Tag: Bitcoin ira

How to Calculate your Basis in Bitcoin and Other Cryptocurrencies

So it’s finally time.  You got that last-long awaited W-2 and have compiled all of your crypto transactions into one gigantic spreadsheet, and it is time to follow that time-honored tradition of reporting your earnings and paying your taxes because we all like roads, parks, and military superiority, right?

The challenge of filing your return boils down to this: When is a gain reportable and what is the basis?

Depending on whether you are a day trader or a HODLer like me, the difficulty in making those determinations can vary widely.

Well, fear not because, as the title indicates, I am going to show you how to figure out what the heck you gained and what the heck you owe.

I considered adding a subtitle: “Why, oh why, did I choose to day trade?  LIFO, FIFO, Long-Term, Short-Term – I’ll never figure all this mess this out.  Oh, Roger Ver!  Will you please hurry up and establish your Libertarian country so I can move there and be free of all this tax chaos?”

But then I realized I don’t want to live in such close proximity to Roger Ver, even if he did tone down his use of Bitcoin’s twitter account to pump Bitcoin Cash.

So let me start with an example to easily help you determine when you have a taxable gain.  The accounting language we use is if the gain has been realized or remains unrealized, and it is actually quite simple.

If you bought a bitcoin in 2017 for $2,000 and still have it today, it is worth, $20,000, oh – $14,000, crap! –  $8,900, relief – $10,500.  Good grief, the market is volatile right now.  For the sake of this example, let’s just say $10,000.  Your Bitcoin being at $10,000 today is a true gain of $8,000 but because you haven’t “realized” that gain by selling your Bitcoin, you have not triggered a taxable event.  Therefore, you have an unrealized gain and nothing to report to the IRS so life is good.  On paper, you are $8,000 richer, but the IRS can’t charge you for that.

On the other hand, if you sold your Bitcoin for $10,000 on or before December 31, 2017, after buying it for $2,000 earlier in 2017, you have “realized” that gain of $8,000 and triggered a taxable event – specifically, a short-term capital gain.  If you held it for longer than a year, it is a long-term gain.  I won’t expand on that here since I have covered long-term and short-term gains sufficiently in What is The Cryptocurrency Tax Fairness Act of 2017 and how could it affect my Bitcoin transactions?

Now, we have been doing a little basic math here.  $10,000 – $2,000 = $8,000.  In that equation, the $10,000 represents the Fair Market Value, the $8,000 represents the gain and the $2,000 represents your basis, or cost.  It really is just about that simple.  Basis means cost.  Or, more specifically, all costs incurred in the acquisition of the asset.  That means you can add to your basis any fees or other charges associated with the acquisition.

For example, let’s say you used Coinbase to make your crypto purchase and paid a fee of $30 to buy that $2,000 of Bitcoin.

Side note ->  Before I continue, I know someone is skipping to the end already to comment to me that I’d be an idiot to use Coinbase to buy anything when I can transfer everything for free to GDAX and pay no fees on a limit order.  I can assure you, I and the 60,000 Youtube content creators claiming to have just “discovered” this tip on their own are aware of this.  This is just an example to show how to treat a fee.  Now go delete your comment and chill out.

So you paid a $30 fee to acquire that $2,000 Bitcoin.  Because the fee was a cost of acquiring the Bitcoin, you add it to your basis which becomes, in fact, $2,030.  That means your gain is actually only $7,970.00.

You can also deduct the cost of any fees associated with selling your Bitcoin so if it cost you another $30 to sell it, then you would report that as a deductible fee against the gain and reduce the capital gain to $7,940.00.

That, in a nutshell, is how you calculate your basis, your realized gain, and what you report to the IRS.

Like all things associated with the IRS, however, things tend to be much more complex.

For example, let’s assume you don’t have $2,000 to drop on Bitcoin at any given time so you have purchased $200 in Bitcoin per week since October effectively dollar cost averaging your purchase.

Using real, historical  prices now, that means that, roughly, you made the following purchases.

table

Following that methodology, on December 31, 2017, you own just over 0.22 Bitcoin with an overall basis of $2,000.  On December 31, the price of Bitcoin closed at $14,156.40, so the value of your investment at 12/31/17 is $3,167.68, giving you an unrealized gain of $1,167.68.  Not bad.  Would have been a lot better if you could have picked up a whole Bitcoin at $2,000 back in July but you missed the early train same as me.  Talk about a validation for FOMO.

