Have you heard of cryptocurrency? Chances are you have come across the term before, but have you ever wondered what cryptocurrency is and how it’s treated for tax purposes? Let’s dive into cryptocurrency and try to answer these questions below.

What is cryptocurrency?

The most common definition of cryptocurrency, otherwise known as virtual currency or digital currency, is an internet-based medium of exchange that can be used as an alternative to paper money to conduct financial transactions. Unfortunately, this is not quite how the IRS views cryptocurrency. As cryptocurrency becomes more relevant, it is important to know how it could make an impact on your tax return.

How is Cryptocurrency taxed?

Currently, cryptocurrency is treated as property, meaning it is subject to the same tax treatment as stock.  If cryptocurrency is held for any period of time, there is a good chance that when it is sold or exchanged, the value will have changed.  If the cryptocurrency has increased in value when it is sold or exchanged, a taxable event has occurred. If the cryptocurrency was held for less than a year, the gain should be included as ordinary income. If the cryptocurrency was held for longer than one year, it is taxed as a capital asset and is subject to the more favorable long-term capital gains rates. If the cryptocurrency is sold at a loss, the loss can be used to offset other capital gains or reduce ordinary income. If there are any other capital gains, they must be offset first. If there are no gains available to offset or if there is excess loss after the gains have been offset, the losses can be deducted up to $3,000 in a single tax year as a reduced ordinary income with any excess loss rolling forward to future tax years.

Does converting or trading one cryptocurrency for another create a taxable event?

Yes, converting one type of cryptocurrency into another is considered a taxable event. (Example: converting Bitcoin (BTC) to Litecoin (LTC)) The tax is computed by taking the current value of the cryptocurrency that is being converted and subtracting the amount that the cryptocurrency was originally purchased for (the basis).  If this number is positive, it is considered a gain. This gain will be taxed as either ordinary income or a capital gain depending on if it was held for longer than a year or not. If the basis is subtracted from the cryptocurrency’s current value and the number is negative, there is a loss. The loss can be used to offset other capital gains and any excess can reduce ordinary income up to $3,000 in a given tax year with the remaining balance being carried forward to the next tax year.

How do I know what my basis is?

The basis is the amount of money that you have spent to acquire the specific crypto asset. This amount includes the fees paid to acquire the asset. Example:  If one spends $20 on BTC and pays $1 in fees, the basis in BTC would be $21.

How do I calculate the basis after a conversion?

Following a conversion, the basis in the new asset is going to be the value of the currency that is being converted at the time of the exchange plus any fees incurred to convert the asset. Please see conversion examples below:

  • Basic Sale: Abe spends $100 to acquire 1 BTC on 1/1/19. Abe sells the 1 BTC on 12/1/19 for $150. Abe will have a short-term gain of $50 ($150-$100). This gain is short-term because Abe held the BTC for less than a year. This $50 gain will increase his ordinary income and will be taxed based on his tax bracket.
  • Conversion: Abe spends $100 to acquire 1 BTC on 1/1/19. Abe Converts the 1 BTC to 5 LTC on 12/1/19. The value of the BTC at the time of conversion is $150.00. Abe will need to report the same information on his 2019 taxes as he did in the first example. Abe will have a $50 short-term gain from the conversion of the BTC to LTC. The basis in the 5 LTC is the value of the BTC at the time of the conversion, in this case $150. The date for when the LTC was acquired to determine short-term or long-term treatment would be 12/1/19.
  • Conversion – Additional Option: After acquiring the 5 LTC, Abe sells 3 LTC on 12/31/20 for $100. To compute the gain on this transaction, it is important to determine how much of the basis belongs to the 3 LTC being sold. This is calculated by taking the total basis of the LTC at the time of purchase ($150) and multiplying it by the percentage of the LTC assets being sold. The basis of $150.00 will be multiplied by 3/5 or 60% equaling $90 for the basis of the 3 LTC and a $60 basis for the LTC still being held. The gain/loss is determined by taking the value the currency was sold for, in this case $100, and subtracting the basis of the 3 LTC, $90. In this example, there is a $10 long-term capital gain that needs to be reported on the 2020 tax return.

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