The US Tax season has now opened and while the IRS are accepting returns you may be looking at your 1040 and then at your Bitcoin wallet and thinking, "What do I do?".
Fortunately BitcoinTaxes is here to help you work out all the overly-complicated and burdensome tax calculations that are required when trading, spending or mining Bitcoins and any other crypto-currencies.
This is the first of three parts that will begin explaining what taxes you might owe and how they are calculated, and finally showing you how you can do this with BitcoinTaxes.
The first thing to know is what you need to declare. Here is the typical list of events that have tax consequences:
- You sold some Bitcoins for dollars or any other foreign currency
- You traded some Bitcoins for another crypto-currency, e.g. ETH, or vice versa
- You spent some Bitcoins
- You donated some Bitcoins to a registered charity
- You mined Bitcoins or any other crypto-currency
- You were paid in Bitcoins
- You had some Bitcoins stolen
If none of these apply then you do not have to include anything about Bitcoins on your tax return.
For instance, if you only bought Bitcoins this year then you do not need to report anything. However, you should keep records because they will be needed when filing taxes after you have sold or spent those coins.
Capital Gains & Losses
This is most likely where you will need to add details into your tax return.
In March 2014, the IRS published a notice clarifying that all crypto-currencies should be treated as property for tax purposes. Therefore any gains from exchanging such property would be considered capital income, and taxed as capital gains.
Capital gains, like stocks and shares, are reported on your 1040 tax form as part of Schedule D. However, unlike stocks and shares, we don't have a broker that works out all the figures and provides us with a 1099 form. Current Bitcoin exchanges, such as Coinbase and Circle, do not report account information to the IRS and so you are left to calculate and report these figures yourself.
Working out your capital gains can vary a lot depending on how and when you sold or spent your Bitcoins.
Buying and Selling in the Same Tax Year
If you bought Bitcoins during the tax year and also sold them all within the same year, you can simple take the amount you received on the sale, less the cost to buy them, less any fees.
For example, say you used Coinbase and bought some Bitcoins in April, spending $480, and again in May spending $450 and then sold them all in July receiving $1,200, your gain is simply:
$1,200 - ($480 + 450) = $270.
For most users, unfortunately, it is more complicated than this if they previously owned, still own, spent or traded coins.
One of the more difficult parts of working out capital gains, is knowing what you bought the coins for in the first place, their cost basis.
If you buy 1 BTC for $100 and sell 1 BTC for $200, then it all is fairly simple. But more often it might be:
- Buy 0.325 BTC for $30.00
- Buy another 0.897 BTC for $98.78
- Spend 0.2134 BTC for $21.34
- Trade 0.2443 BTC for 20 ETH
- ....and so on.
The original cost basis has been mixed where it is not possible to simply see how much profit has been made when you do sell the remaining 0.7643 BTC, or those purchased ETH.
As with stocks and shares, when we buy coins, we can allocate them to "lots". A lot is a set of assets that have the same cost basis, i.e. the same type, price and date.
As you can see, we might generate multiple lots while using Bitcoin, but we need to keep track of them in order to work out any potential gains.
In our example above, we can see we have created two lots:
Lot 1: 0.325 BTC @ $92.31 per BTC
Lot 2: 0.897 BTC @ $110.12 per BTC
So when we come to spend our first 0.2134 BTC, we take it out of Lot 1, and our gain is:
$21.34 - (0.2134 * $92.31) = $1.64
and Lot 1 now only has 0.1116 BTC left.
First-In-First-Out or Specific Identification
However, notice that we have two lots we could use. Why the first one? Taking the oldest lot is known as First-In-First-Out or FIFO, and it is the default IRS method of calculating gains. If you trade stocks and shares, for instance, FIFO is being used on your account, unless you requested otherwise.
So what would the gain be if we had taken the 0.2134 BTC from Lot 2?
$21.34 - (0.2134 * $100.12) = $-2.16 (loss)
Here we would have made a loss and essentially owe no taxes on this transaction. We can instead use the loss to reduce any other gains or our taxable income for the year. By doing it this way, we just saved $1 in taxes (gains are rounded, as we'll see later).
