Counting Cryptocurrency Gains And Losses Without Running Afoul Of IRS Rules
January 31st, 2018
Here’s an article from our own Adam Bergman that originally appeared on Forbes.com –
2017 is viewed by many as the year of the crypto. However, with the increase in popularity and surge in value of cryptocurrencies, a significant number of cryptocurrency investors are now finding themselves in the uncomfortable position of trying to determine what, if any, is their tax liability attributable to their 2017 cryptocurrency transactions. The heightened level of taxpayer concern with correctly reporting the tax liability associated with their transactions can be directly associated to the John Doe summons the Internal Revenue Service (IRS) issued to Coinbase, one of the largest cryptocurrency exchanges in the United States.
The IRS is concerned that many U.S. taxpayers may not be accurately reporting the gains or income they have generated from their cryptocurrency transactions. Since the majority of cryptocurrency transactions have likely resulted in significant gains due to the surge in value in most cryptocurrencies, coupled with the fact that the gains are likely short-term capital gains (subject to ordinary income tax rates) since the cryptocurrencies were likely held less than 12 months, the IRS has good reason to be concerned.
As a result, in a petition filed November 17, 2016 with the U.S. District Court for the Northern District of California, the U.S. Department of Justice (DOJ) asked the court for a John Doe summons to be issued to Coinbase. The John Doe summons would require Coinbase to provide the DOJ with information related to all Bitcoin transactions it processed between 2013 and 2015. The DOJ would then share the information received with the IRS to be matched against filed tax returns. The IRS summons power is extremely broad and has been protected by the courts over the years. However, Coinbase actually had some success defending the John Doe summons issued by the IRS and was able to limit its demand to ask only for accounts that conducted Bitcoin transactions (either exchanging Bitcoin for dollars or sending or receiving coins from another Bitcoin user) worth $20,000 or more between 2013-2015.
IRS Notice 2014-21 stated clearly that for federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency. In addition, the Notice made it clear that virtual currency is not treated as a currency for tax purposes. The Notice then confirmed that cryptocurrency would be treated as a capital asset. IRS Notice 2014-21 holds that cryptocurrencies, such as Bitcoins, will be considered property, which is a capital asset and subject to the capital gains tax rules so long as it’s not held for business purposes.
As long as one holds cryptocurrencies for personal or investment purposes, any gain/loss from the sale of the cryptocurrency would be subject to the capital gains tax regime. If the cryptocurrency was held for less than twelve months (short-term capital gains), then ordinary income tax rates would apply. Whereas, if the cryptocurrency were held for twelve months or more, the favorable long-term capital gains rate would apply. The determination of a taxpayer’s overall net capital gain or loss is based on a netting formula involving all capital (cryptocurrency) transactions during the year, with the short-term gains netted against the short-term losses and the long-term gains netted against long-term capital losses. However, if one was considered in the business of trading cryptocurrencies or mining cryptocurrencies, they could be subject to the ordinary income tax rate.
The tax law divides capital gains into two different classes determined by the calendar. Short-term gains come from the sale of property owned one year or less; long-term gains come from the sale of property held more than one year. Short-term gains are taxed at your maximum ordinary income tax rate, where the maximum tax rate was lowered to 37% under the Trump tax plan. Most long-term gains are taxed at either 0%, 15%, or 20% and can be subject to the additional 3.8% tax under Obamacare. For lower-bracket taxpayers, the long-term capital gains rate is 0%.
There are exceptions, of course. The long-term capital gains rates were not impacted by the Trump tax plan. In order to determine whether your capital gains transaction will be subject to the short-term or long-term capital gains tax rules, one will need to determine their holding period. The holding period in connection with the capital asset transaction is the period of time that you owned the property before sale. When figuring the holding period, the day you bought property does not count, but the day you sold it does. So, if you bought a Bitcoin on April 20, 2017, your holding period began on April 21, 2017. Thus, April 20, 2018 would mark one year of ownership for tax purposes. If you sold on that day, you would have a short-term gain or loss. A sale one day later on April 21 would produce long-term tax consequences, since you would have held the asset for more than one year. The tax rate you pay depends on whether your gain is short-term or long-term.
On the other hand, a capital loss is a loss on the sale of a capital asset, such as a stock, mutual fund, real estate, or cryptocurrency. As with capital gains, capital losses are divided by the calendar into short-term and long-term losses and can be deducted against capital gains, but there are limits. Losses on your investments are first used to offset capital gains of the same type. So, short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other kind of gain. So, for example, if you have $2,000 of short-term loss from a cryptocurrency investment and only $1,000 of short-term gain from a cryptocurrency investment, the net $1,000 short-term loss can be deducted against your net long-term gain (assuming you have one).
If a taxpayer makes a number of stock or cryptocurrency trades in a particular year, the end result could be a mix of long-term and short-term capital gains and losses. If you have an overall net capital loss for the year, you can deduct up to $3,000 of that loss against other kinds of income, including your salary and interest income, for example. Any excess net capital loss can be carried over to subsequent years to be deducted against capital gains and against up to $3,000 of other kinds of income. If you use married filing separate filing status, however, the annual net capital loss deduction limit is only $1,500.
Since the IRS has treated cryptocurrencies as property for tax purposes and the SEC has indicated it should be treated as a security, it is believed that an individual taxpayer can generally determine whether they will be using the specific indication method, which lets one identify the specific cryptocurrency to be sold, or the first-in-first out (FIFO) method for determining the cost basis of the cryptocurrency. The FIFO is the default accounting method by the IRS, unless one has records to support another method. The specific identification option is the method likely to give one the most flexibility and potentially the best tax result. The net capital gain or loss is reported on the individual taxpayer’s federal income tax return (IRS Form 1040 – Schedule D).
It is important to remember that each time you sell or exchange a cryptocurrency for either cash, another cryptocurrency, or for goods or services, the transaction would be considered a taxable event, which would be subject to either, short-term or long-term capital gain/losses based on the basis (what you paid for the crypto), holding period, and the price the cryptocurrency was sold or exchanged for. Moreover, if the transaction was part of a business, such as mining activity, the applicable corporate or ordinary income tax rates would apply. The good news is that new mobile applications and wallets are available that can help taxpayers keep track of the necessary tax reporting information needed to properly calculate and report their tax liability with respect to their cryptocurrency transactions during the year.
In sum, as long as one purchases cryptocurrencies for personal or investment purposes, any gain/loss from the sale or exchange or the cryptocurrency would be subject to the capital gains tax regime. If the cryptocurrency was held less than twelve months, then ordinary income tax rates would apply and if the cryptocurrency were held for twelve months or more, the favorable long-term capital gains rate would apply. The total short-term and/or long-term tax due or loss recognized would be determined based off a netting formula. However, if one is considered in the business of trading cryptocurrencies or mining cryptocurrencies, the taxpayer could be subject to ordinary income tax rates.
Investing in cryptocurrencies can be a risky and speculative investment option. Nevertheless, with the potential for financial success comes real and complex tax reporting obligations. It is important to consult with a tax adviser when navigating the cryptocurrency-related tax reporting rules.