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

Mining for cryptocurrencies and why the IRS may owe you a refund.

Perhaps you have dropped a couple of thousand dollars on a new mining rig and you have it churning away, performing blockchain confirmations for Bitcoin or some other altcoin.  The coins started accumulating and you began to feel like an evil super genius, laughing maniacally as thoughts of Lambos danced in your head.  Then, the post-mining electric bill arrived and it all came crashing down around you as you realized that all those fans whirring 24/7 were actually consuming a significant amount of electricity and the local utility monopoly now wants their share of the take.

Suddenly, that Lambo doesn’t look quite so attainable.

Well, take heart, my friends, because I am going to share some resources to help you determine how you can profitably mine for cryptocurrencies and, more importantly, show you how you can get the IRS to help you subsidize those utility bills and the mining rig through a tax break.  For a while, at least.

Picking a mining rig

To start with, an excellent resource I would recommend if you are interested in mining is www.cyrptocompare.com.  They give detailed analysis on the cost of various graphics cards and mining rigs with a breakdown of the payback period for each piece of equipment, reflected based on the current prices for equipment as well as the current value of the desired coin you might wish to mine.

I will offer one word of caution.  In some cases, they reflect the payback period on just the costs of a graphics card (the Nvida Geforce GTX 970 listed at $520 with an 1,836 day payback period mining Ethereum as of the publication of this column, for example) and in others, they reflect the payback period on the total cost of a mining rig (the ETH Mining Rig Ambition 1070 listed at $43,900 with a payback period of 9,112 days also mining Ethereum) so you don’t necessarily get a true apples to apples comparison in some cases.

With all of these breakdowns, there are even a few losers that currently could never sustain a profit and would only ever generate a loss.  “Why list them then?” you might ask.  Well, it is important to keep in mind that there are a lot of moving parts to these calculations so if one variable changes (i.e., price of the equipment drops or the price of Ethereum skyrockets), the payback period could change significantly and a processor that currently can’t turn a profit may suddenly be able to – especially if the cost of the mined coin rises.  Also, there is the very real possibility that the coin you mine today will be worth far more than today’s prices in the future making the whole process worthwhile after all.  Cryptocompare.com explicitly states what the values are for the estimates they are making – even the estimated kWh per hour cost of utilities.  Further, if you have your own configuration and data, they have a nifty little calculator where you can plug in your own variables.  I find it to be an excellent resource for anyone considering mining.

Now the fun part… Taxes

So you have made your selection and dropped some cash on your desired mining equipment.  What now?  Now you make the tax man help you get started by taking advantage of the various legal deductions you can take for your mining operation.

The key to taking advantage of every opportunity the IRS presents you is fairly straightforward.  Treat mining like a business.

If you have never owned a business before, this can sound pretty scary, but it really isn’t.  You don’t have to get a federal ID number to start.  It can all flow under your social security number and be filed on what is referred to as a Schedule C.  That is simply the portion of a tax return where a sole proprietor reports business income and losses.  So congratulations, you are now a sole proprietor!  Not quite as glamorous sounding as Lone Wanderer for all of you Fallout fans but it still has a nice ring to it.

For purposes of this scenario, I am going to use the Nvidia Geforce GTX 970 simply because that is what I am running in my rig so it is a real world scenario for me.

So based on cryptocompare.com, I will be able to mine $255.83 per year in Ethereum using my machine.  Actually they reflect $103.41, which is net of the estimated electrical costs of $152.42 but let’s hold off on all of the expenses for now.   If you take no deductions on the $255.83 and fall into the most common tax bracket, you will owe 25% of your mining profits in taxes.  That’s about $64 bucks you would owe the IRS.  But we are not going to pay any taxes on this income.

Side note: If you have read my previous columns, you may be asking, “what if I hodl and don’t sell the mined coins?”  Well, again, the IRS does not currently provide clear guidance on that other than to say cryptocurrencies are property.  I believe from the IRS perspective, you will be deemed to have sold the mined coins for their current market value.  If you, in fact, hold them for investment, you have converted them from business income to investment property and they will take the basis for the same exact amount you reported as income.  So if you mine one Ethereum which lists at $270, then you are deemed to have sold it for $270 in USD and have “earned” that amount in revenue.  If, in fact, you hold it, it is as if you immediately bought it back for $270.  If you then later sell it for $250, you will actually have a capital loss.  See my previous column for more clarification on the impact of long-term and short-term capital gains.