Now, the fun part.  Let’s pretend that on December 31st, you needed to sell some Bitcoin to cover the cost of the new mining rig Santa brought you.  So how do you account for which Satoshis you sold and what your basis was in those specific trades?

First, I need to make a correction.  See two paragraphs ago where I said you have an overall basis of $2,000?  Well, smack my hand because you can’t think of an “overall basis” in terms of your taxable gains and losses. You have to identify each transaction individually to determine the basis and subsequent realized gain or loss on what you sell.

Two common methods of identification are First-In-First-Out (FIFO) and Last-In-First-Out (LIFO).  They mean exactly what they say.  FIFO means you sell the oldest (or “first in”) asset in your holdings.  LIFO means you sell the most recently purchased (or “last in”).

Generally speaking, in times of rising prices, it is most tax beneficial to utilize LIFO.

Think about that.  Prices generally rose from October to December.  Would you rather sell your First-In Bitcoin purchased October 23rd, realizing a gain of $277.42, or would you rather sell the Last-In Bitcoin purchased on December 25th and realize a gain of $1.85?  I’d much rather pay tax on $1.85 than $277.

Likewise, in times of falling prices, it is frequently more tax beneficial to utilize FIFO which will create the bigger loss.  Of course, you can only take the capital loss to offset against existing capital gains but you can carry the loss forward into future tax years if you can’t use it all in this year.  This is the part where I again remind you to read my previous columns and, more importantly, consult with your tax professional.

Also, you should know that the default assumption by the IRS is that you are selling everything FIFO – of course, because that most often creates the largest gain and the biggest tax revenue for them.  The burden is on you to document if you use a method other than FIFO and ensure that you track everything very carefully.

Another method I haven’t mentioned yet is Specific Identification.  This is more challenging in that it requires a more detailed level of tracking but it can be the most beneficial because you can take advantage of the benefits of both LIFO and FIFO, depending upon the current environment, by handpicking which portions of your Bitcoin you will sell specifically.

So, for example, let’s say you need about $800 to cover that mining rig.  You could sell the Bitcoin acquired on November 27th, and December 11th, 18th, and 25th, but not that purchased on December 4th.  That would put $805.51 in your pocket and result in a realized net capital gain of only $5.51, and you are not left with any Loss Carryforward like you would be by selecting December 4th instead of November 27th.

I feel like I need to touch again briefly on a topic I have addressed more specifically in Will we finally get some relief from taxes on our Crypto? (U.S. Tax Code).  That is trading cryptocurrency for cryptocurrency.  If you exchange Bitcoin for Stellar Lumens for example, you are deemed to have sold your Bitcoin for fiat currency at its market price at that moment and purchased Stellar Lumens for their value in Fiat currency at that moment as well.  Although we all know it is a trade, it is deemed to be a separated sale and subsequent purchase thereby creating a taxable gain or loss on the Bitcoin and establishing a new basis for the Stellar Lumens.

Yep, this stuff is complex.  And, honestly, even though you are smart enough to figure out investing in crypto, you cannot get what you need to prepare a tax return from a column like this.  What you can get from a blog like mine is a strong general knowledge that enables you to speak the same language, ask the right questions, and compile and provide the necessary data when meeting with your personal tax professional.

Even if they are new to the crypto space, they have spent a ton of time educating themselves on how to best handle every single scenario they might face and how to thoroughly research new ones like crypto.  And since the tax code has sweeping changes for 2018, they get to do all the research and study again to figure out what best suits your tax situation next year.  But the bottom line is, doing your part by reading columns like this saves your tax professional from spending time educating you on the basics, and saving their time means you get to keep more of your crypto gains for yourself.

