Disclaimer: This article is for informational and educational purposes only and does not constitute tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors when filing your taxes.
While the tax deadline has been extended from April 15, 2020 to July 15, 2020 due to the COVID-19 crisis, it’s still a good idea to file as soon as possible, especially for those taxpayers who are expecting a refund. For crypto holders, it’s important to note that for the first time ever, this year every tax-paying American will be getting quizzed explicitly on their crypto activity. Indeed, the 2020 season will mark the first time the following question appears right at the top of the 1040 tax form:
“At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
The Internal Revenue Service (IRS) isn’t referring to your Fornite or Call of Duty digital bucks — but to cryptocurrencies, which is a sign of the industry’s growth. The IRS set guidelines back in 2014 outlining how to report cryptocurrencies when it came to taxes, following existing tax reporting rules similar to real estate. In short, the IRS previously considered cryptocurrency along the same lines as property.
This year however, federal tax forms ask about your bitcoin and other cryptocurrency activities, the latest move to more directly specify details for cryptocurrencies. The IRS is focusing on those who may be underreporting their crypto transactions or not reporting them at all.
What does this new sentence in your tax form this year really mean, and how should it impact how you report crypto in your 2019 taxes? To help understand, we asked SALT experts, along with our partners and friends at Node40, TaxBit, Blox and Friedman LLP.
Know Your Cost Basis
The first thing to know is that one is taxed on profit — the key figure to find out is the gain number. The most recent set of guidance from the IRS was released in October 2019 and it included a few methods of “cost basis assignment” mentioned therein. For those who aren’t accountants, this means one of a few ways to track profits and losses. Know your cost basis and what the IRS deems taxable. Most importantly, know your “gain number.”
Cost basis means the price at which you initially acquired an asset. For example, if you hold one BTC today, which you previously purchased at $9,000, and the price today is $11,000, the cost basis is that acquisition price of $9,000. So, the unrealized gain number (without selling) and the realized gain number (if you were to sell) is the net between today’s price and the cost basis, meaning in this case $2,000.
Cost basis can also mean the fair market value of the asset on the date of acquisition. For example, you received one BTC from work as compensation for services on 1/1. The value of BTC on 1/1 is $9,000. Later when you sell one BTC at $11,000, the then fair market value of $9,000 would be the cost basis, and you would realize $2,000 gain. The fair market value can be determined using a reasonable method, such us prices on any third-party independent trading platforms, as long as the same method is applied consistently for all your crypto transactions.
Loan collateral does not count as a transaction
For SALT customers, it’s important to know that your crypto held as collateral for a cash or stablecoin loan does not count as a taxable transaction unless your collateral is liquidated; a liquidation is a taxable event. If your collateral increases in value during the course of your loan term, this does not count as a gain or taxable action unless the collateral is sold. According to Friedman LLP, should you have a business loan with SALT, take note that business interest is deductible and subject to limitations (generally 30% of adjusted taxable income if the business had more than $25 million gross receipts). While interest on personal loans is generally not deductible, it may be deductible if you are self-employed and you use the loan for your own business or if you are employed but you use the loan to make other investments that generate income (the loan then becomes a business loan or investment loan).
First-In-First-Out (FIFO) is the default accounting method. Your cost (the price at which you purchase a crypto asset) is calculated at the initial purchase date. So, if you buy a Bitcoin in January, another in March, and sell one in June, the “cost” isn’t from March, but January. The first “in” is the first purchasing transaction. First “out” is the first one sold. With digital currency the date of purchase and sale are clear in the coins and tokens themselves, making reporting much easier.
The aforementioned guidance from the IRS clarifies how to calculate your gain number.
By way of example: assume you purchase one BTC on 1/1 for $10,000, one BTC on 2/1 for $15,000, and then sell one BTC on 3/1 for $12,500 — your taxable gain or loss using first-in-first-out is computed by taking $12,500 of proceeds less your cost basis of $10,000 (which comes from the earliest purchase of BTC). This results in a $2,500 taxable gain.
