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While there are numerous reasons to own crypto (fascination with the technology, wanting to change the world), many who have bought crypto simply bought it with the hopes that their investment(s) would appreciate (and hopefully dramatically). While substantially more volatile than other investment options, this also tends to mean that there is an asymmetric upside that could lead to a very profitable selling opportunity. On the other side of the investing coin, this also means that these volatile cryptocurrencies could incur heavy losses.
For those who have the opportunity to take profits and are considering it, it’s helpful to have an idea of how much of these as-yet unrealized profits will need to be allocated to pay capital gains taxes. Having this knowledge beforehand can help you determine when—or if—you’ll be selling certain crypto assets within your portfolio. Let’s dive into the basics of crypto capital gains, the accounting realm where profitable crypto sales and taxes intersect.
Crypto Capital Gains Basics
If you profitably sell crypto you previously bought, you’re taxed on the difference between your sales price and your initial purchase price. Let’s look at a relatively simply example where a crypto investor purchased a full bitcoin (BTC) on four separate occasions using U.S. dollars (USD), paying $5,000; $15,000; $25,000; and $50,000; respectively (these examples are merely for simplicity’s sake and don’t incorporate historical BTC pricing data).
They then decided to sell one BTC for the current market price of $25,000. Depending on which BTC they sold, the delta (the difference between the purchase and sales price) would be as follows:
- The first Bitcoin purchased for $5,000 would have $20,000 ($25,000-$5,000)
- The second would have $10,000 ($25,000-$15,000)
- The third would have $0.00 as it was sold at the same price it was bought for
- The fourth would have a loss of $25,000 as it was purchased for $50,000
In this example, you’d owe capital gains taxes if you sold either of the bitcoin that was purchased below the $25,000 sales price. Further, the sale of the BTC purchased at $5,000 would be twice as profitable as the BTC purchased at $15,000. You’d therefore owe twice as much in taxes. If you bought and sold for exactly the same price, this isn’t a taxable event as you’re merely “breaking even.”
In the last BTC sale example, you’re selling for half your purchase price of $50,000. As you’re selling for a loss (and a relatively steep one at that), you don’t owe any taxes; you are only taxed on profitable sales. Considered a capital loss, we’ll address how this relates to your tax liabilities in a later article within this “taxing series” — double entendre intended.
Capital Gains: The “Short” and “Long” of It
Like investing in the traditional stock market, the tax rate of profitable crypto sales depends on the length of time you have held onto your asset prior to selling it. This is because there is a different rate that rewards investors for holding onto investments longer. Called the long-term capital gains rate, this tax rate is lower than the short-term capital gains rate.
If you owned crypto for less than a year before selling, you’d owe the short-term capital gains rate. If you owned that same crypto for over a year prior to selling, you’d be taxed using the long-term capital gains rate. This is an important consideration as it could significantly affect your tax liabilities. When I said you’d owe twice as much in taxes when profiting by $20,000 instead of $10,000 — I left out a few important caveats. Let’s reexamine this example.
- Scenario One: You bought one BTC at $5,000 and later sold it for $25,000. The time of ownership prior to selling was 300 days.
- Scenario Two: You bought one BTC at $5,000 and later sold it for $25,000. The time of ownership prior to selling was 400 days.
In this example, scenario two would be better from an investor’s point of view as it would incur the lower capital gains rate. While a good generalization is that the long-term tax rate is around half as much, the difference between these rates depends on your income. The current short-term capital gains rate ranges from 10 – 37%; the long-term rate varies from 0 – 20%.
Crypto Sales: How “Less Is More” Is Actually True
Let’s look at our example again, this time looking at our same investor looking to sell his one BTC priced at $5,000 for $25,000 (for a net profit of $20,000). Further, he wants to sell it soon as the price has been continually moving downwards and he suspects this trend will continue. At this moment, he has held this bitcoin for 364 days. Considering this, he decides it is likely in his best interest to wait a few days to sell (even though the price is still dropping).
This is because when he first thought of selling his BTC, he would be paying short-term crypto capital gains. By merely waiting a few days, he will be charged the lower long-term crypto capital gains rate. So even if he sold it for $25,000 instead of something slightly higher a few days earlier (like $25,250), he’d be taking home a much better net profit once the taxes are factored in.
On the other hand, if the price really plunged drastically over those two days (from say $25,500 to $5,500) and he still sold one BTC, any tax savings wouldn’t make up for the precipitous BTC price drop. While this is an extreme example, those that are looking to sell around a year later should factor in how this annual timing threshold can affect their profitability. Sometimes “less is more” and “taking longer is better” when selling crypto — when you factor in the difference between the short-term and long-term tax rates.
Your Income Bracket Affects Your Crypto Gains
If you’re familiar with how income taxes vary based on your annual adjusted gross income (AGI), you’ll be familiar with the short-term crypto capital gains rates as they are identical. Separated into seven separate tax rate tranches, short-term capital gains are taxed at 10% for those making less than $11,000 and taxed at 37% for those making over $578,125 (for those that are filing “single”). The intermediary rates are 12%, 22%, 24%, 32%, and 35%.