As usual, feel free to subscribe for future updates, and when your tax professional marvels at your foundational knowledge and intellect, please consider making a small donation so my wife will quit griping about how much time I waste “goofing around with crypto.” Support The Crypto Tax Center

© Michael L. Collins

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Is Uncle Sam setting up the foundations to Big Brother your Crypto? (U.S. Tax Code)

In my previous column, I hinted that we might all go to jail for money laundering.  While that was a lighthearted reference to today’s topic, Senate Bill 1241, which aims to tighten the controls on money laundering, counterfeiting, and bulk currency smuggling primarily in an effort to reduce the funding of terrorism, the bill actually does throw out a few zingers at the crypto space.

I’ve heard quite a ruckus about this bill so decided to take a look at it myself.  It was introduced in the Senate in May but was referred to the Senate judiciary Committee November 28th and, in its pure form, it really does just appear to be designed to strengthen regulation against money laundering, which is a crime perpetrated to make money earned from another crime seem like legitimate income.  Think of the whole garbage and construction businesses in the Sopranos.  If you haven’t seen the Sopranos, stop reading immediately and go binge the entire series.  I’ll wait here.

The crypto community seems to be up in arms partially because digital currency is specifically mentioned in a bill with such negative connotations.  The truth is, digital currency is mentioned in a lot of bills with negative connotations.  Countering Iran’s Destabilizing Activities Act of 2017 is about as negative a connotation as you can have, and it directly names digital currencies as a means by which this could be accomplished.

I think the simple rule for us legitimate, law-abiding crypto HODLers and traders is to simply not do crime with our crypto.  Easey Peasey.  We make bundles of money, legally, and can all sleep at night.

That said, there are a couple of other pretty concerning references to cryptocurrency in this bill if you dig deeply enough.

The bill itself establishes that cryptocurrency is a means by which money laundering or bulk currency smuggling can occur.  Not a big deal in itself until you see that the bill seeks to establish that the money laundering statute will apply to tax evasion.

The specific language is this:

     SEC. 11. MAKING THE INTERNATIONAL MONEY LAUNDERING STATUTE APPLY           TO TAX EVASION.

     ‘‘(ii) with the intent to engage in conduct constituting a violation of section 7201 or 7206        of the Internal Revenue Code of 1986;’’

Section 7201 of the internal revenue code is entitled, Attempt to evade or defeat tax, and Section 7206 of the Internal Revenue Code is entitled, Fraud and false statements. 

 I have included the exact language of both sections here (US Code Sections 7201 & 7206) if you want to read them in detail but just know that, in general, efforts to evade tax, when prosecuted, can result in serious jail time and monetary penalties.

Uh-oh.

Not “uh oh” for me, cause I am going to pay Uncle Sam every penny I owe. which is a lot of pennies and not a lot of dollars.  But, given that so many in the crypto space seem intent on avoiding the reporting of taxable income related to crypto, it could be an “uh-oh” for many somebodies.

To be completely honest, though, none of that is new.  There have always been significant penalties for tax evasion and they haven’t changed with this bill.  They are just being folded into the criteria defining money laundering.  Why?

That is where what I believe is the scariest point related to this bill comes into play, Section 10, entitled:

SECTION 10: TECHNICAL AMENDMENT TO RESTORE WIRETAP AUTHORITY FOR CERTAIN MONEY LAUNDERING AND COUNTERFEITING OFFENSES.

Specifically, Section 10 aims to include offenses related to (among others) violations of US Code Section 5324 of the Internal Revenue Code which prohibits the intentional structuring of transactions to avoid reporting requirements for taxable income.  This is frequently referred to as “structuring” or “smurfing” in the non-crypto world.  If you read my last column, Will we finally get some relief from taxes on our crypto? I joked about buying a Lambo with 350+ transactions of $599.99 to avoid taxable reporting under the potential new tax rules.  Doing exactly that would be considered structuring by the Feds.

There are currently no real world examples of how exactly this would apply in the crypto space, but I have read an interesting, although somewhat dated, article here:  http://www.fraudsandscams.com/Commentaries/Smurfing.htm

 I suppose the bottom line for me after reading through this piece of the bill can be summarized using simple logic in a nice little if…then statement:  If the bill aims to restore wiretap authority for money laundering and counterfeiting offenses and the bill aims to apply the money laundering statute to tax evasion, then Uncle Sam can wiretap anyone suspected of avoiding income taxes.

