THIS POST IS NOT UPDATED and the tax implications are from U.S. tax perspective.
Please access one of the below links for 2021 posts:
Crypto-currencies like Bitcoin, Etherium and Ripple are gaining traction as alternative forms of payment. You can now even use crypto-currencies to buy regular stuff with brands like Dell, eBay and PayPal accepting payments in Bitcoin.
Many people invest in crypto-currencies in the hopes of capital gains. For example, the value of Bitcoin grew by approximately 700% between January 2017 and November 2017. While it’s been crypto winter since then, with prices of Bitcoin falling significantly, over 70% in 2018, many expect it to rebound once market conditions are better. Many continue to hold on to their Bitcoin and other crypto-assets for just that.
What Makes Crypto-currency a Valuable Asset?
Crypto asset is a financial asset similar to stocks except that it is a lot more volatile. So, you can expect some great returns if you play your cards right. That’s one of the reasons investors like to invest in one.
The other reason is that crypto-assets are safe. Most of the crypto-currencies out there today work through block-chain. In Bitcoin, for instance, a successful transaction is nothing but value transfer between Bitcoin wallets – transactions of which are added to the network of the blockchain.
You can store your Bitcoin or Etherium assets, in say Bitcoin or Etherium wallets, easily with a private key or seed. All your log-in attempts are recorded, and these packs also act as a proof of transaction. The Bitcoin ledger, for instance, notes down that they have originated from the owner of the wallet, and prevents the transaction from being tampered with any other person once it has been initiated.
All the block-chain transactions are broadcast between its users, and block-chain ensures that everything happens in real-time. For the transactions to be confirmed, all the transactions must be firmly packed in a data block that suits all the strict cryptographic protocols that will be, at a later instant of time, verified by the network system.
While it’s the ease to use crypto-currency that you may like, keeping track of your crypto assets for tax purposes is a different ball game.
Why Do You Need to Be Ready for the Tax Season?
If you are not aware, your crypto-currency transactions can come under tax implications. The IRS in the U.S. for instance, wants you to disclose your digital transactions and evading it could land you in prison for five years and incur a fine of up to $250,000. For Canadian taxes, please check another blog post.
Here are some of the common accounting principles applicable to crypto-currencies and the taxation effects of such transactions.
Which Crypto do You Own?
There are over 1,600 crypto-currencies in the market, but accounting standards are not clear enough on how to treat them. IRS issued guidelines on virtual currency transactions and taxation in Notice 2014-21 which is almost five years back. Since then crypto-currencies have taken on different forms, so the current guidelines do not cover all aspects.
The Notice 2014-21 considers virtual currency as property for taxation purposes. So, the general guidelines of property tax are also applicable in the case of cryptocurrencies like Bitcoin, Ethereum and Ripple.
Crypto-currencies can be considered as personal property, investment property or business property depending on the circumstances of the taxpayer. You are liable to identify loss or gain for each transaction involving crypto-currency whether you exchange it for other property or use it to purchase products and services.
Here are some tax implications for crypto-currencies:
- Trading, converting or exchanging crypto-currencies are taxable events
- Salaries and incomes received in crypto-currencies qualify as normal income subjected to tax
- Airdrops and crypto mining are taken as normal taxable income
- Initial Coin Offerings are also taxable when they produce income for the investors
Transaction Tracking and Transactional Investment
Track each of your crypto-currency transactions and transactional investment so that you can accurately calculate your loss or gain. You can access the details of your transactions and investments from the block-chain ledger, but recording them in a spreadsheet over the cloud gives you a consolidated database.
The record should include the date of crypto-currency purchase, the market value, date of selling or exchanging the crypto-currency along with price and so on.
Let’s take an example to find out how you can calculate gain or loss for a transaction. Let’s say Steven bought five Bitcoins for $5,000 ($1,000 for each coin) on January 25. Now he uses one Bitcoin to purchase goods worth $2000. So the gain of the transaction is $2,000 minus $1,000 (the market value of Bitcoin) or $1,000.
You will have to report this gain for tax purposes. IRS allows you to deduct your losses from crypto-currency transactions only if they are made for investment purposes. If Steven made a loss of $200 on his purchase, it is a nondeductible personal loss which cannot be claimed.
How to Calculate Your Tax Implications?
How much tax you will need to pay, and how you calculate it, will depend on factors like how you store your crypto. Here is how you can go ahead calculating taxes for this tax season.
1. If You Own Digital Wallets
You can store your cryptocurrencies in digital wallets and use the same to make payments and exchanges. Every transaction that is performed through the digital wallet should be recorded. The same applies if you own multiple digital wallets which also makes it difficult to account for all transactions.
The receipt, sale, and purchase of crypto-currencies through a digital wallet are subjected to the same gain or loss taxation guidelines by the IRS.
If you use the wallet to hold crypto-currency with an investment aim, then you have to pay applicable long-term and short-term capital gain taxes. You can use Schedule D in Form 1040 from the IRS to disclose your earnings.
2. If You Have Invested in Crypto Platforms
You don’t have to pay any tax if you have invested in a crypto platform or ICO. The only time you have to think about taxes is when you sell or exchange the tokens you received from the platform.
You have to report your gains when you sell or exchange the tokens for a profit. The gain will be calculated based on the fair value or cost at the time of receiving. You will also be able to claim your losses in your filing as the transaction falls under investment.
Which Method Should You Use?
Accounting standards are not yet clear on the guidelines of treating cryptocurrencies for accounting.
The IFRS framework does not cover how to deal with crypto-currencies clearly. So accountants treat crypto-currency taxes based on the major IFRS standards.
Crypto-currencies cannot be considered as cash or cash-equivalent due to their digital and volatile nature. They also don’t qualify as financial assets under IFRS.
You can include cryptocurrencies under IFRS IAS 38 that deal with intangible assets. The standard provides two approaches- cost and revaluation to account for crypto-currencies. The cost is determined based on fair value or the amount of cash or equivalent paid to acquire the asset.
Under revaluation, the crypto-currencies are measured at initial cost and again through fair value after accounting for impairment losses and amortization.
Some crypto-currencies can also be classified under IAS 2 dealing with inventories.
Cryptocurrencies are classified as intangible assets under GAAP definitions as they lack physical substance. The intangible asset will be initially measured at cost since they don’t have a specific lifetime.
Intangible assets are also not subjected to amortization, but you need to test them for impairment annually or at frequent intervals. GAAP recognizes the decrease in value of cryptocurrencies while increases in value are not considered.
GAAP doesn’t address the disclosure of cryptocurrencies and you have to depend on relevant accounting standards like ASC 350 or ASC 820.
Cheat Sheet: Top Tips to Keep in Mind
Want to pay as little tax as possible on your cryptocurrency investment and transactions? Then try the following-
1. Be a Long-Term Investor
The best way to reduce your crypto tax is to hold them for more than a year. If you cash out your cryptocurrency within a year, you have o pay high taxes based on your tax bracket which can even reach 40%. But long-term investments in cryptocurrencies come with 0% to 23.8% tax depending on your tax bracket.
2. Make Some Losses
If you make a loss while selling cryptocurrency, you can use the amount to offset your capital gains. You can claim losses up to $3,000 of ordinary income.
3. Gift Cryptocurrencies
You can gift cryptocurrencies to friends and family and avoid paying taxes just like in the case of stocks.
This blog post can neither be considered as Financial advice or Tax advice. Due to the complex nature of accounting, tax and cryptos please always consult a tax professional or your accountant.