Different cryptocurrencies have risen in popularity in the recent few years. And this fame has urged governments to take notice and regulate this new stream of revenue. In other words, the IRS (Internal Revenue Service) has released guidelines on cryptocurrency tax calculations for investors.
Cryptocurrency tax calculations can often seem confusing, particularly for those who are new to this trading platform. However, if the income generated is not reported properly, it can invoke penalties and even criminal prosecution. The following guide is designed to break down the crypto tax implications for those filing the crypto taxes in the U.S.
What Are the Different Taxation Methods for Cryptocurrency?
Since 2019, the costing methods for calculating cryptocurrency-related capital gains have become explicitly clear. Prior to this FIFO, or the ‘First in, first out’, calculation method was used extensively by traders for determining their tax liability. Today, LIFO (Last in, first out) and HIFO (Highest in, First Out) can also be used for calculation purposes. This is good news for cryptocurrency traders as it allows them to benefit from opportunities for tax savings.
The following three calculation methods use different ways to calculate this cost price of the currency:
FIFO - First In, First Out
As the name suggests, this method of calculation takes into consideration the first cryptocurrency coin that is purchased as the first item that is considered for a sale.
Using the FIFO method, capital gains will be calculated as per the price of the 1st 10 units that were bought on 10th February 2017, i.e. $400 per unit or $2000 for all.
So, FIFO calculation will be as follows,
In other words, the coins are sold in the same chronology as they were purchased, hence, ‘First in, First out.’
LIFO - Last in, First Out
In complete contrast, the LIFO method takes into consideration the last units purchased as being the first ones for sale. So, the calculation of capital gains and selling price will be done on the last 5 BTC purchased. The calculation will be as follows,
HIFO - Highest in, First Out
This method uses the coins with the highest purchase price as the one sold first. So, the calculation will be as follows,
The HIFO method is ideal for minimizing tax as it is designed to calculate the largest capital losses as well as the lowest capital gains providing the tax calculator the best case in both the scenarios. While here the HIFO is displaying the same capital gain figure as LIFO, it changes as volumes increase.
Out of the 2 methods of calculation, HIFO and LIFO can help the taxpayer arrive at a lower amount of capital gains on which crypto tax may be owed. On the other hand, FIFO is a great method for tax-loss harvesting as it helps generate the most amount of losses.
In short, they protect one from paying short term capital gains rate as they extend the overall holding period of the Cryptocurrency. Also, capital losses generated from the sale of cryptocurrencies are allowed to be deducted against any other capital gains as well, even if these gains are not from cryptocurrency.
Comparing Unrealized and Realized Crypto Gains
Both unrealized and realized cryptocurrency gains (as well as losses) have different tax implications. To realize the difference between them, it is important to understand that any capital gain or loss can only be counted towards tax once it is realized. Even if the taxpayer owns a crypto asset that is showing a loss, it cannot be claimed unless the asset is sold.
Realized Gains and Losses
Any gains on cryptocurrency are not considered as ‘realized’ until it is sold, exchanged it, or spent. However, claiming realized losses as capital losses can offset other capital gains and help minimize taxable income.
Unrealized Gains and Losses
On the other hand, if the taxpayer has bought the cryptocurrency once and not sold or exchanged it then there is a case of ‘unrealized’ capital gains or losses. And, because the gain or loss is not realized, there is no need to claim it as a profit or loss. This allows one to hold onto cryptocurrency and potentially defer the associated taxable income.
Comparing Multiple vs. Single Depot Methods
Multiple and Single Depot transaction methods are simply different ways of representing cryptocurrency transactions to calculate gains or losses enabling tax calculations.
The multiple depot calculation methods take into consideration all exchanges as well as wallets as separate depots. Therefore, the short-term gain or loss calculations are based on individual transactions pertaining to that specific cryptocurrency silo.
On the other hand, a single depot calculation considers all different trades as one large virtual depot for tax estimation purposes. In other words, the short-term gain or loss is calculated based on all trades of the cryptocurrency in one large virtual depot.
While both methods have their own advantages and disadvantages, the benefits depend on the volume, rate, purchase, as well as the sale price of transactions being considered for a specific taxation period.
Cryptocurrency received in any form including from forks, mining, airdrops, lending, etc. will be treated as regular income and must reflect as such in income tax calculations. However, it is essential to remember that cryptocurrency is considered as property for tax calculation purposes. And any sale of this cryptocurrency will attract a capital gains tax depending on the duration for which the cryptocurrency was held. Therefore, the best method to minimize crypto tax is to buy and hold cryptocurrency for more than a 12-month period.