In 2017, Crypto Currencies reached a peak popularity — and some peak profits. Predictably, investors in these types of instruments have been reaching out to accountants in a state of perplexed confusion. Others are looking back at prior year profits and realizing that they never reported their income from the Crypto Currency. Although there are hundreds of types of such currency, examples of Crypto Currencies include:
Ultimately, any gain you realize, whether in real estate, precious metals, collectors’ items, bonds, options, derivatives, stocks, and Crypto Currencies, must be reported to the IRS. The schedule for doing so is Schedule D, which categorizes your gains as long-term or short-term.
A brief note about realization: if you hold an asset that you bought at $1 and you sell it for $100, you have a taxable gain of $99. However, if you bought the item and, at the end of the taxable year (Dec 31), you still have not sold it, even if that $1 investment is now worth $1 million in the open market, no taxable transaction exists (unless, of course, you have elected trader status with mark-to-market accounting, which is out of the scope of this article).
Link to qualified trader IRS site section
So, any item that you sell in a taxable year is subject to taxation as the selling is the taxable event (not the buying & holding).
Now that we have some basics out of the way, we can move onto holding periods. Ideally, you want the holding period of each sale of an asset to be over one year in order to gain favorable tax treatment. Holding periods of one year or more qualify you for “long-term capital gain” treatment, which has far lower tax percentages than short-term capital gains. The highest bracket for long-term capital gains is currently 20%, while short-term capital gains can be taxed as high as 39.6%, which is the highest ordinary tax bracket for Federal Purposes.
Link to 2021 tax brackets on ordinary income (aka short-term capital gains) and long-term capital gains
On a side note, none of these numbers include your state tax, if applicable. Please contact us (of course, we charge consulting fees), or look on your state’s department of revenue website to determine the rate you can expect to be taxed on long-term capital gains. We have clients in all 50 states and have found that these can vary — some states (7 of them) don’t even have a state tax on individual income!
Link to states with no income taxes, etc.
The point here is that long-term capital gains are the way to go — the government has, for whatever reason, decided that they want the US public to invest prudently and for the long-term, thus encouraging us through tax policy to hold onto our investments longer. The logic is that this type of behavior may cause less volatility, etc. This is not for us to analyze, however — we will move on to the forms and the means of reporting.
The appropriate form that all capital gains transactions roll into is known as Schedule D of Form 1040. However, the detail should be expressed somewhere — for qualified traders, that can be form 4797. For most of us, however, we would report these gains & losses on form 8949 in detail.
There is a site, bitcoin.tax, that claims to help categorize these for you. We had a client recently claim to have produced an acceptable 8949 form using this site. I am bringing this up for an important reason:
The gains in Crypto Currency can be great, but if, at the end of the year, your only records of what you bought and sold are in the form of 114,793 lines of transactions CSV data downloaded from your Cryto Currency platform, you will likely be at a loss on how to aggregate this data into the information the IRS wants to see — namely: investment description, quantity of investment, date of purchase, date of sale, price (in USD) of purchase, price (in USD) at sale. This information is used to determine your holding period (discussed above), as well as the gain (or loss).
Here are the tax pitfalls of trading in Crypto Currency:
- Far too much data — for an active Crypto Currency investor, coming up with neat numbers that will go into form 8949 or schedule D will be a task beyond most people’s data crunching ability. The type of expertise required to do this can be found amongst quants, big-data gurus, database programmers, applied mathematics wizards, and other professionals with the ability to summarize large amounts of data. If you are not in these categories, getting the numbers you need for IRS reporting will require you to hire one — and these skills are very expensive
- Transaction amounts may or may not be listed in USD and may not be easily convertible into USD. This calls for the expertise described in the bullet-point above
- Holding periods may be difficult to calculate — if one has purchased 1,000 units of a currency in June 2015, for example, and then purchased another 1000 units in Feb of 2016, but then chooses to sell 500 units in April of 2016, what is the holding period? Is the holding period over a year (as would be favorable from a tax perspective) or is it less than one year? The IRS normally recommends specific identification methodology (the ones you sold need to be specifically traced to the ones you bought originally to determine holding period), or FIFO (first in, first out). Clearly, applying FIFO on a consistent basis will systematically extend your holding period, so this is what we recommend
- Purchases are mixed into the transactions — this is a major issue that is difficult to explain to non-tax professionals. Again, we are happy to consult, but we would have to bill for time (your free alternative would be calling the IRS to ask — good luck with that [smiley face]). Specifically, unless you are filing as a trader, the purchases you made in a given year are not relevant to your 8949 or schedule D reporting. If you purchased an investment that you are still holding onto at the end of the year, no taxable event has occurred. You must only report sales, the sale price, the cost of the original item that you sold, the date of the sale, and the date of the original purchase. This pertains to all items sold in the year. Any items that you bought but did not sell must be removed form that year’s annual data as they do not pertain to any events of realization (realization is explained above). Again, if you do not understand this, please research the concept of realizing capital gains. Google has a wealth of information about this.
Once you have your 8949 and schedule D ready, these, you will notice, will wrap up neatly into the front page of from 1040 of your individual tax return. If you show gains, you will be taxed on them. However, if you show losses, you will only be able to deduct capital losses to the extent of capital gains. The IRS gives you a small amount of deduction against ordinary earned income if you have losses that exceed your gains. This amount of deduction is only $3000. This is very minimal, especially if you have hundreds of thousands, or even millions, in losses. However, you are able to carry forward unused losses to subsequent years indefinitely. This means that if you lost $100,000 in 2016 and had no gains you can apply the loss to, you will be able to deduct only $3000 toward your 2016 earned income (earned income includes active partnership income, s-corp income, W2 wages, 1099 freelancer items, etc.). However, the remaining $97,000 will carry forward to 2017, and, if you made $200,000 in gains in 2017, you would only pay taxes on $103,000, as the $97,000 from 2016 will be applied, thus reducing tax burden.
A word of caution here: I inherit client returns more often than one can imagine where they have either mixed up, not used, or entirely forgotten about their prior year losses. Here is an example: Investor Ed uses a CPA for his taxes but is tired of paying the outrageous $650 fee the accountant is charging him (which actually ends up saving him thousands in deductions, but let me not be biased). He decides to file his complex return in TurboTax the following year in order to save the $650, and unknowingly forgets to include his Schedule D investment losses from prior years. He thinks nothing of it, as he has not made anything in the market in his first TurboTax year. However, 5 years later, Investor Ed sells a portion of his business for $2 million. All of a sudden, he is hit with a large tax bill, which would have been much smaller if the old, long-forgotten losses were appropriately kept track of & applied. The moral of the story is, if it is taking you more than one hour to complete your tax return, you should not be doing it on your own. Consult with a qualified professional.
There are circumstances where the tax treatment may need to reflect loss of investment. This can occur when a cryptocurrency fails. In prior years, it was possible to partially “write off” such an event using the casualty loss rules. However, future years may require that these losses be reported as long or short-term capital losses. Part of this deduction may be disallowed. We are more than happy to assist with tax treatment of failed cryptos, including instances where a currency’s organizers have committed sham ICOs.