When you trade, sell of cryptocurrency , or exchange a digital asset (read cryptocurrencies), it will always give rise to either gains or losses on transactions. The nature of gains or losses depends on the nature of digital asset holdings. If you are in the business of buying and selling cryptos, profit or loss shall be your business income or loss. But if you purchased the cryptocurrencies as an investment, the sale or transfer will give rise to short- or long-term capital gains. Selling or trading is one of the eight taxable events of cryptocurrencies..
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Gains or Loss of Business in Cryptos
It is easy to understand. Just as in any other business, purchasing cryptocurrencies as stock-in-trade will give rise to business profit or loss. Every expense incurred for earning income from the business of trading digital goods is applicable. At the end of the year, net profit or loss will be taxed at the ordinary income tax rate.
Gains or loss on sale of cryptocurrencies held as investment.
The digital asset is regarded as “property”.The holding period of digital assets (property) before sale/transfer determines whether the resulting gains or losses are long-term or short-term capital gains/losses. The tax rates applicable to long-term capital gains are lower and specified, whereas the short-term gains are taxed on ordinary slab rates or rates applicable to the sellers of digital assets.
How do you compute capital gains or losses on crypto trades/exchanges?
Computing gains or loss is principally easy -sale minus the asset’s cost. However, unlike traditional assets, the computation of gains or losses is more complex in digital assets.
You must find out the following for computing capital gains /loss on the sale or trade of digital assets. :
- Precise sale value
- Basis of the digital asset sold
- Period of holding of digital asset
- Method of accounting -FIFO or LIFO?
1. Precise Sales Consideration
Finding “precise sales consideration is easy, as it is the sale value on any crypto exchange.
2. Basis of the Digital Asset( Cost of acquisition)
The cost basis of digital goods is complex, depending on how you acquire the digital asset. When you acquire cryptocurrencies through a trading platform or exchange, the cost basis of the cryptocurrency is the amount that is recorded by the trading platform or the exchange for that transaction.
However, suppose the digital asset acquisition is made “off-chain”, meaning the transaction is not recorded on the distribution ledger. In that case, the basis is the amount that the virtual currency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it had been an “on-chain” transaction.
If the cryptocurrency is acquired in a peer-to-peer transaction or another transaction that does not involve a platform or exchange. In that case, the basis of the cryptocurrency is determined at the date and time the transaction is recorded on the distribution ledger or would have been recorded on the ledger if it had been an on-chain transaction.
3. How period of holding is determined?
The period of holding determines the nature of capital gains. If the period of holding of a digital asset is more than 12 months, the digital asset is a long-term capital asset and transferring (sale) will give rise to long-term capital gains. Otherwise, the gains are short-term capital gains.
Section 1223 of the Internal Revenue Code provides the method of determination of the holding period of a “property”. As already above, digital assets are considered “property.” Therefore, general principles set in section 1223 of IRC are applied to determine the holding period of digital assets.
The holding period for digital assets begins the day after the digital asset is received. But, there are special rules for finding out the holding period of digital assets in the following specific situations:
(i) Short-against-the-box strategy or constructive sale cases
Let us first know about this constructive sale of property, known as “short against the box”.This is a strategy used by investors where they short-sell a security or digital asset they already own in their portfolio. While traditional securities have regulatory restrictions for “constructive sale”, the world of cryptocurrencies doesn’t have such extensive regulations, so many investors apply the same strategy in the crypto market. Here’s how it could work:
Let’s say that you own 10 Bitcoins (BTC), which you purchased when the price was $20,000 per BTC. Now, the price has increased to $60,000 per BTC.
- You foresee that there might be a drop in Bitcoin’s value in the near term, but you want to hold onto your Bitcoin for the long term, perhaps because you believe in its value proposition or don’t want to trigger a taxable event.
- To protect against potential losses, borrow another 10 BTC from a lender offering crypto loans and sell them immediately at the current market price of $60,000. You now have a short position of 10 BTC and a long position of 10 BTC.
- As you predicted, Bitcoin’s price drops to $40,000. You buy back the 10 BTC you owe for $400,000. Remember, you sold them for $600,000, so you’ve made a $200,000 profit on the short sale.
- So, even though the value of your originally owned Bitcoins has decreased by $200,000 ($60,000 – $40,000 = $20,000 decrease per Bitcoin x 10 = $200,000), this loss is offset by the profit made from your short position.
(ii) Holding period in constructive sale cases
Section 1259 of IRC provides law for the recognition of gain on the sale of appreciated financial position of a property, which includes “digital assets”. This provision of law forces an investor to recognize the gain concerning hedged positions.
The IRS” Ruling 2014-21 and “the Commodity Futures Trading Commission have issued rules stating that virtual currencies should be treated as commodities. The “appreciated financial position” definition under Code § 1259 does not include commodities. Taxpayers generally do not treat commodities as subject to Code § 1259. Accordingly, without further IRS guidance or rulings, an interpretation may be taken that IRC § 1259 does not trigger a constructive sale when cryptocurrency is sold short against the box.
The holding period of the appreciated financial position is determined as if the position were originally acquired on the date of the constructive sale.
For example, let’s say you have held 1 Bitcoin (purchased at $10,000) for 11 months, and its value has increased to $20,000. Anticipating a market decline, you short-sell Bitcoin (short against the box). If you maintain this short position for two months, this period will not count towards your original Bitcoin’s holding period. Hence, even though you technically bought the Bitcoin 13 months ago (11+2), for tax purposes, your holding period for original holding is considered to be 11 months.
Readers should be careful while interpreting that section 1259 does not apply to “appreciated financial position “because FAQs issued by the IRS state that when a taxpayer owns multiple units of one kind of cryptocurrency and sells or is deemed to sell, exchange, or otherwise dispose of some units, the taxpayer is free to choose which units are deemed sold, exchanged, or otherwise disposed of, but only if a taxpayer can specifically identify which unit or units of cryptocurrency are involved in the transaction and can substantiate his tax basis in those units.
(ii) Holding period in case of digital assets received as a gift
If you receive digital assets as a gift, your holding period includes the time the virtual currency was held by the person who gifted it to you. This means the holding period is not reset when you receive the gift.
Method of accounting -LIFO or FIFO
Last In First Out (LIFO) and First In First Out are two accounting principles of movements of inventories from stock.
When you sell all the cryptocurrency simultaneously, it does not matter which digital asset was bought first. But when you sell some digital assets out of your holding, it certainly matters which one you are selling. Unlike stocks, it looks like from the FAQ published by the IRS, only two ways are available for determining which digital asset was sold out of total holding:
- FIFO – First In, First OUT – so when you sell some out of many of your digital assets, the digital assets that came to your wallet first will be deemed sold. So, the cost of acquisition and holding period will be determined for those digital assets.
- As per FAQ, the IRS also says that if you can claim that a specific digital asset was sold, only if you identify a specific unit of virtual currency either by documenting the unit’s private key, public key, and address or by records showing the transaction information for all units of a specific virtual currency held in a single account, wallet, or address.
The LIFO (Last in, First Out ) method is not allowed while deciding which digital asset was sold. When you collect all four pieces of information, computing the capital gains or losses on the transfer/sale of digital assets becomes easier.
While the information on this site - Internal Revenue Code Simplified-is about legal issues, it is not legal advice or legal representation. Because of the rapidly changing nature of the law and our reliance upon outside sources, we make no warranty or guarantee of the accuracy or reliability of information contained herein.