The long-term capital gains rates are only separated into three categories. Those that make from $44,625 – 492,300 per year are taxed at 15%. Those that make more than that maximum pay a 20% rate and those that make less than that minimum pay no long-term taxes (0%). Again, this is for those filing individually. In general, those that are married and file jointly need double the income to reach the same tax rates. Those that file as “Head of Household” get slightly higher income allowances for similar incomes. For example, a 12% short-term gains tax is incurred for single filers who earn between $11,001 – 44,725, while a Head of Household filer pays 12% when they earn $15,701 – 59,850. Those that are married but file separately generally pay the same rate as single filers.
First Things First When to Comes to Selling Crypto? Not Exactly
Specific Identification Method to support LIFO or FIFO
According to the guidance issued by the IRS (A39), you can use the Specific ID method to calculate the cost basis of each unit of crypto asset you are disposing of. Specific ID means that when you dispose of your crypto asset, you must document the specific unit’s unique digital identifier such as a private key, public key, and address, or by records showing the transaction information for all units of a specific virtual currency, such as Bitcoin, held in a single account, wallet, or address.you are specifically identifying the exact units you are selling. The information for specific identification must show:
(1) The date and time each unit was purchased
(2) Your cost basis and fair market value of each unit at the time it was purchased
(3) The date and time each unit was sold, exchanged, or otherwise disposed of
(4) The fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.
You will need to use the specific identification method if you want to use any method other than FIFO, and these are elements we help you track using CryptoTaxCalculator.
If these cryptocurrencies could not be specifically identified using the factors above, the FIFO accounting method would need to be used, and our prospective investor would have to sell the first Bitcoin for a net $20,000 gain. If the Bitcoins can be specifically identified, it’s up to the investor to decide which BTC he wants to sell. In this example, our investor has three choices.
In accounting, this requirement to buy and sell in order is colloquially known as “first in, first out” accounting. If this was a requirement, it would mean that our prospective investor would have to sell for a net $20,000 gain. As there is no requirement that the first BTC purchased must be the first BTC sold, it’s up to the investor to decide which BTC he wants to sell. In this example, our investor has three choices.
- Pay no taxes but sell for a substantial loss by selling the $50,000 BTC.
- Pay long-term capital gains (on the $5,000 BTC or $15,000 BTC).
- Pay no taxes by selling at the same price you bought at ($25,000 BTC).
In this example, there are a variety of considerations.
- Do you want to pay more taxes now so you can pay less later?
- Do you want to pay less in taxes now? But potentially more later?
- Do you want to simply break even and take the money out?
- How much in losses can you harvest on your next tax bill?
While some would recommend the break-even option or selling the $15,000 BTC (for less profit but also a smaller tax bill), it’s ultimately up to you to decide what accounting decision works best for you when you’re filing your annual taxes. This will vary based on your income, the performance of your other investments, your investing time horizon(s), personal needs, and a host of other individual considerations. Crypto Tax software such as CryptoTaxCalculator can help with specifically identifying each individual cryptocurrency so that there is the option to use a more favorable accounting method. If you’re wondering about selling for a loss and the implications of such an action, we’ll be exploring the pros—and cons—of this in our next crypto tax primer.
Crypto-to-Crypto Trades and Crypto Purchases Aren’t Tax Exempt
As a reminder, it’s worth reiterating that selling for fiat currency (such as USD) isn’t the only type of crypto transaction that incurs a taxable event. Let’s look at the $5,000 BTC that was purchased by our prospective investor again (current market price is $25,000). If he used that BTC to purchase another cryptocurrency or stablecoin, that would also incur a taxable event (on the $20,000 price differential). Further, you can’t fool Uncle Sam and get around crypto taxes by making a direct purchase; any direct purchase with BTC in this scenario would also be a taxable event. If you used one BTC to purchase a car or a luxury watch, that would also be a taxable event. Or, you could use some accounting magic and use your break-even BTC (also at $25,000) to purchase that watch or crypto — tax free.
- The IRS expects you to pay taxes on profitable crypto sales.
- If you’ve held crypto for less than a year, you’d owe short-term capital gains taxes on any related sales.
- If you’ve held crypto for more than a year, you’d owe long-term capital gains taxes on any related sales.
- Long-term capital gains rates are less than the short-term capital gains rate.
- Both your short-term and long-term capital gains rates are dependent on your annual income. Those with higher incomes pay a higher tax rate.
- There is no “first in, first out” accounting requirement when selling crypto if the assets can be specifically identified using the 4 factors outlined by the IRS.
- Crypto-to-crypto trades and the direct purchase of goods and services can also be taxable events.
Disclaimer: This crypto tax series is merely for informational purposes and should not be considered legal or tax advice. Please solicit the services of a crypto knowledgeable certified public accountant, tax professional, or lawyer should you need further guidance.