The cryptocurrency bull run of 2017 was awe-inspiring. The resulting taxable implications are not.
With the IRS focusing on the new tax laws, there has been no new cryptocurrency tax guidance since 2014. Consequently, few investors fully understand the issues and implications of how to treat 2017 crypto gains.
“There’s a lot of confusion around taxes and cryptocurrency, and for good reason,” said Mark Steber, Chief Tax Officer and CPA at Jackson Hewitt. “Changes in tax law significantly lag the rapid growth in crypto popularity. It’s not always clear when a realized gain is taxable income, as defined by the IRS.”
With the goal of shedding light on the most important (and lesser known issues), here are some essential insights to help you navigate this tax season:
What most know
Hopefully, everyone knows taxable gains (or losses) are “realized” when you sell cryptocurrency.
If you bought 2 bitcoins at $4,000 in August and sold 1 for $14,000 in December your taxable gain is $10,000 (less commissions or fees). You realize a gain on the coin you sold. If you held it less than 12 months (short-term) the gain is taxed as ordinary income.
You don’t have to withdraw funds for the gains to be taxable. If proceeds from the sale are sitting in your Coinbase US dollar wallet, you still owe tax on the gain.
Exchanging one coin for another coin is a taxable event. If you sold 1 bitcoin (with a $4,000 cost basis) for 20 litecoins valued at $400 each ($8,000 total), you realized a $4,000 gain – just as if you had sold bitcoin for $8,000 in $US dollars.
“While traditional investment gains and losses typically easy to track and report, cryptocurrency can be confusing,” Steber said. “For example, even when trading one coin for another, gains and losses must still be reported.”
What some know
Spending crypto is the same as selling it.
If you purchased a $14,000 car with 1 bitcoin, it’s the same as if you had sold bitcoin for $14,000 and used the proceeds to purchase the car. If your cost basis was $4,000, your gain is $10,000. The tax you’ll owe on that gain just made that car significantly more expensive.
Cryptocurrency donations are deductible! Assume you donate 10 litecoins to charity valued at $200 each ($2,000) and that your cost basis is $50 each ($500). You can deduct the greater of the market value or the cost basis without paying tax on the gain.
In this case you can book a $2,000 donation and avoid tax on the $1,500 gain. Now you can see why crypto donations exploded in 2017.
Pro tip: make sure you document the transaction so you can account for it on tax day.
What few know
To date, the IRS has not been specific about which methods are acceptable for calculating cost basis for gains and losses. That said, experts believe that when the IRS does issue guidance, it’s going to treat cryptocurrency the same as securities.
For stocks and index funds FIFO (First In, First Out) is required unless you specifically match a lot you sold to a lot you purchased (not a trivial task with crypto). Last In, First Out and Average Cost are also popular methods for accounting. But if you choose the wrong approach, it could be costly.
Why does it matter if you choose FIFO, LIFO or Average Cost? While FIFO is safer, it will result in a higher tax bill for most who bought and sold crypto in 2017.
- Assume you bought 1 bitcoin in September for $5,000 and 1 bitcoin in November for $10,000 ($15,000 invested with an average cost of $7,500)
- If you sold 1 BTC in December for $15,000 your FIFO cost basis was $5,000, implying a gain of $10,000. Under LIFO (last in, first out) your cost basis would be $10,000, implying a gain of only $5,000. Using Average Cost, your cost and gain are $7,500.
US residents who choose LIFO or Average Cost will likely be under-reporting their 2017 tax liability. While a few loopholes may tempt some to take an aggressive approach (e.g. LIFO or Like Kind Exchange), it’s likely the IRS will require FIFO in the future – possibly with retroactive enforcement. If you choose LIFO for 2017, this could result in future payment of back-taxes, penalties, and interest.
What everyone must know
When thinking about your tax strategy, remember 3 things:
- The IRS will (at some point) issue new guidance on cryptocurrency taxation
- IRS rules can be retroactively enforced
- IRS audits may cover the three previous years
Decisions you make today may help you (or hurt you) in the future. If you fail to report (or materially under-report) for 2017, it may come back to haunt you.
We believe it’s only a matter of time before crypto brokerages and exchanges have to report as traditional brokerages do today. On February 23, 2018, Coinbase announced it had been required to provide the IRS with information on 13,000 customers (about 0.1% of its customers). This is likely a sign of things to come for US residents who use US brokerages.
If you under-report for 2017, you may face monetary damages in the future – or worse. At a minimum you could owe back taxes, penalties, and interest. Those who severely under-report may face the risk of criminal charges for tax evasion. As ignorance will not hold up as an excuse, please talk to a tax professional.
“The best advice I can give is to work with a tax professional who understands cryptocurrency,” Mark Steber said. “It’s also a good idea to check in with your advisor throughout the year to make sure you’re not caught off-guard come tax time.”
There are numerous new tools on the market (including my company’s) to help you calculate taxable gains for 2017. But regardless of the tool you use, the quality of the reporting is governed by the quality of the information you enter.
For this reason, it’s critical that you take the following actions:
- Include all crypto exchange accounts and digital wallets
- Review all transactions – especially transfers, payments, gifts and donations – to confirm they are correctly classified.
- Spot-check some of the calculations to make sure they are right. Our initial review of some of the popular tools found that accuracy varies by provider.
- When in doubt, talk to a professional.
The IRS allows residents to request an extension (for any reason) for up to six months, provided you pay your estimated taxes by April 17.
In talking with CPAs and active traders, we anticipate a spike in extensions this year as taxpayers buy time to figure out their crypto tax picture.
For more on filing extensions, please talk to your tax advisor.