Cryptocurrencies, like any other investment, are subject to taxation. However, tax rules surrounding cryptocurrencies can be harder to navigate than other asset classes.
Given the novelty of the technology, many investors don’t fully understand how cryptocurrency taxes should be filed and calculated. Some investors might not even be aware that taxes should be reported. New tax laws and regulations are constantly being introduced to keep up with recent developments in the technology.
Informed discussions can help investors cut to the chase and stay on top of these requirements. Here’s how financial advisors can prepare for conversations about crypto taxes with clients.
- Many clients are unprepared to handle taxes on their crypto investments, as tax rules surrounding cryptocurrencies can be harder to navigate than other asset classes.
- Having discussions ahead of time with a financial advisor can limit unnecessary headaches.
- Cryptocurrencies are treated as property and taxed as investment income, ordinary income, gifts, or donations in the United States at the state and federal levels.
Understanding Cryptocurrency Taxes
In the United States, cryptocurrencies are treated as property and taxed as investment income, ordinary income, gifts, or donations for tax purposes at the state and federal levels. Tax laws vary by state and territory but are the same for individuals, corporations, and funds federally. The cryptocurrency can be anything from Bitcoin or Ethereum to non-fungible tokens (NFTs) and decentralized finance (DeFi) products. The Internal Revenue Service (IRS) is the federal tax agency that handles taxes across all U.S. states and territories.
- Investment income: Crypto that is bought and later sold, usually on a crypto exchange, is considered income from an investment. Returns are taxed as short- or long-term capital gains or capital losses, similar to stock trades.
- Ordinary income: Crypto is considered ordinary or non-investment income when it is not purchased by the holder and is received as a form of payment or passive income, usually from interest-bearing accounts, an employer, staking, mining, or a cryptocurrency airdrop.
- Gift: Crypto is considered a gift if it was given for free and wasn’t a payment, loan, or interest.
- Donation: Crypto donations are tax-deductible for donors. Recipients owe gift taxes.
Federally, long-term capital gains are taxed according to a sliding scale that depends on income level and is capped at a fixed percentage. Tax rates on short-term capital gains and ordinary income are equal to the tax rate of the annual income tax bracket corresponding to the tax-filing status of an individual, a business, or an investment fund.
Tax-registered entities like corporations, nonprofits, and limited partnerships pay different tax rates, including variations between S corporations (S corps), limited liability companies (LLCs), and other corporate structures. Ordinary income may include self-employment taxes if the crypto was paid as a wage.
Gifts worth less than a certain amount don’t carry federal tax implications and don’t need to be reported to the IRS. After they hit that limit, gift taxes apply and increase based on their taxable value up to 40%. Virtual currency received as a gift is not considered income until it is sold, exchanged, or otherwise disposed of.
Donations made in crypto can be deducted from gross income to lower taxable income, similar to standard and itemized tax deductions.
Many investors might not know that quarterly estimated taxes must be filed if they expect to owe more than $1,000 in crypto taxes on their annual federal tax return.
Discussing Crypto Taxes with Clients
Discussing cryptocurrency taxes with clients is important to minimize their tax liabilities for financial planning purposes and to avoid potential consequences from tax authorities. Failing to file returns and pay the correct amount of taxes could result in time-consuming audits and stiff penalties from financial regulators. Investors may be tax-advantaged by moving to other states and territories, trading in certain volumes and frequencies, or calculating taxes with reference prices that present less capital gains taxes.
The IRS and some states ask about cryptocurrencies on tax forms and have dedicated personnel to figure out if taxes aren’t reported. Popular crypto exchanges—like Coinbase, Kraken, and Gemini—share data on customers who earn above a certain threshold of cryptocurrency income in a taxable year. Cryptocurrency tracing technologies—like Chainalysis, Elliptic, and TRM Labs—are contracted to trace unreported transaction activity and correlate it with known identities.
