Crypto Tax: How to calculate gains and losses on cryptocurrency transactions

Cryptocurrency tax laws and guidance develop at a much slower pace than the technology that gives rise to the issue. Much uncertainty remains, but to the degree possible, Blue J helps clarify tax obligations arising from cryptocurrency transactions. Not sure when or how to report gain from transactions involving bitcoin or other crypto? In this blog post we cover the tax implications of cryptocurrency gains and losses and how to calculate them.

Selling cryptocurrency held as a capital asset for legal tender, for another virtual currency, and exchanging it for a service constitute barter transactions. Consequently, a capital gain or loss occurs on the transaction which must be recognized and reported. On February 1, 2022, the Virtual Currency Tax Fairness Act was introduced to Congress, proposing a $200 threshold for capital gains realized on personal cryptocurrency transactions in order to facilitate the usage of Bitcoin and other cryptocurrencies as a daily currency. Individuals and tax professionals should keep an eye on how the bill progresses, as it may change the reporting obligations going forward.

Gains and losses from cryptocurrency transactions must be reported on form I.R.S. Form 1040 (Schedule D, Capital Gains and Losses). However, determining the exact amount of gain or loss accrued on the many transactions involving cryptocurrency a taxpayer may have engaged in in the taxation year can be difficult. First, it needs to be determined whether the transaction actually gave rise to a capital gain or loss or merely an ordinary gain or loss. Secondly, the holding period of the cryptocurrency must be determined and the fair market value (FMV) of the cryptocurrency must be calculated. Lastly, there may be certain deductions available to set off any capital gains.

Capital gains and losses vs. ordinary gains and losses

Generally, the IRS considers cryptocurrency to be property, not currency. Furthermore, most of the available guidance from the IRS relating to the calculation of gains and losses from cryptocurrency transactions is explicitly limited to those transactions of taxpayers that hold cryptocurrency as capital assets (see § 1221).1 For example, cryptocurrency held mainly for sale to customers in a trade or business is not a capital asset (§ 1221(a)(1)).2 In those instances, recourse must be taken to the general rules, namely that the sale of property other than a capital asset generates ordinary income or loss. This will likewise be the case if property other than capital assets is transferred by a taxpayer in exchange for virtual currency.3

Holding period

There are no special rules that apply to short-term or long-term holding periods of cryptocurrency. The holding period, defined in § 1223, starts the day after the cryptocurrency was received and ends on the day of the sale, § 1222. An exception applies if the cryptocurrency is received as a gift. In that case, the holding period also includes the time that the cryptocurrency was held by the donor. If the period is one year or shorter, the taxpayer will realize a short-term capital gain or loss, otherwise a long-term capital gain or loss. Short-term capital gains are taxed (less favorably) as ordinary income.4

Calculating capital gains and losses

To calculate the gain or loss, the difference between the adjusted cost base (ACB) of the virtual currency and the amount received, in the case of legal tender, or the FMV of the virtual currency or the service received in exchange must be determined in U.S. dollars for the time of the exchange. That time is generally when the transaction is recorded on the distributed ledger. The FMV determined at the time of the exchange is then also the cost basis of any virtual currency received in exchange.5

A difficulty in reporting income from cryptocurrency transactions is the determination of its FMV. If the transaction is facilitated by a cryptocurrency exchange, the FMV of the cryptocurrency at the instance when the transaction was recorded on the distributed ledger is the price value publicly published by the cryptocurrency exchange or a cryptocurrency data aggregator in U.S. dollars. A report of all transactions can usually be downloaded from the exchange portal.6 It is unclear what documentation the IRS would accept in instances where cryptocurrency exchanges do not publish and record the required information for the user. 7

If the transaction occurs outside of a cryptocurrency exchange, acceptable evidence of the cryptocurrency’s FMV is “the value as determined by a cryptocurrency or blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates the value of the cryptocurrency at an exact date and time.”8 Absent such an explorer value, the burden is on the taxpayer to establish that the value at which the transaction is reported is an accurate representation of its FMV. If the cryptocurrency is exchanged for other property or a service, the value of the cryptocurrency is the FMV of the property or service. The time at which the FMV must be determined is the time when the transaction was recorded on the distributed ledger, or absent that, when it would have been recorded on a distributed ledger, had it been an on-chain transaction. 9 In either case, the FMV valuation must occur “in a reasonable manner that is consistently applied”. 10

Multiple units of the same cryptocurrency

The calculation of the FMV and the cost basis of cryptocurrency becomes more complicated when the taxpayer holds multiple units of the same cryptocurrency and acquired those units at different times and at different cost basis amounts. If the taxpayer sells those units, he or she can choose which units are deemed to be sold, exchanged, or otherwise disposed of. However, in that case it is necessary to be able to specifically identify which units form part of the transaction and their cost basis, either by providing the unit’s unique digital identifier such as a private key, public key, and address, or records showing the transaction information for all units of a specific virtual currency held in a single account, wallet, or address. The IRS requires such records to show:

(1) the date and time each unit was acquired,

(2) the basis and the FMV of each unit at the time it was acquired,

(3) the date and time each unit was sold, exchanged, or otherwise disposed of, and

(4) the FMV of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.