While FIFO is the default method, the IRS makes it clear that the Specific Identification method can also be used if a taxpayer can document unique digital identifiers such as a private or public key. The acceptance of specific identification is favorable for taxpayers, as it allows taxpayers to assign their highest cost basis lots first, which in return minimizes their tax liability.
More details on this specific topic can be found over at Taxbit’s blog here.
Be Careful Using 1099s from Exchanges
If you have been buying crypto through exchanges, the exchange may have sent you a 1099-K or 1099-B form. Even if you did not receive these documents, all the 1099 methods of calculating income are still valid for you. The exchange calculates and reports gross proceeds, meaning that it is on the taxpayer to provide information on the cost they paid to acquire said assets and reported in the capital gains section, otherwise known as IRS 8949.
Specifically, form 1099-K reports gross proceeds, which the IRS interprets as income. The number reported on form 1099-K is not counted as income however, as cryptocurrency trading carries cost basis and is to be reported in the capital gains and losses section of a taxpayer’s tax return. Form 1099-B reports cost basis when available and makes it easier for you as a taxpayer to complete your required IRS 8949. Some cryptocurrency exchanges may not send you anything at all. Regardless of which form you receive or don’t receive, your responsibility as a taxpayer is to use the information to complete your IRS 8949, which reports your capital gains and losses.
Verify the Data You Receive
The crypto industry is still relatively new and while the exchanges and trading technology may have some advanced reporting features built in, the institutions built around that technology are still new. With traditional securities, there is a clearinghouse, a broker, and well-established financial statements that make it easy to determine your taxes. With cryptocurrency, many of the exchanges are still in the process of refining external reporting standards. This means that, as a user, the level of completeness in reporting expected from NYSE cannot possibly be replicated by virtually any new institutions.
According to data by NODE40, the reports generated by cryptocurrency exchanges will be incorrect for about 80% of cryptocurrency traders. We can’t fault the exchanges because there is simply no way for them to determine the cost basis of the assets you’ve been moving around. For this reason, it’s important to consider using a third-party platform that can calculate the gains and losses on your cryptocurrency as you move it from exchange to exchange or wallet to wallet.
Conclusion: Educating Ourselves is Essential
Crypto accounting and tax reporting can be daunting and complex, which is why staying engaged with news and trends is essential to understanding the evolving landscape of crypto taxation. Especially in the U.S, the IRS is taking more steps to introduce greater guidance and clarity. But without proper education and trained professionals, navigating crypto tax can be tough.
Tax preparers and investors rely on 1099 forms in traditional markets — crypto is no different. Without it, the burden of responsibility shifts to the investor, requiring them to keep track of all of their crypto activity for the year. This includes tracking every crypto-related transaction, like fair market value based on the date of purchase or sale of assets.
All of this information is vital for preparers to determine cost basis and properly calculate gains and losses. Therein lies the primary challenge. Some crypto accounting and management platforms have emerged to solve this growing industry need for smarter solutions. Industry giants need reliable, accurate and smart tools.
Because crypto remains a new field and exchanges are widespread around the world, not all exchanges report in the same method. This is why the savvy users will double check the work of the exchange, a task for which there are now new tools available. These errors can have a massive tax impact, particularly when it comes to tracking the cost of acquisition of the asset over time. Luckily there are tools that exist that can provide traders and crypto entrepreneurs with intelligent support.
Taxes are a part of life. This year hundreds of millions of Americans will be reminded explicitly of the existence of digital assets — a good thing for the industry that will drive greater awareness and adoption of cryptoassets. If you’re already a crypto hodler or trader, diligence is key to successfully filing your 2019 taxes this year. Whether you use a third-party tool or rely solely on exchanges to track the movement of your assets, it’s crucial that you know your gain number and verify its accuracy, that you review the IRS guidelines, and that you use trusted sources to educate yourself on what to report and how to go about it.