So back on point, we have $255.83 in taxable business income.  Now it is time to start chipping away at it.

First, let’s take the layup, $152.42 in increased utility costs as estimated by cryptocompare.com.  Your costs will actually be slightly higher than that because you don’t just plug a GPU into the wall.  You need all the parts and pieces, motherboard, CPU etc.  Review them in part or whole to determine the estimated kWh costs and plug it into the calculators at cryptocompare.com for a better estimate.  Also, document this!  That will be important if the tax man ever cometh riding in on a black steed with sickle in hand to dig through your underwear drawer.

Deducting the utilities puts us at a net income of $103.41.

The next deduction is the cost of the computer itself.  This is going to be your biggest expenditure.  With a GTX970, it is not unreasonable to assume you will spend another $1,000 to have a suitable rig so let’s say your startup cost for that is $1,500 just to keep things clean.

You can’t actually take the full cost in the first year though.  Long-lived assets have to be depreciated (expensed over multiple years).  I, and probably most other conservative CPA’s, would probably call it 5-year property but I could almost argue that with the rapid changes in technology and the fierce competition out there for mining, it might have a useful life of only 3 years.  For this example, let’s stick with 5 years.

The IRS utilizes Accelerated Cost Recovery methods to calculate depreciation which is actually good for us, allowing us to deduct a larger portion in early years.  In this case, we are using what they call the Double Declining Balance Method (also known as the 200% Declining Balance Method) which means we divide the asset cost by its useful life, so $1,500 divided by 5 years gives us $300.  Then we double the result giving us $600 which is the portion we can deduct in year one.  That will leave $900 for us to deduct in future years.

Also, there are other rules which allow you to take a larger portion of the asset in year one that are commonly known as Section 179 deductions but for this example, it is unnecessary.  If you want to read more about Section 179, click here.

So, if we do a little more number crunching, we take $103.41 less our $600 in depreciation and suddenly we have a beautiful business tax loss. -$496.59 to be exact.

We have now generated a tax loss that can be used to actually reduce taxable income you might have in another category – from your W-2 or other business income, for example.  But we’re not done yet.

Now, think about where you have that rig sitting, clicking and whirring 24 hours a day, performing a valid business function for you but taking up personal space in your beloved resdience.  This is my favorite deduction which the IRS refers to as “Business Use of Home.”  This can be a tiny number or a relatively decent number depending upon a number of factors.  The first thing is to make sure you have a designated space for your mining business.  It could be as large as an office completely dedicated to mining or as small as a small desk or stand to hold the PC.  The calculation to determine how much of a deduction you can take is based upon the ratio of square footage used for the business to the square footage of the home or apartment.  Then take that ratio against the number of hours of use per day.  Although 24/7 business use is rarely allowed in a home, this rig is running 24 hours a day so you get 100% of the square footage ratio in my opinion.  Next you take that percentage against either the rent paid or the mortgage interest you are paying on the home.  You can actually use a portion of your mortgage interest as a business deduction which is better than simply taking it as an itemized deduction if you have gone that route previously.  Whatever portion you can’t use for the business deduction can still be taken as an itemized deduction though.  This typically isn’t a gigantic amount, but every penny helps.

For simplicity’s sake, let’s say it calculates out to $20.  Now you have a business tax loss of -$516.59 which can be used to directly reduce your otherwise taxable income… dollar for dollar.

That scenario is actually a pretty conservative estimate if you are serious about mining and sink some significant money into it.  If you are going that route or just tinkering around for fun, I strongly encourage you to seek the advice of a qualified tax professional which, by the way, can also be taken as a tax deduction.

Pitfalls

An important thing to note is that you should actually strive to make a profit within a few years.  This is important because if you continue to lose money after three or four years, it is entirely possible that the IRS will deem your little mining project to be a hobby and no longer allow you to use the business loss to offset other taxable income.  If you later turn it into a profit-making venture, they will be happy to forcibly reinstate it as a business and collect taxes on your profits.  Seriously they will do that.

Don’t worry though, you have done your due diligence and documented thorough research at cryptocomparison.com that you have the equipment to eventually turn a profit, which frees you up to shamelessly take your business loss this year and reduce your tax burden.  Good for you.

Now go out there and mine some crypto!

Finally, if you didn’t TL;DR me, I probably saved you honest tax payers a bunch of money.  Now send me a Satoshi or two by clicking here and go impress you tax preparer with your newfound knowledge.  Also, view an important disclaimer here.

© Michael L. Collins