How to Calculate Cryptocurrency Taxes Safely & Easily
Current capital gains tax rules mean that is easy for crypto traders to owe more in tax than they can afford to pay at the end of the tax year. Thankfully, there are relatively simple ways to avoid such nightmare situations.
- Whenever transacting or trading cryptocurrency, calculate applicable taxes and a set aside a corresponding amount of fiat cash accordingly
- If you are a novice trader, never trade coins for like amounts of other coins directly. Instead, trade coins for fiat cash, set aside taxes, and reinvest accordingly
- If confused or investing a large sum of fiat cash in cryptocurrency, always consider hiring a professional cryptocurrency tax accountant
When investing, trading, and spending cryptocurrency, the most important thing is to keep a precise record of every transaction. In early 2018, it was found that just 900 Coinbase users declared cryptocurrency holdings on their tax return. The IRS is watching and noncompliance today, will cost investors tomorrow.