In the past few years, use of cryptocurrencies for investment, trading, and as a means of payment is steadily rising. Digital nomads, around the world are already beginning to allow payments in Bitcoins and other cryptos in their location independent businesses. Countries that are crypto-friendly are also becoming hot destinations for digital nomads as they can scout out a potential country for residency purposes that won’t tax them on their crypto gains.
Recent success stories in crypto trading have gained a lot of attention from traditional investors who so far, had only invested in equity markets and had negative views about cryptocurrencies. However, crypto has also generated a lot of concerns for both governments and investors as well.
One of the prime discussions around the world is how to possibly tax cryptocurrencies. In some instances, it seemed paradoxical that certain governments didn’t want anything to do with cryptos but then decided to put a tax anyway on crypto gains made for investors and traders alike.
In this blog, we are providing an easy yet detailed explanation on when and how taxes are attracted on crypto trades; and how to calculate and pay them. For every country, the tax liability and return filing procedure will be different but the basics of tax events and tax liability will be more or less the same. For a more detailed explanation, we highly recommend you check out the Crypto Tax Tips Masterclass.
A taxable event means when tax becomes applicable on your crypto transactions. In the majority of countries, cryptocurrencies are treated as a commodity or asset and not currency for the purpose of taxation. Thus, gains realised on the sale of cryptocurrencies is treated as income for the purpose of taxation. This income can be ordinary business income if you are considered to be a trader, or long-term capital gain or short-term capital gain based on the holding time and treatment of cryptocurrency.
Every tax has a taxable event at which point tax is attracted on the transaction. Generally, such a tax event arises at the time when you receive the right to earn any income. In the case of cryptocurrencies, the taxable event arises in the event of:
- Selling cryptocurrency in exchange for fiat currency such as $ or £.
- Trading a cryptocurrency to a different cryptocurrency [for example – exchanging Bitcoin with Ethereum.]
- Using cryptocurrency as a payment for goods or services. [Using Bitcoin to buy a car.]
- Earning cryptocurrency in course of business or job.
- Mining cryptocurrencies
- Staking, airdrops yielding, and farming cryptocurrencies
Further ahead, we will learn how to calculate the amount on which tax rate will be applied for each of the above scenarios.
Type of taxes on cryptocurrency
Cryptocurrencies, when invested or traded other than in the ordinary course of business i.e. investment done as a hobby or side hustle, which is in 90% cases, attract short term capital gain or long term capital gain tax.
In most scenarios, if the holding period of the cryptocurrency i.e. the time period between purchase and sale of the crypto, is a short time frame ie. less than 12 months then the short term capital gain tax applicable can be significantly higher than if the holding period is for a longer-term ie. Longer than 12 months.
For example in the case of the USA, the tax brackets of short-term capital gain are similar to ordinary income tax brackets. While the long-term capital gain tax brackets are much less than the above two. Thus from a tax perspective, it is more beneficial to hold cryptocurrencies for a longer period of time.
Crypto Tax Rates
The exact rate of tax applicable for different persons will depend on your total income from all sources of income such as profits from other businesses, wages, rental income, etc. For example in the US, if the total income from all sources of income including gains from the sale of crypto is $100,0000, then for a single individual the rate of tax will be 24% in case of short-term capital gain. But if the holding period was more than 12 months, then the long-term capital gain rate would drop down to 15%.
In the case where you are in the business of trading in cryptocurrencies on a regular basis, the income earned from such trading is considered to be ordinary income and treated as such. The rate of tax applicable in such a case will depend on the total income of the person depending on what their personal marginal tax rate is.
Calculation of gain or loss
In order to compute the amount of gain or loss made from the sales of cryptocurrencies, the difference of selling price less cost of sales and purchase price including associated costs must be calculated. The formula will look something like this:
Gain/Loss = [(Selling price – costs of sales) – (Cost Price + Associated costs of purchase)]
Tip: don’t forget the fees associated with acquiring your cryptos as these can be included in the cost price and a lot of people forget to include them.
