How to Calculate Crypto Gains and Losses

The Internal Revenue Service (IRS) views cryptocurrency as property for federal income tax purposes, not as currency. This means its treatment aligns with assets like stocks or bonds, making transactions involving digital assets subject to capital gains and losses. Calculating these gains and losses can be complex due to the variety of ways they can be acquired and transacted. This article provides a foundational understanding of how to calculate cryptocurrency gains and losses for tax purposes.

Understanding Taxable Crypto Transactions

Certain actions involving cryptocurrency trigger a taxable event, requiring individuals to recognize a gain, loss, or report income. Selling cryptocurrency for traditional fiat currency, such as US dollars, is a common taxable event. The value at the time of sale compared to its original cost basis determines the capital gain or loss.

Trading one cryptocurrency for another, for instance, exchanging Bitcoin for Ethereum, also constitutes a taxable disposition. The IRS considers this an exchange of property, meaning the disposition of the first cryptocurrency is a taxable event, and the acquisition of the second establishes a new cost basis.

Using cryptocurrency to purchase goods or services is another taxable event. When you spend crypto, it is treated as if you first sold the cryptocurrency for its fair market value and then used the resulting fiat currency to make the purchase. Any difference between the cryptocurrency’s cost basis and its fair market value at the time of the transaction results in a capital gain or loss.

Receiving cryptocurrency as income is also taxable. Activities such as mining, earning staking rewards, or receiving airdrops and hard forks are generally considered ordinary income. The fair market value of the cryptocurrency at the time it is received must be reported as income.

Determining Your Crypto Cost Basis

Before calculating gains or losses, determine the cost basis of your cryptocurrency. This represents the original value or price paid for an asset, including any associated costs like transaction fees. This figure is subtracted from the sales price or fair market value at the time of disposition to ascertain the gain or loss.

For purchased cryptocurrency, the cost basis is the fair market value at acquisition, plus transaction fees. These fees increase the cost basis, reducing potential capital gain or increasing a capital loss. For example, if you bought Bitcoin for $1,000 and paid a $10 fee, your cost basis would be $1,010.

When cryptocurrency is received from mining or staking activities, its cost basis is its fair market value at the exact time of receipt. This value is recognized as ordinary income, establishing the basis for future capital gains or losses. For crypto received as an airdrop or from a hard fork, the cost basis is its fair market value when you gained control.

If cryptocurrency was received as a gift, the cost basis depends on the donor’s basis and the fair market value at the time of the gift. For a gain, your basis is the donor’s basis. For a loss, your basis is the lesser of the donor’s basis or the fair market value at the time of the gift. Inherited cryptocurrency typically benefits from a “stepped-up” basis, meaning its cost basis is adjusted to its fair market value on the date of the decedent’s death.

Accounting Methods

Various accounting methods can be used to track the cost basis of specific units of cryptocurrency:

• First-In, First-Out (FIFO): Assumes that the first cryptocurrency acquired is the first one sold. This means you match the oldest units purchased with the units sold.
• Last-In, First-Out (LIFO): Assumes the last crypto acquired is the first one sold.
• Specific Identification: Allows individuals to choose which specific units of cryptocurrency are sold, often enabling tax optimization by selecting units with a higher cost basis to minimize gains or realize losses. This method requires meticulous record-keeping to track each individual unit.
• Highest-In, First-Out (HIFO): Aims to sell the highest-cost units first, which can help minimize capital gains by disposing of assets that would result in the smallest profit or largest loss.

Calculating Gains and Losses

Once the cost basis for your cryptocurrency is determined, calculating capital gains or losses involves a straightforward formula: Sales Price (or Fair Market Value at time of disposition) – Cost Basis = Capital Gain or Loss. A positive result indicates a capital gain, while a negative result signifies a capital loss.

When selling cryptocurrency for fiat currency, such as US dollars, the sales price is the amount of fiat received. For example, if you sell Bitcoin for $5,000 with a cost basis of $3,000, your capital gain is $2,000. This gain is subject to capital gains tax.

Trading one cryptocurrency for another, like exchanging Ethereum for Solana, requires applying this formula twice: once for the disposition of the first asset and once for the acquisition of the second. If you trade Ethereum with a cost basis of $1,500 for Solana with a fair market value of $2,000 at the time of the trade, you recognize a $500 capital gain from the disposition of Ethereum. The acquired Solana then has a new cost basis of $2,000.

Using cryptocurrency to purchase goods or services also necessitates this calculation. If you use Bitcoin with a cost basis of $100 to buy a coffee that costs $5, and the Bitcoin’s fair market value at the time of the transaction is $5, you incur a $95 capital loss ($5 sale price – $100 cost basis). Even small transactions can trigger tax implications.

Holding Period

The holding period of a cryptocurrency asset is important, as it determines whether a gain or loss is considered short-term or long-term.

• Short-term capital gains or losses apply to assets held for one year or less. These gains are typically taxed at ordinary income tax rates.
• Long-term capital gains or losses apply to assets held for more than one year. These gains generally receive preferential tax treatment.

Record Keeping and Tax Reporting

Maintaining accurate and comprehensive records of all cryptocurrency transactions is fundamental for tax compliance. Detailed records help ensure that calculations of gains, losses, and income are precise and defensible if audited.

Essential Data Points to Track

For each transaction, essential data points to track include:

• Date of acquisition and disposition
• Amount of cryptocurrency involved
• Fair market value at both acquisition and disposition
• Purpose of the transaction
• Any associated fees

Transaction histories from cryptocurrency exchanges are a primary source of data for reporting purposes. It is also important to track transfers between wallets, as well as any off-exchange transactions. Personal records, such as spreadsheets or specialized accounting software, can help consolidate this information and ensure all activities are accounted for.

Relevant Tax Forms

Several tax forms are relevant for cryptocurrency activities:

• Form 8949, Sales and Other Dispositions of Capital Assets: Used to report individual capital asset sales, including cryptocurrency dispositions. Each sale or exchange of cryptocurrency that results in a gain or loss must be listed on this form.
• Schedule D, Capital Gains and Losses: Summarizes totals from Form 8949 to calculate the overall capital gain or loss for the tax year and integrates with your main tax return, Form 1040.
• Schedule 1 (Form 1040), Additional Income and Adjustments to Income: For ordinary income derived from cryptocurrency activities, such as mining or staking rewards.
• Schedule C (Form 1040), Profit or Loss from Business: If crypto-related activities constitute a trade or business, income and expenses might be reported on Schedule C (Form 1040), Profit or Loss from Business.

Specialized cryptocurrency tax software can significantly streamline the process of aggregating transaction data, calculating gains and losses, and generating the necessary tax forms. These tools are particularly useful for individuals with a high volume of transactions, as they can automate much of the record-keeping and calculation burden. Utilizing such software can help ensure accuracy and compliance, especially as tax regulations continue to evolve.