Crypto taxation is a hot topic in 2018, given the growth of the space, and dramatically appreciating prices, over the past few years.
There have been some good discussions of the topic, including Laura Shin’s Unchained podcast episode with Tyson Cross and Jason Tyra, and last week’s Crypto Street Podcast, with guest @CryptoTaxGirl. While these were both quite informative, there were some points I felt needed expansion, clarification and additional emphasis, and so I decided to finally write-up and post the general article I’ve been procrastinating on.
(Update: Don’t miss the new section added at the end, with links to good articles I’ve discovered since posting this one.)
Take crypto taxation seriously
I’ve come across two camps of people exposed to crypto taxation risks:
- Those banking on anonymity — Betting on staying anonymous with your crypto, or pleading ignorance as a Plan B, is a huge risk. If your anonymously-held crypto ever hits the fiat system, you will no longer be anonymous. If you purchase something conspicuous, you will no longer be anonymous. If your crypto was purchased with sources identifiable to you, it will become increasingly likely, with the emergence of better chain analysis tools, that your activities will be closely scrutinized.
- Those unaware they’ve had taxable events — These are the folks who didn’t realize that a crypto-to-crypto trade results in a taxable event.
In either case, if it’s discovered that you’ve failed to report taxable events, you will run the risk of costly penalties, costly professional help, costly loss of time, and even the risk of criminal prosecution for fraud or tax evasion.
You do not want to find yourself on the wrong side of an audit, so take crypto taxation seriously.
We’re flying a little blind
While there hasn’t been guidance from the IRS on crypto since 2014, the crypto space has advanced significant, and so on nascent issues like, “when did you receive your forked coins, the day the project forked, or the day you extracted them?” we simply have to take our best, informed guesses as to the approach we take on recognition.
But taking action, on your best informed guess, is far better than taking no action at all.
The IRS treats crypto as property
This means that when you sell it, you will be liable for either short-term or long-term capital gains, based on the value at which the crypto was bought and sold, and the time it was held. If you held the crypto for more than a year, you’ll pay long-term gains, which for most people will be 15% under current laws. If you held your crypto for less than one year, you’ll pay something closer to personal income tax rates.
Use an automated service to keep track of your activities
This is a no-brainer. Given the disparate export formats of the various exchanges, the need to track changes in accounting method from year to year and the need to determine the fair-market USD value of crypto-to-crypto trades, it’s essential to use an online service like Cointracking.info or Bitcoin.tax to track your crypto activities.
These services integrate via API directly to most of the common exchanges, and support manual entry and CSV data uploads for everything else.
As regards complete and accurate record-keeping, don’t forget the following:
- Some exchanges limit records export to, say, a period of one year. It’s therefore important to be diligent about downloading and importing your records promptly, before they’re gone.
- Some exchanges, like ShapeShift, don’t provide records at all. It’s therefore important to enter these transactions manually when you make them, including the transaction URL in the notes field to provide evidence of the transaction.
- When considering the use of a DEX (decentralized exchange), be sure to first confirm that it supports the export of trading records, and confirm for hold long records are kept.
- Don’t forget to report earnings from staking, masternodes and other sources of crypto passive income.
Masternode & staking rewards are income
Staking and masternode rewards are considered income at the time they are received. If you do you not immediately exchange them to fiat, then they simply are treated as property moving forward, with a cost basis equal to their income value at the time of receipt.
Cryto-to-crypto trades are taxable events
Perhaps the most widespread problem in the crypto space, as regards taxation, is lack of awareness that a direct crypto-to-crypto trade (like BTC → ETH) is a taxable event. Such a trade is treated as if you sold BTC for USD, and then bought ETH. At that point, your sale of BTC is taxable based on the amount of time you held it, and the price at which you purchased it, known as your tax basis.
This also means you need to track the fair-market value of the BTC at the time of the trade! As mentioned above, an indispensable feature of the online services is that they will automatically asses and record the fair-market value of the selling half of the traded pair.1
Recently, there has been much discussion about the use of “like-kind exchange” laws (also known as “1031 exchanges”) to claim that crypto-to-crypto trades can be tax-deferred. Since crypto is considered as property by the IRS, the idea is that like-kind exchange laws—that allow for the non-taxable exchange of certain kinds of property—may be applicable to crypto-to-crypto trades.
First, from 2018 onward, this is clearly disallowed, as the 2018 tax reform included clarification that like-kind exchanges are only applicable to real estate.
So the only question is whether to declare like-kind exchanges on crypto trades made in years prior to 2018. I’m not a tax professional, but I engage with some good ones, and their strong opinion is that it’s likely not a good idea, for two reasons:
- You can’t just declare a like-kind exchange, and be done with it. You have to present argumentation, and a like-kind exchange is anything but obvious. Just as gold and silver are not considered like-kind, bitcoin and ethereum could arguably also be considered sufficiently different to exclude them from 1031 applicability. So at minimum, you’ll be faced with the professional costs of preparing your 1031 justification.
- Then, if the IRS doesn’t accept your claim, you’ll be faced with the costs of defending your position, and potential penalties if you lose.
These risks have to be weighed very carefully, if deciding to claim like-exchange for years prior to 2018.
