Cryptocurrency is among the fastest growing investment classes globally, appealing to millions of investors that want to capitalize on the appreciation in value of cryptocurrencies like bitcoin, ethereum and many others. While profit potential is one of the main attractions to investing in cryptocurrency, many investors neglect another equally important aspect in their investing – taxation. In most jurisdictions, realised gains (profits) made while trading cryptocurrencies are taxed as capital gains. As such, ignorance in understanding how capital gains taxes apply could lead to costly surprises resulting in financial liabilities, penalties and inaccurate tax returns. If you’re a person who’s been in possession of cryptocurrencies for a while, a frequent trader of them, or one who buys or sells them occasionally – then it’s important that you understand the tax implications related to capital gains that arise from your activities involving cryptocurrencies. Know the timing of when taxes will apply, how to calculate the size of your gain, and what documentation to retain in order to comply with tax law will allow you to make informed choices about your strategies for investing in them.
What Is Capital Gains Tax?
An investor is subject to capital gains tax if they sell their investment at a profit (i.e. when sold for more than the original investment (i.e. purchase price)). In many countries around the world, capital gains tax is being applied to cryptocurrencies in the same way as they are applying capital gains tax on most other investments when sold. This means that if you buy a cryptocurrency for one price and sell it for a higher price, your capital gain will usually just be the difference in your purchase price and your sale price.
For instance, if you purchased Bitcoin for $20K USD and later sold that same bitcoin for $30K, your capital gains tax liability generally would equal $10K. If, however, you sold a cryptocurrency at a price lower than your original purchase price; you would have realized a capital loss. Depending on local taxation laws, a capital loss may be applied to reduce future taxes owed.
When Does Capital Gains Tax Apply?
Many people have the misperception that taxes apply only when you convert your cryptocurrency to a fiat currency or when your cryptocurrencies are sold or traded for other cryptocurrencies. There are, however, a number of different types of transactions or events that may cause you to receive some kind of a notice for your capital gains taxes. For example, if you sell your cryptocurrency for cash, you have incurred a capital gain (the difference between your cost and sales price) and will owe taxes on that amount. Other types of events that may be subject to capital gains taxes include: switching one type of cryptocurrency to another; using cryptocurrencies as a method of payment; or involving cryptocurrency in certain types of investment activities.
You will not incur capital gains taxes just by holding onto your cryptocurrencies without exchanging or selling them. As a result, for many long-term holders, their tax responsibility will not occur until they choose to sell or otherwise dispose of their assets. The two most important skills that you must possess as an investor in cryptocurrency are the ability to identify the types of transactions that will trigger capital gains taxes and the ability to document those transactions in a manner that will allow you to file a complete income tax return.
Short-Term and Long-Term Capital Gains
There are various tax rules in each nation on short-term versus long-term capital gains. Short-term gains will normally occur when you sell your cryptocurrency after holding onto it for only a short while, often less than 12 months. These short-term capital gains can, in many cases, be taxed at some of the same rates as your ordinary income since they are often applied in a similar fashion to your ordinary income.
Long-term capital gains, on the other hand, will apply to any assets that you have owned prior to selling them for a longer period of time. To encourage long-term investing of their people through investing, most nations will give you a lower rate of taxes on the long-term capital gains you generate on your investment. While the length of time required and the tax rate levied for each nation differs, learning about these two types of capital gains can help investors generate a more tax-efficient investment decision by holding their investment longer in hopes of not only reducing taxes but developing a more disciplined investment style.
How Capital Gains Are Calculated
To figure out how much profit you have made from the sale of your cryptocurrency, you first need to determine your cost basis. Your cost basis is the original price you paid for your cryptocurrency plus the transaction fees you paid when you purchased it.
Once you have sold your cryptocurrency, you will compare your selling price to the original cost basis.This tells you how much money you made or lost in that transaction.
If you had made several different purchases of the same type of cryptocurrency but paid for them all using differing amounts, determining how much you have in taxes will become a bit more challenging. The accounting method used will depend on what your taxing authority permits or requires (for instance, FIFO, LIFO, or average cost). There is no single answer as to which accounting method should be used; therefore, keeping good records of all your transactions will be necessary for determining and reporting your capital gains accurately.
Can Capital Losses Reduce Taxes?
Capital losses can provide a tax benefit or an offset of your total other taxable earned investment income from non-ordinary sources. If you sell your cryptocurrency at a lower price than what you purchased it at, you could report that loss against your current year or potentially future investment income through retirement accounts and charities. In many places around the world, investors utilize tax loss harvesting (selling losing assets) as a strategy in order to offset any gains realized within their portfolio.
In some areas, any capital losses incurred offset (are subtracted from) other capital gains incurred. However, if the total amount of capital losses exceeds the total amount of capital gains, then the unused capital losses can be carried forward into the following taxable year. Knowing how the local tax laws calculate capital loss carry forwards, will help inform investors on how to utilize any applicable losses to reduce their overall tax liability.
Keeping Accurate Records
One of your key duties as an investor in cryptocurrencies is to keep good records. Because you can buy, sell, transfer and trade cryptocurrencies between multiple wallets and exchanges, it’s critical that you maintain accurate records to support your tax filings.
At a minimum, you should document the date of the transaction, the amount of the transaction, any fees paid as a result of the transaction and the wallet address you’re using for the transaction. Many investors also use tax software to help automate tracking their investments, as well as their gains/losses on these investments. Not only will having accurate records make the process of completing your tax return easier, but they can also serve as evidence of your activities if the IRS or other tax authority requests additional verification for your activity related to your cryptocurrency investments.
Common Mistakes to Avoid
Some investors believe crypto trading won’t incur income tax because they assume anonymity applies to all things crypto including trades. These same investors may be shocked to find out that most tax agencies worldwide do expect all crypto exchanges to report user trading activity so it’s very important for users to accurately report their gains on tax returns when they file their taxes. Most people will have a taxable event every time they swap one type of crypto for another, as well as when they use crypto to buy something. Therefore, if investors are unable to accurately document every transaction, treat all fees associated with a transaction as part of that transaction when determining their profit, or fail to document all taxable events, they will likely have a hard time accurately reporting their activities to the taxing agency and/or may create unintended taxable liability.
Conclusion
Every cryptocurrency investor needs to know about capital gains tax and how it affects their investment. Although cryptocurrencies have many opportunities to create wealth, you usually owe taxes on the profits from purchasing, selling or trading the crypto. By understanding when capital gains taxation applies, the calculation of gains and utilizing losses to reduce taxable income, investors can make more informed financial choices.
The crypto regulations change on an ongoing basis, therefore, it is even more crucial to maintain good records and keep up with local tax regulations. If you’re a crypto investor, getting a handle on the fundamentals of capital gains tax (as well as planning your investment purchases) may be your best bet to remain compliant with regulations, be less prone to errors and maximise your investment returns – no matter how turbulent the market becomes in the future.