If no specific units are identified as the ones sold, exchanged or disposed of, a chronological order will be assumed commencing with the unit that was acquired first (so-called first in, first out basis or FIFO). 11 Note, however, that the FIFO method is not permitted under the I.R.C. and that the guidance provided in the FAQs referenced herein is therefore in tension with the Code.12

§ 102 - Gifts

The mere receipt of a gift in the form of cryptocurrency does not give rise to any tax liability. However, if the cryptocurrency is subsequently sold, it needs to be determined whether a gain or a loss arises upon that transaction. When determining whether a gain arose from the transaction, the cost basis is that of the donor plus the donor’s gift tax, if any, § 1015. On the other hand, to establish whether a loss resulted from the transaction, the cost basis is the lesser of the donor’s cost basis and the FMV of the cryptocurrency determined at the time the gift was received. In the absence of any documentation of the donor’s cost basis, the taxpayer’s cost basis is deemed to be nil.13

Refer to the comment under § 1222 above for the holding period carry-over issue. Any other issues related to the gifting of property may arise as well in the cryptocurrency context.

Deductibility of certain expenses

Income deductions

Generally, ordinary and necessary expenses are deductible from business income, that is, only if the activity performed and in the course of which expenses are incurred qualifies as a business as opposed to a mere hobby. Likewise, losses cannot be used to offset income when the activity is undertaken as a hobby. Therefore, it must be determined whether the activity that gave rise to the income, e.g., mining or trading cryptocurrency, constituted a business activity. 14

Exchange fees

No IRS guidance is available regarding the deductibility of exchange fees that accrue when depositing, transferring, and withdrawing cryptocurrency from wallets at an exchange.

As these expenses are generally added to the ACB of the cryptocurrency, an argument can be made that they should be deductible from capital gains realized from the transactions, or, if the transactions are undertaken as a business, some of the expenses may be eligible business expenses. The Tax Section of the ABA seemed to lean into the opposite direction when it directed comments to the IRS in 2015 noting the deficiency of the available guidance: “If disposition of virtual currency is a transfer of property, then gains or losses would arise on the retransfer of the virtual currency and recovery of transaction fees incurred would be deferred until such retransfer of the currency. We are concerned that taxpayers may find it difficult to comply because of uncertainty in this area, especially in high volume transactions as a result of the absence of identifying information and recordkeeping. This may suggest an approach for these types of costs similar to those used for credit card fees, which are treated as ordinary business expenses.” 15

For details on crypto tax reporting obligations, refer to Blue J’s other Crypto Tax blog “Tax treatment and reporting of cryptocurrency transactions.”

Footnotes

1See Notice 2014-21, 2014-16 I.R.B. 938 and the corresponding I.R.S. - FAQs on Virtual Currency Transactions. Note that the FAQs on the IRS’s website were accessed for purposes of this Template Overview on December 17, 2021. The IRS may change the content or numbering at any time without tracing such changes. Furthermore, the guidance provided therein is not binding and hence unreliable for taxpayers to some degree. Where reliable guidance is available, reference to that guidance is provided herein. Such guidance is, however, scarce.

2 See I.R.S. Pub. No. 544, Cat. No. 15074K (Mar. 16, 2021) for guidance on how to distinguish capital assets and non-capital assets.

3 A19. FAQs on Virtual Currency Transactions.

4 A6., A29., and A33. of I.R.S. - FAQs on Virtual Currency Transactions and I.R.S. Pub. No. 544, Cat. No. 15074K (Mar. 16, 2021).

5 I.R.S. Pub. No. 544, Cat. No. 15074K (Mar. 16, 2021) and I.R.S. Pub. No. 551, Cat. No. 15094C (Dec. 10, 2018) apply. A4., A7., A8., A16., A17., A18. and A19. of I.R.S. - FAQs on Virtual Currency Transactions.

6 A26. of I.R.S. - FAQs on Virtual Currency Transactions ; C.C.A. 2021-14-020 (Apr. 4, 2021).

7 This issue, too, was flagged by the Tax Section of the ABA. American Bar Association - Comments on Notice 2014-21.

8 A27. of I.R.S. - FAQs on Virtual Currency Transactions.

9 A27. and A28. of I.R.S. - FAQs on Virtual Currency Transactions.

10 Notice 2014-21, 2014-16 I.R.B. 938 at A-5.

11A39., A40., and A41. of I.R.S. - FAQs on Virtual Currency Transactions.

12 This issue has been flagged in AICPA - Comments on IRS Virtual Currency Guidance.

13 I.R.S. Pub. No. 551, Cat. No. 15094C (Dec. 10, 2018) applies. A32. of I.R.S. - FAQs on Virtual Currency Transactions.