Calculating gains/losses from the sale of cryptocurrency

Cryptocurrency is a type of digital currency that is not reliant on a central government or bank. It is an exchange on a computer network that is stored on a digital ledger where transactions are secured and verified through cryptography. Coinbase, a popular exchange, had 30,000 users in January 2013. As of March 2021, that number grew to 56 million, with more than $223 billion assets in USD. As large as that sounds, the total value of crypto assets on Coinbase accounts for 11.3% of the entire crypto market capitalization.

With this much wealth that has been created, the IRS has taken notice—so much so that they put a question on page 1 of the 2021 1040 U.S. Individual Income Tax Return asking “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?”

Classification of cryptocurrency

The IRS considers cryptocurrency as “property” (IRS Notice 2019-21). If your client bought and sold bitcoin, then the client would have to report their sale of bitcoin as a capital gain/loss on Schedule D and include it on Form 8949, Sales and Other Dispositions of Capital Assets, if the basis was not reported to the IRS. 

Here are practical steps to reporting the gains and losses from the sale of cryptocurrency:

Track your basis. Your basis is your original purchase price, plus any fees to obtain that cryptocurrency. Although the value of these cryptocurrency purchases are held on a blockchain, it is important to keep detailed records of the purchases and dates, as it can become complicated quickly without proper record keeping and documentation. 

Determine if there was a transaction. The IRS defines a transaction as: 

• Conversion back to your fiat currency (typically USD).
• Trading one currency for another currency.
• Purchasing a product or service with cryptocurrency.

Under any of the above three transactions, the taxpayer will need to recognize the gain between the acquisition price (basis) compared to the “strike price” when the transaction or event takes place.

Determine your accounting method: FIFO, LIFO, or HIFO. When a taxpayer reports sale of cryptocurrency for the first time, they have three methods.

• Specific Identification—If a taxpayer owns multiple units of one kind of virtual currency acquired at different times with different basis amounts, the taxpayer can choose which units are deemed sold, exchanged, or otherwise disposed of, provided the taxpayer can specifically identify which units are involved in the transaction and substantiate one’s basis in those units. 
• FIFO: First In First Out—If specific identification is not chosen, the units are deemed to be sold, exchanged, or disposed of in chronological order beginning with the earliest unit of the virtual currency you purchased or acquired on a FIFO basis. In this method, a taxpayer is selling the earliest purchased coin, which could end up being a bigger capital gains tax bill for those who have appreciated stock. FIFO is also a great method for tax-loss harvesting as it helps generate the most amount of losses. 
• LIFO: Last In First Out—Another method of specific identification is the LIFO model. In a period of rising cryptocurrency prices, LIFO will most likely lead to less total taxable gains. When prices fall, LIFO will most likely yield better savings. But this method might not be ideal for those active traders as capital gains could be considered short term, which aren’t subject to preferential capital gains rates. 
• HIFO: Highest In First Out—The last method of specific identification is HIFO. A higher cost basis translates to less tax on your sale. When you sell cryptocurrency, you can pick out the most expensive bitcoin you bought and use that number to determine your tax obligation.

Calculate: While it is possible to calculate manually, there are great options out there for automating the tracking of purchases and sales provided you connect a third-party app with the taxpayer’s wallet. Cointracker.io, Legible, and CoinLedger are just some of the options to help tax professionals keep in step with their clients’ books. There are also options to automate accounting methods such as FIFO, LIFO, and HIFO and provide you with real­time results as transactions happen within your clients’ wallets.

Conclusion

When you sell virtual currency, you must recognize any capital gain or loss on the sale, subject to any limitations on the deductibility of capital losses. But cryptocurrency is still evolving. As the Metaverse and Decentralized Finance (DeFi) start to transform the way cryptocurrency is used, tax practitioners need to embrace the fact that cryptocurrency may be the new normal and need to keep in step with the ever-changing landscape of their clients’ financial portfolios.

Editor’s note: Access a library of crypto articles on the Intuit® Tax Pro Center.