In an environment that values anonymity and seeks to enhance the widespread benefits of decentralization, wiretapping at the source (i.e. the personal internet activity of the individual initiating the transactions) could pretty much do away with any anonymity.

All that said, I don’t believe that you will start seeing white vans with guys in black suits running sophisticated electronic monitoring equipment parked on your street anytime in the near or distant future.  I suspect that just like they have set an example with Coinbase (we’ve all by now seen the pop-up message to “please pay your taxes” when you log in), the IRS will find some gross violator and maybe wiretap them (if this bill passes) and prosecute just to show the gazillion small-time investors that it can be done, thereby encouraging them to report.

As an investor and a CPA, let me say that I too encourage you to report, but not because I do not value personal freedom.  Simply put, there is too much legal money to be made by us early adopters through legitimizing cryptocurrency in the public eye and drawing more investors into the space.  The high-risk bet of “saving” money on taxes by failing or refusing to report crypto gains is not likely to pay off in the long run compared to the trillions at stake in market capitalization as crypto is increasingly recognized more and more as a legitimate investment.

As usual, feel free to subscribe by providing your email for updates whenever I publish a new column and if you have found anything I have published of value, please consider a donation to the Crypto Tax Center by clicking here: Support The Crypto Tax Center

© Michael L. Collins

How to tax shelter gains on crypto currencies through a Self-Directed Roth IRA.

If you have not already, I recommend reading my Previous Columns on the topic of cryptocurrencies and taxes, as this column builds upon foundations established previously.

I like little better than the phrase “tax-deferred” or, even better, “tax-free.”  That is why I am so excited to help you seriously consider whether you should open a self-directed Roth IRA to shelter your cryptocurrency profits from capital gains taxes and income taxes.  Before we get to that, let’s talk a little about IRAs in general though.

When it comes to IRAs there are two main types that an individual can open:  A traditional IRA or a Roth IRA.

Traditional IRAs, as we know them today, were established by dear Uncle Sam in 1974 as a way to offer individual tax payers the opportunity to take control of their own retirement.  As corporate-managed, defined-benefit pension plans began to fail miserably, many retired people and others near retirement discovered their promised retirement benefits were missing in action due to poorly managed pension funds (I’m looking at you, American Airlines).  As a result, IRAs became wildly popular.

The appeal of a traditional IRA is that a taxpayer can make investments into the IRA and defer the tax not only on the invested portion but also on any interest, dividends, or capital gains earned on that investment.  Upon reaching retirement age, the taxpayer can start taking distributions, which are then taxable at the taxpayer’s current tax rate.

For example, let’s say you earned $55,000 last year and put $5,000 into an IRA.  In the simplest terms possible, the IRS allows you to say you only earned $50,000, and you have successfully deferred the taxes on the $5,000 investment – good for you.  Now, let’s say you invested all of that $5,000 in Tesla through your IRA because, let’s be honest, that new Roadster is pretty freaking awesome (0-60 in 1.9 seconds – seriously?). Tesla, of course, does amazingly well because why would anyone spend a half a million dollars on a Lambo when you can get a faster car from Tesla for $200,000.  So when you reach retirement age in 30 years, that $5,000 investment is now worth $150,000.  You begin taking distributions on that $150,000, and as you withdraw, it becomes taxable income to you.  If you take $10,000 out, your taxable income is increased by $10,000 in the year distributed.

This all sounds pretty good, huh?

Well, there was one drawback.  Typically, a taxpayer’s income increases over time and the taxpayer climbs into higher tax brackets with age.  It is entirely possible, then, that one might defer taxes of 15% or 25% upon investing the money, only to be taxed upon withdrawal in a 40% tax bracket, so paying higher taxes on the distributions.

That may not be true for everyone but you, my friend, are a crypto investor and, by many accounts, destined to be a gazillionaire, so the odds are, you will be in a higher tax bracket someday when you start taking disbursements.