The only point of contention I had with the Crypto Street episode, was the statement that the coffee you buy today, is paid with the bitcoin you purchased in 2011, due to a requirement to use the FIFO (first-in-first-out) accounting method.
The reality is that, as long as you keep careful and accurate track of things, you can use any accounting method you like, and choosing one over another can have a huge impact on your current tax liabilities.
In this regard, and important feature of the online tracking services is that they will actually show you which method is optimal for the current year, highlighting it green:
And an even more important feature, is that they’ll keep track of the fact you claimed LIFO on that little BTC purchase in 2016, HPFO on that other one in 2017, and FIFO on that one in 2018.
How to treat a fork
The IRS hasn’t provided guidance on this, but there are two possibilities.
- Forked coins should be treated as the receipt of zero-basis property. (This is how, for example, newborns of farm animals are treated.)
- Forked coins should be treated as income, with a fair-market value for the basis moving forward.
It seems highly probable that the correct recognition is zero-cost basis, and that an income approach would be unfair and simply unworkable.
- In the zero-basis approach, the question of when you received your forked coins is only relevant to the determination of long-term vs short-term applicability. If they were treated as income, the question of whether you received them at the time of fork or at the time of receipt becomes important, as it relates to the determination of the fair-market value. If at the time of fork, then all forks of a project should be treated as income, whether or not you received them, and whether or not you even knew about them.
- In the zero-basis approach, we don’t have to answer the question of the fair-market value of the coins when they were received, since it will be zero. If they were treated as income, determining the the fair-market value would be very difficult, especially for obscure forks that aren’t quoted. Income treatment would also be unfair to the owner of a coin with a high value at inception, but dropping before the owner had a chance to sell them.
So it really seems that an income approach would be unworkable, and that a zero-basis receipt of property is the better claim to make.
(Update: Here is an interesting article analyzing the tax treatment of a fork, and leaning towards an income classification. The arguments are solid, but I still find it hard to be tenable, for the reasons listed above.)
Risk of double-taxation for expat Americans
The United States is the only country in the world that taxes its citizens regardless of residence. So if you left the US to do your crypto transacting in another county, you will be liable for both taxation in the country where you’re resident, and the United States.
And even though the USA has dual-tax treaties with most countries, you are especially at risk of double-taxation with crypto, since there is diversity among countries in the “concept” of crypto. Many countries, for example, tax crypto as currency, and may not extend double-tax protection if you’ve paid property capital gains tax in the United States.
Move to a tax haven?
If you’re American, it doesn’t matter where you move, as the US taxes its citizens regardless of residence. The exception is Puerto Rico, in which, as a resident, you are subject to Puerto Rican taxation, rather than mainland US taxation. But even then, it’s widely anticipated that the IRS will have keen interest in claiming tax on the gains one’s crypto experienced prior to the change of residence. This remains an open question.
Renouncing US citizenship is an option, but then you have to research whether you’ll be considered for the exit tax, and weigh all the non-financial trade-offs of giving up that passport forever.
And if you’re European, the situation is always much better, unless you’re lucky enough to be living in Germany, where there is no long-term capital gains tax on crypto! For other countries, some have laws stating that if you move to a country considered to be a “tax haven”, you can remain liable for taxation in the former country for up to 10 years.
A difficult future ahead
If the area of crypto taxation has some ambiguities today, the situation is likely to get even murkier in the future. How will ICOs be taxed? What about participation in synthetic products like the Prism Portfolios, or the Abra mobile app, which don’t involve directly holding crypto at all, but rather involve the collateralization of Smart Contracts that aren’t even denominated in USD? What tracking and reporting burdens will be expected of the taxpayer, when we live in a world of thousands of token-to-token exchanges happening daily in automated, machine-to-machine systems, in which the tokens serve utility but at the same time are “valued”?
One thing we can depend on is that the advancement of crypto will far outpace the tax authorities’s abilities to keep up with clear guidance. And unfortunately, that means early adopters will, as always, bear a disproportionate amount of the pain and costs, defending themselves in ambiguous situations, and establishing the case law that will benefit all those coming later.
As you’ll have noticed from my previous articles, I’m transitioning from the world of traditional investing, to the world of crypto investing. I hope to use this blog as a platform for publishing my experiences and the things I learn along the way.
Crypto taxation is like going to the dentist, something we’d like to avoid, but better addressed earlier rather than later, and in this article I hope to have provided quite some food for thought and consideration. I hope you’ve enjoyed it, and if I’ve left out anything you’d like to see included, just post a comment below.
- Tax treatment of forks
- Another tax treatment of forks
- Crypto taxation in-depth FAQ
- IRS charging tax on crypto purchases may backfire
- Applicability of like-kind 1031 exchanges
- Overview of the practical difficulties of compliance
- How to mount a tax defense
- If you use Bitcoin.tax, it is critical to understand that their tracking of daily average cost is only up-to-date as of the previous day. So if you import, today, the crypto-to-crypto trades that you made today, resulting in the sale of BTC, then the Bitcoin.tax website will use yesterday’s BTC price. That can be very costly, given the volatility of the crypto market. So just remember to wait a day before importing your transactions to the Bitcoin.tax service. ↩