What was once an investment considered a fringe has now become a mainstream asset class: cryptocurrencies. Popularization of Bitcoins, Ethers, and other digital currencies has sparked growing concerns about its tax implications. Calculation of cryptocurrency taxes can be very challenging, especially for novices in the investment market. Knowing the concepts and proper procedures could make taxpayers avoid penalties and maintain compliance with tax authorities.
In this comprehensive guide, we take you by the hand to step through the process of calculating cryptocurrency taxes.
Cryptocurrency Tax Fundamentals
Before we get into the steps to calculate your crypto taxes, it is crucial to get a notion of how various governments, in particular, the IRS or Internal Revenue Service in the US, classify cryptocurrencies.
Essentially, virtual currencies fall under the definition of property or property-type assets. So therefore, when you sell, trade, or use cryptocurrency, it becomes a taxable event in itself. Just like stocks and bonds, the moment you’re selling a cryptocurrency for a higher price than you purchased it at, then you must pay capital gains tax. Conversely, whenever the difference is you’re selling the cryptocurrency at a lower price than what you paid sometimes you can offset that with capital loss.
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Step-by-step process to calculate cryptocurrency tax
Step 1: Note all the cryptocurrency transactions.
You’ll be able to keep track of kinds of cryptocurrency transactions you make, if you are able to compute your taxes properly. It encompasses:
Purchases: Know at what date, at what time and at what price you bought the cryptocurrency.
Sales: Write down the date, the amount and price for which you sold your cryptocurrency.
Trading: If you traded one cryptocurrency for another-for example, Bitcoin for Ethereum-this is a taxable event and must be track.
Gifts: If you gift or receive cryptocurrencies as gifts, tax implications may arise.
Rewards from mining or staking: If you mine or stake cryptocurrency, the earnings are consider taxable income.
To do that, you will want to use a cryptocurrency portfolio tracker or tax software which will help you to keep track of the basis, or purchase price, and your purchase or sale history.
Step 2: Identify taxable events.
Not all cryptocurrency transactions are taxable. Here are the situations where the tax applies:
Selling your Cryptocurrency to receive Fiat: If you sell your Bitcoin, Ethereum, or any other crypto for cash, you owe taxes on any capital gains.
Exchanging one cryptocurrency for another: The act of converting Bitcoin for Ethereum would cause a taxable event because you are giving up one asset for a different one.
Spending the cryptocurrency to buy goods or services: When you spend cryptocurrency to acquire something, that is a sale, and you must recognize the gain or loss
Cryptocurrency-based income: If you mine cryptocurrency or receive it as an exchange for goods or services, you can include the amount received in your gross income, based on the fair market value of that cryptocurrency at the date of receipt.
Generally non-taxable events fall into these categories:
Buying cryptocurrency: Using fiat money to purchase cryptocurrency does not constitute a taxable event.
Transfer from one wallet to another: Shifting your cryptos from one wallet into another is nontaxable.
Step 3: Capital gains and losses
The tax imposed on any sale or trade of cryptocurrencies is the capital gains tax. To determine your capital gain or loss, follow this formula:
Capital gain (or loss) = Sale price – Purchase price
Calculate this for each transaction. The selling price is the fiat at the time of sale, say US dollars, and the buying price is the amount one pays to buy the cryptocurrency initially.
For example:
Assume that you bought 1 Bitcoin for $10,000 and later sell for $15,000. Your investment will earn
$15,000 (selling price) $10,000 (buying price) = $5,000
On the other hand, if the price for the sale is lower than that for the purchase, there will be a capital loss. For instance, if you sold Bitcoin at a price of $8,000, you would lose $2,000.
Step 4: Short-term vs long term gains.
Well, capital gains in cryptos are short-term or long-term. Everyone is taxed differently, so:
Short-term gains: If you hold the crypto for a year or less before selling it, then it’s a short-term gain and at ordinary income tax rates, which one happens to earn, can be anywhere from 10% – 37%, depending on.
Long-term benefits: Should you hold your cryptocurrency for a period of over one year, you will pay the lower long-term capital gains tax rates of 0%, 15%, or 20%, depending on your income. .
A big difference indeed since you will be paying a much lower rate when it comes to long-term capital gains.
Step 5: Account for cryptocurrency received as income
Any income from mining, staking, or being paid for services in cryptocurrency is taxable. It is reported when received at its fair market value.
For instance, if you received 0.1 Bitcoin as a form of compensation for freelance work when the price of Bitcoin was $40,000, then that is equivalent to $4,000 of income subject to normal income tax rates.
If you own this cryptocurrency and you eventually sell or trade, then you will determine your capital gain based on the price when it’s sold.
Step 6: Report cryptocurrency tax in proper forms.
If you want to report your cryptocurrency tax, you will utilize the correct forms IRS. What do you need?
Form 8949: This is used to report capital gains and losses deriv from the sale or trade of cryptocurrency. You keep a record of each transaction and, thus, calculate total profits or losses.
Schedule D: Use this form to summarize totals from Form 8949 and report on your tax return
Schedule 1: If, as income, you mined, staked, or had cryptocurrency paid to you, you must report it on Schedule 1.
One must complete these with complete accuracy since errors will incur penalties or an audit by the IRS.
Step 7: Tax Loss Harvesting
If you have an investment in cryptocurrency that has declined, you may sell those at a loss to offset a gain from other transactions. The strategy is called tax loss harvesting, and it may decrease your actual tax liability.
For example, if you sold 1 Bitcoin at a profit of $5,000, and the other 1 Ethereum at a loss of $2,000, then your taxable profit would reduce to $3,000 ($5,000-$2,000).
Secondly, you can also use excess losses to offset other incomes up to the limit of $3,000 per year.
Step 8: Keep records and update your knowledge of the tax rules.
Regulations surrounding cryptocurrency tax are evolving and therefore need to be updat with changes as they happen. Some jurisdictions and their tax authorities may enact new legislation or amend already existing one, so it is very important to consult a tax professional or use cryptocurrency tax software to stay on par.
You should keep thorough records of every single cryptocurrency transaction, noting the date, the amount, and the fair market value at the time of the transaction. The better your record-keeping, the easier it will be when you eventually start preparing to file the tax return and if you are audit.
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The result
Calculating cryptocurrencies taxes is a very complex process; however, if segregated into simple steps and keeping organized records, it can become more manageable. The concept is knowing when there is a taxable event, correctly calculating capital gains or losses, and reporting the information on the tax return. The more one is updated about the changing tax regulations and is given the right advice from the professionals, the more equipped they would be in fulfilling their obligations.