It gets a little bit more complicated…
The above calculation is a very simple way of figuring out your crypto taxes and if you’re a hodler (someone who holds their investments long term) then you won’t be faced with too many difficulties in figuring out how much crypto taxes you owe.
However, if the transaction is of a nature other than direct selling i.e. trading a cryptocurrency to a different cryptocurrency, using cryptocurrency as a payment for goods or services, or earning cryptocurrency in course of business or job, then the selling price of cryptocurrency cannot be ascertained directly. In such cases, in place of the selling price, fair market value will be used.
Hence the above formula is no longer valid:
Gain/Loss = [(Fair market value – costs of sales) – (Cost Price + Associated costs of purchase)]
In every case, fair market value will be calculated differently as explained below:
1. Trading a cryptocurrency to a different cryptocurrency
Suppose, you exchanged 1 Bitcoin for 10 Dogecoin and the value of 1 Dogecoin was $10. Then the fair market value of Bitcoin given will be 10 * $10 = $100.
2. Using cryptocurrency as a payment for goods or services.
Suppose, you paid 1000 Bitcoins for a car worth $50,000. Then the fair market value of each Bitcoin paid will be $50,000/1000 = $50.
3. Earning cryptocurrency in course of business or job.
Suppose, your employer gave you 500 Bitcoins in lieu of your monthly wages of $20,000. Then the fair market value of Bitcoin will be $20,000/500 = $40.
Thus, it is very easy to calculate the gain or loss if the number of transactions are limited as opposed to if you use your cryptocurrencies more regularly.
Valuation methods when transactions are in huge numbers
If it’s looking like you’re doing up to 100 or even thousands of transactions every month because you follow actively the advice of big crypto youtube channels then it will become increasingly difficult to calculate the profits on a case-by-case basis. In such cases, different costing methods such as the FIFO method, LIFO method, weighted average method have to be applied. Generally in most countries, FIFO or weighted average method is used.
Suppose you purchased 1 Bitcoin each in three instances at the price of $10, $20, and $30 respectively and then later sold 2 of them at a price of $40 each. Then,
In case of the FIFO method, the cost of 2 Bitcoins will be the cost of the first 2 Bitcoins purchased i.e. $10 + $20 = $30. Thus, the gain in this sale will be ($40 + $40) – ($30 as calculated above) = $50.
Weighted average method
In case of weighted average method, the cost of each Bitcoin will be the average cost of entire purchase in the period i.e. ($10 + $20 + $30)/3 = $20. Therefore, the total cost of 2 Bitcoins will be $20 * 2 = $40. Thus, the gain in this case will be ($40 + $40) – ($40 as calculated above) = $40.
So, we can see that the method applied to calculate the gain or loss can even change the gains or losses to some extent. In some countries, where the option is available for taxpayers to select the method, then a detailed calculation should be done before deciding which method to select. However, once a method is selected, then in ordinary circumstances, it is not allowed to be changed in the subsequent years. Thus, the method beneficial in the current year may not be beneficial next year.
In any case, you will have to maintain a detailed record of the purchase and sale of cryptocurrencies with separate entries for every transaction in each type of cryptocurrency with the separate date and rate columns. This is proving to be very difficult for a new crypto and hobby investors.
But now, most crypto trading platforms allow you to generate these data with one mouse-click and you can simply extract the information and provide it to your accountant who will hopefully do the crypto tax calculations of gains or losses from all the different crypto trade on your behalf.
If you’re interested to get more country-specific guidance, find out what software we recommend our clients and receive a detailed crypto tips explanation on how you can potentially lower your crypto taxes and make your life easier in the long term make sure to check out our crypto tax tips masterclass who is made for anyone that comes from a high-taxing Western country.
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NOTICE: The content of this article is not to be considered as a legal opinion or tax advice. Wanderers Wealth does not hold itself out as a legal or tax advisor. If you want to receive a legal opinion or tax advice on the matter in this article please contact us directly and we will refer you to a legal practitioner.