This is called specific identification, as we selected which specific asset we wanted to sell. You could choose the lot based on criteria, such as Last-In-First-Out or LIFO, where you always sell the newest coins, or perhaps by selecting ones that have the closest cost in order to minimize gains.
It should be pointed out that the IRS has not clarified that specific identification can or cannot be used. It ought to be used consitently and not switching methods just to decrease tax liabilities. Get advice from your tax professional if you are unsure.
Long Term and Short Term Gains
When we make a gain, and report it on our tax forms, it is classed as either short-term gains or long-term gains.
Short-term gains are where we are selling assets that have been owned for a year or less, and they are taxed as if they were ordinary income.
Long-term gains are when we have owned the assets for more than a year and have more favorable tax rates depending on other income.
For instance, there is no long-term capital gains tax to pay if you are in the lower two tax brackets (less than $36,900 single income or less than $73,800 married income). The capital gains rate is only 15% for other tax brackets (less than $405,100 single income) with 20% for the final bracket.
Back to the example above, we can see that although we have made $1.64 in capital gains, depending on how long we had owned those coins there might not have been any taxes anyway. And trying to use Lot 2 to create a loss might actually have an effect in the future where we are reducing the long-term rates we could have received.
Trading Between Alt-Coins
Further in our example, we can see we spent some of our Bitcoins to buy some Ethereum.
This is an area without clear guidance from the IRS.
Some exchanges of property, real estate for example, are treated as a like-kind exchange, since they have the same rights, characteristics and obligations.
In this case there is no tax event and the cost basis is passed from one property to the other. If that were the case with Bitcoin, then purchasing Ethereum would just pass over the cost basis, we wouldn't have to work out the gains, and there would be no taxes.
However, restrictions in what would be allowed under a like-kind, or Section 1031 exchange, would probably exclude crypto-currencies. It must be for investment or business purposes and cannot be inventory or stock. Also a portion does not qualify if it is exchanged for cash or other property.
While it is unlikely the IRS would allow like-kind treatment, it simply isn't known for sure. If you do decide to use like-kind you should be prepared to recalculate past taxes if the IRS rejects it in the future.
Otherwise, trading one alt-coin for another is treated like selling one coin for USD and then using that USD amount to purchase the next coin. Here we have effectively disposed of one coin and created a new lot for another.
Back to our ETH example, we can now see our trade of 0.2443 BTC for 400 ETH can be rewritten as:
Sell 0.2443 BTC for x USD and Buy 20 ETH for x USD
The value of x USD becomes the fair value, or market price, of BTC. We will typically use the average daily price from some established source, as long as we use it consistently. Say the price was $100 that day, or at that time on the exchange where we did the trade, then it is:
Sell 0.2443 BTC for $24.43 and Buy 20 ETH for $24.43
However, Lot 1 only has 0.1116 BTC left whereas Lot 2 has 0.897 BTC.
We could, of course, use specific identification and take it from Lot 2. Or we could use FIFO and take all of Lot 1 and then a portion from Lot 2.
This would give us:
Sell 0.1116 BTC (@ $92.31) for $11.16 and Buy 9.1363 ETH for $11.16 Sell 0.1327 BTC (@ $110.12) for $13.27 and Buy 10.8637 ETH for $13.27
Lot 1 is now empty. Lot 2 has 0.7643 BTC remaining, and we have two new ETH lots, although they can be merged into one of 20 ETH @ $1.2215.
As if all this wasn't complicated enough, we now also need to include fees in the calculations.
Trading Bitcoins for USD on an exchange often incurs a fee. For example, Bitstamp is typically 0.2% and Coinbase is 1%.
These fees can be added onto the cost basis when buying, and taken from your proceeds when selling. This reduces your gains and so reduces your tax liabilities.
You can see that just buying, spending and trading Bitcoins has quickly become complicated and is now difficult to track the cost basis.
This is why BitcoinTaxes was created. All the intricacies of capital gains we've seen above are calculated automatically by simply importing your trades from exchanges, such as Coinbase, Cryptsy or BTC-e, and quickly showing the results from the different cost basis methods.
The second part in this series will continue to discuss some more finer issues around Bitcoin taxation, such as wash sales, calculating losses, income and mining.
The third part will show you how you can use BitcoinTaxes to calculate your capital gains, mining income tax liabilities and what to include on your 1040.