Wouldn’t it be cool if you could just go ahead and pay your 15-25% tax on the $5,000 before putting it into your IRA and then take the distributions upon retirement age tax-free?  Well, you can.  That is the Roth IRA, and although there are lots of complexities as to how much you can contribute annually (imagine a deep baritone voice in the background saying, “consult your local tax professional” as you read this sentence), it really is that simple.  You pay the tax up front on the investment and get all the earnings on it tax free as retirement distributions.  So, in the example we used above, you actually report all $55,000 of your earnings as taxable income and the $5,000 you put into your Roth IRA can grow exponentially with all related interest, dividends, and capital gains sheltered from any additional taxes upon distribution at retirement age.

In my opinion, there is simply no other way to go between the two options but to take the Roth IRA.  It is truly a piece of legislation that offers an incredible long-term tax benefit to thrifty taxpayers.

You have repeatedly heard me refer to retirement age in relation to distributions from each of these IRA’s.  Of note, though, you can take early distributions from either form of IRA, and that actually becomes an important point as we begin to talk about our ultimate goal of sheltering our crypto gains.  Early distributions are any withdrawals taken from an IRA before the taxpayer reaches age 59 ½ and are subject to a 10% early withdrawal penalty and, in the case of the traditional IRA, taxes on the distribution as well.  Some situations permit an early withdrawal without tax or penalty (like a first time home purchase), while other circumstances might incur tax liability on an early distribution even from a Roth.  The rules are very complex and beyond the scope of what we are trying to accomplish here – refer back to the previously mentioned baritone voice.

By now, you may be starting to recognize why a Roth IRA might be a good tool for holding cryptocurrency investments.  You pay tax on the investment, and later, when the crypto goes to the moon, you can take it out tax-free with, at worst, only a 10% penalty if you withdraw before age 59 ½.  That is a lot cheaper than paying either long-term or short-term capital gains taxes on assets held by you personally.

The challenge becomes how to get the desired cryptocurrency into your personal Roth IRA.

Here, the “self-directed” component comes into play.  Most IRAs today are self-managed but custodian held.  “Custodian held” means a third party such as T Rowe Price, Fidelity, Vanguard, TD Ameritrade, or some other investment firm or brokerage is the custodian of your assets, and you send your fiat currency to them to fund your IRA.  “Self-managed” means that you get to choose from the investment options they offer, but nothing else.  With T Rowe Price for example, you may have decent variety but still be limited to only funds they manage.  TD Ameritrade offers a wider selection including pretty much any stock, plus a variety of bonds and other securities as well but you can’t buy gold or cryptocurrency, for example.

Self-directed IRA’s give you more flexibility in that you can expand your investments beyond those approved by a custodian to encompass a much wider range of options including real estate, precious metals and now, thanks to the IRS declaring that virtual currencies are property (see my previous column What is The Cryptocurrency Tax Fairness Act of 2017 and how could it affect my Bitcoin transactions?), even Bitcoin and other cryptocurrencies.

Setting up a self-directed IRA can seem somewhat daunting, however.  The easiest route is to open an account with a self-directed IRA custodian.  As previously, you still send the investment to the custodian, but instead of being limited to a small handpicked list of investments, you can direct them to purchase whatever IRS-approved asset you desire.  The drawback on this type of self-directed IRA is that custodial fees can get expensive.

A more challenging route is to establish a Limited Liability Company (LLC) that will house the investments. The LLC which is held (or owned) by members, has one lone member, the IRA, which is a separate legal entity from you, the investor.  But, while the IRA “owns” the LLC, you manage it and direct the investment selections.  This type of self-directed IRA is often referred to as a “checkbook control IRA” because you literally control the checkbook.  The drawback here is up-front legal fees, plus it is easy to make a mistake that could void the tax-advantaged status of the IRA putting you in a precarious spot with Uncle Sam.   Maintaining a clear divide between you the taxpayer and the IRA is critical.  Again… baritone voice guy.

No matter which route you take, it is extremely important to understand that you should seek the advice of your personal tax professional in advance.  Any misstep along the way can result in lot of dollars spent without accomplishing your ultimate goal of sheltering the gains on your crypto from taxes.

If you successfully establish a Self-Directed Roth IRA, purchase only one bitcoin through it and it does eventually reach a million dollars as so many predict, these steps could literally save you hundreds of thousands of dollars in taxes.

I will follow up soon with some recommendations on reputable companies that can help you establish a self-directed Roth IRA.

© Michael L. Collins

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