Did you know that your crypto transactions may impact your annual tax bill? Here's how to calculate your crypto taxes and what you can do to minimize them.

Crypto taxes in the US

Along with the breathtaking rise of cryptocurrencies such as Bitcoin and Ethereum, many crypto holders must have serious tax questions in their minds. Once it becomes more popular and used in various different sectors in the financial world, the Internal Revenue Service (IRS) began to take enforcement actions against cryptocurrency. 

Those who hold the currency may be subject to their audit and compliance verification, let alone crypto traders who make frequent transactions with cryptocurrency. If you're a US resident and a crypto holder, read further to find out how to calculate your crypto taxes and what other essential things you need to know.

 

How is Crypto Taxed?

Basically, the IRS identifies crypto as a property, just like bonds and stocks. This means that tax rules that apply to property transactions such as selling collectibles or vintage cars that might appreciate in value, also apply to cryptocurrency. Starting from 2019, the IRS has been asking a yes or no question about whether you had any crypto transactions during the year.

Note that if you attempt to lie or fail to report your activities, you could be subject to the IRS' levying penalties as the IRS certainly doesn't take kindly on tax cheaters.

Before we begin to calculate the actual number of taxes that you would need to pay, it's important to get familiar with some of these terms:

  • Capital gain: The amount of money that you earn from trading cryptocurrency over the past year. For example, if you purchase a crypto coin for $100,000 and you sell it for $130,000, then your capital gain is $30,000.
  • Capital loss: The amount of money that you lose from trading cryptocurrency over the past year. For example, if you purchase a crypto coin for $100,000 and you sell it for $80,000, then your capital loss is $20,000. Individual filers who lose more than what they gain are eligible for a $3,000 deduction from the taxable income.

Apart from that, you also need to know the cost basis of your cryptocurrency, which refers to the amount of dollars you need to buy the asset. In other words, it is the sum of money you've spent to acquire a single cryptocurrency. The cost typically includes brokerage fees, transaction fees, and other related costs.

When you sell your crypto for real currency or use it to buy goods and services, you may create a tax liability. You'll create a tax liability if the price of the value you receive is greater than your cost basis in cryptocurrency. Don't worry, you may also create a tax loss if the value you receive is lesser than your cost basis in cryptocurrency. Either way, you need to know your cost basis to make the calculation.

Here is the simple formula that you can use to calculate the cost basis of your cryptocurrency:

(Purchase Price + Fees) / Quantity

However, keep in mind that this should also depend on the accounting method that you use:

  • FIFO (First In First Out): the cost basis for a sale is the cost basis of the first crypto that you acquired.
  • LIFO (Last In First Out): the cost basis for a sale is the cost basis of the last crypto that you acquired.
  • HIFO (Highest In First Out): the cost basis for a sale is the cost basis of the most expensive crypto that you acquired.

Even if you're just a crypto hodler, it's necessary to learn about what's taxable and what's not to determine if you may owe some taxes.

 

Taxable Transactions

  • Selling crypto for cash in fiat currency, regardless of profit or loss.
  • Trading one crypto asset for another. For example, converting Bitcoin for Ethereum is considered a disposition of the Bitcoin.
  • Receiving crypto from staking or liquidity pools.
  • Receiving crypto as a result of hard fork or mining.
  • Using crypto as currency to pay for goods and services.

 

Non-taxable Transactions

  • Purchasing cryptocurrency with fiat currency.
  • Holding cryptocurrency.
  • Transferring cryptocurrency between wallets.
  • Receiving a cryptocurrency gift as the recipient.
  • Giving out cryptocurrency as a gift as long as it doesn't exceed $15,000 per recipient. If it does exceed $15,000 per recipient, you must file a gift tax return.
  • Donating to a tax-exempt charity or non-profit organization.

 

Calculating the Tax Rate

Now that you know which transactions are taxable, you can calculate the tax rate. There are two tax rates for cryptocurrency: ordinary income (short-term) and long-term capital gains. Note that the applicable capital gains rate changes every 365 days from when you transact and hodl particular crypto. Therefore, cryptocurrencies that are held for more than a year are qualified for long-term capital gains.

