Cryptocurrency: Big Gains, Big Taxes (Part 1)

We've all heard stories about Bitcoin millionaires - people who took a chance early on, invested a few hundred dollars, and now they're worth millions. The stories are real and have inspired generations of people worldwide to get in on the cryptocurrency action. Bitcoin, specifically, has become the best-performing asset of the last decade, with the market cap hitting over 1.2 trillion dollars at its peak in November 2021.

The IRS treats cryptocurrency as property, and, just like your home, taxes are assessed on the gain, i.e., the difference between the purchase and sale price. With cryptocurrency, the gains can be a magnitude larger than is usually associated with appreciating assets. Returns of 10,000X are not unheard of, especially for early investors. Big returns can mean big tax bills.

How Cryptocurrency Gains Are Taxed

The IRS permits taxes on cryptocurrency to be calculated in three ways. The default method is called "First in First Out," or FIFO. Using the FIFO method, gains are calculated by determining the difference between the purchase price of the first unit of a particular cryptocurrency bought and the price when units of that same cryptocurrency are sold. The problem with the FIFO method, however, is that it does not account for subsequent units purchased at an elevated price. If, for example, you bought a "coin" for $5, and a year later bought another for $90 and then sold one of your coins for $100, the FIFO method will assume a $95 dollar gain. Taxes calculated with the FIFO method can be unusually harsh for someone trying to sell cryptocurrency assets that have appreciated dramatically over the years.

If you keep good records of your cryptocurrency transactions, however, you might calculate taxes based on the "High In, First Out," or HIFO method. As the name implies, the HIFO method allows you to calculate your gain based on the gain associated with the most expensive coin purchased. Going back to the example above, under the HIFO method, the taxable gain on the $100 "coin" sale would be $5, not $95.

Likewise, a cryptocurrency owner may take advantage of the "Specific ID" method when calculating taxes. Again, as the name implies, the Specific ID method allows the taxpayer to sell specifically identified units of cryptocurrency, as opposed to a more generalized number of units. As an example, if you own 100 Bitcoins and sell 10, under the Specific ID method,
you could choose exactly which 10 you sell. If utilized properly, both the HIFO and Specific ID methods are powerful tools to reduce cryptocurrency tax consequences.

So, why use FIFO at all when both the HIFO and Specific ID methods are far more advantageous? The HIFO and Specific ID methods require meticulous record-keeping, and most cryptocurrency exchanges, especially decentralized exchanges, don't provide statements like traditional brokers would. If you didn't keep good records of every purchase, sale, and exchange or swap of one cryptocurrency for another, or don't know how to recreate such records, your taxes will be calculated via the FIFO method.

Detailed records are essential to minimize taxes on cryptocurrency. Whether you are new to cryptocurrency or an experienced investor, record the date, time, amount paid (including fees) for any cryptocurrency purchased, and the value per coin during the transaction.

Likewise, if you sell cryptocurrency or exchange one coin for another, record the date, time, amounts sold or exchanged, and the values of the coin(s) at the time of transaction.

The Bottom Line

If you own cryptocurrency, the burden is on you to keep detailed records of every transaction! If you have concerns about how your investments - crypto or otherwise - will be taxed, please contact us to discuss.

Contributed by: James Crosland, Esq., Associate, Frost Law

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