Depending on your overall income, you may be taxed based on the rates as follows:

  • Short-term capital gains rate = 10 - 37%
    For example, there's an investor who has made 3 buy trades and 1 sell trade within the span of a year. If we're using the FIFO method, we would compare the difference between the first buy trade and the sell trade. If the investor made profits from those two trades, the gains would be taxed at the short-term capital gains rate.

  • Long-term capital gains rate = 0 - 20%
    If we use the same example as above, but the sell trade is executed two years later, then the gains made between the first buy trade and the sell trade would only be taxed at the long-term capital gains rate. Since the percentage is lower than short-term gains, many investors like to hold their crypto coins for longer than a year before using them for transactions.

 

How to Offset Capital Gains with Capital Losses

As with other investments, you also need to calculate your capital loss. This is important because you can actually offset your capital gains by claiming your losses on other investments the year you make your profit.

So if you made $10,000 for selling Bitcoin but lost another $10,000 for selling Ethereum, you would not have to owe any tax since you broke even. Thus, if you're about to cash a large crypto investment, better search through your portfolio to see if there are other lost investments so you can use them to offset your gain.

And if you lose more than you gain in a year, you can deduct up to $3,000 of your personal income taxes and carry any unused losses to offset your future gains. But, remember that you're only allowed to offset losses of the same type. Long-term losses can only offset long-term capital gains and short-term losses can only offset short-term capital gains.

If you have both long and short-term capital gains on a specific asset, it's better to offset your short-term gains first since it has a higher tax rate. Also, keep in mind that not all losses can affect your taxes. For instance, if you send some crypto to a wrong address and end up losing the money, you wouldn't be able to use that to deduct your taxes. Similarly, some hacks or rug pulls are considered negligible for the deduction as well.

 

Tax-loss Harvesting Strategy

If you think you might owe some crypto taxes in the future, you can try minimizing it with tax-loss harvesting. By using the logic of offset capital gains as we've explained before, you can create a condition that could deduct your tax amount.

Basically, the strategy teaches you to take advantage of dips in the crypto market. The idea is to go short on cryptocurrencies when the market value drops below the cost basis in order to make capital losses. You can then net the losses against capital gains and reduce your tax bill.

Let's say you've made $10,000 profit from selling Bitcoin in a single year. You then decided to cash that out, making it subject to capital gains tax. Then, you notice that the price of Ethereum is dropping low, so you decided to sell some and lost $15,000. Now since you have a net loss from your overall portfolio, you could offset the capital gains owed for the $10,000 to zero.

Meanwhile, you can use the remaining $5,000 to reduce the ordinary income tax by the maximum amount of $3,000 and save the remaining $2,000 over to the following year.

Instead of only using a tax-harvesting strategy at the end of the year, you can actually do so at any time you want throughout the year because it would still count as a capital loss just the same. That being said, what you need is a good trading plan to manage your portfolio efficiently.

 

The Bottom Line

If you're a US resident, it's clear that your cryptocurrency is not free of tax. A lot of crypto transactions are considered taxable, so it's necessary to know the detailed policies and what you can do about them. We've learned that it's possible to reduce the tax amount, but it needs a well-calculated strategy to work.

Indeed, reporting your crypto taxes can be an onerous job when the tax season comes, since you need to calculate your cost basis, list all your taxable crypto assets, and pay the tax itself. To ease the process, it would very helpful to keep track of all of your crypto transactions. Alternatively, you can use crypto tax software to save time and money.

Companies like Koinly and Cointracker offer software that connects to crypto wallets as well as exchanges to keep track of your crypto transactions and fill the forms you need to file for the tax.

Last but not least, you can also hire a tax professional to help you strategize and calculate your taxes. Make sure the taxpayer is already familiar with the current IRS guidance and has experience in reporting cryptocurrency gains and losses.

 

While the US has made it mandatory for all crypto holders to report transactions of all kinds, there are some countries elsewhere that don't impose taxes on Bitcoin at all.