Some states or territories don’t require income taxes or capital gains taxes. Other states or territories don’t require personal taxes, but require corporate taxes, and could offer generous tax breaks and incentives for digital assets. Federally, cryptocurrencies sold after one year are taxed at long-term capital gains rates; short-term capital gains are taxed at the same rate as income; and every trade is always taxed no matter the size of the transaction, whether cashing out from crypto to fiat currency or converting between different tokens.
Taxes on crypto holdings recognized as investment income—or when the crypto transaction functionally becomes a trade—are calculated using cost bases of digital currencies purchased in one of two directions. That includes progressing forward from the assets that were first purchased with the first-in, first-out (FIFO) inventory method, or regressing backward from the assets that were last purchased with the last-in, first-out (LIFO) method.
A capital loss is booked if the cost basis of the asset—or the purchase price plus transaction fees, commissions, and acquisition costs—is higher than the sale price of the asset, or the price when it was sold minus transaction fees, commissions, and acquisition costs. A capital gain is booked if the sale price is higher than the cost basis.
Thus, in some circumstances, active investors could owe more in federal taxes than passive investors; clients in higher federal income tax brackets could pay less taxes on crypto held longer than 12 months; taxpayers who engage in crypto tax-loss harvesting and sell on the downturn could book capital losses instead of capital gains to offset tax liabilities; and residents of certain states or territories could pay next to nothing on crypto taxes, an advantage for investors who make regular transactions.
Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Wyoming don’t have income taxes or capital gains taxes. Puerto Rico is a U.S. territory that doesn’t require capital gains or federal taxes.
Preparing for the Crypto Taxes Conversation
It’s important to be aware of the distinction between tax planning and tax advice. Financial advisors who are not licensed to prepare tax returns can work with clients on tax planning broadly—for example, setting aside enough money to cover taxes or informing clients of their likely tax rate. But they should avoid offering more direct, specific tax advice. Tax advisors, on the other hand, are licensed to prepare tax returns and can offer more specific advice about which tax forms clients must file or what they are required to report on taxes.
If financial advisors offer tax advice without the necessary permissions or licenses and give a client faulty advice, it could open them and their firm up to legal liability. When it comes to discussing crypto taxes—or any taxes—with clients, keep in mind what kind of advice or information you’re able to offer clients and what should be left to tax professionals instead.
With that in mind, to prepare for your conversation with a client, aim to understand what cryptocurrencies they’ve held and how they’ve interacted with them. Without knowing how the assets were obtained and valued, you can’t calculate how much they owe in taxes or distinguish if they’re taxed as investment income, ordinary income, gifts, or donations.
A client working with a tax advisor will need to compile records indicating the exact times, days, and prices when the crypto assets were received, bought, or sold; where the crypto originated from; and what transaction fees, commissions, and acquisition costs were charged—which will affect the cost basis of their returns. These records can usually be downloaded from the crypto exchange or platform where the trades or transfers happened.
While it would be beyond the scope of expertise of a typical financial advisor, a tax advisor should find out what tax forms the client is required to file. That includes confirming their state or territory of residence. Taxes are different across each state or territory and come with unique sets of forms. Federal tax forms are standardized across the U.S., regardless of state or territory.
For crypto assets that clients are continuing to hold and haven’t yet liquidated, gauge your client’s financial goals and contingencies. The advice you give will differ if they are moving to another state or territory in the near future, or if they prefer to sell all their crypto this year instead of holding them for another decade before making changes.
Some clients could be short on cash and need to free up wealth soon. Other clients could be either well-positioned to have longer investment horizons or planning to relocate to states or territories with dramatically different tax rates.
Basic Calculations for Crypto Taxes
There are several mathematical formulas and concepts that cryptocurrency owners in the U.S. must understand if they want to calculate their cryptocurrency taxes: cost basis; sale price; capital gains and losses; first-in, first-out (FIFO); and last-in, first-out (LIFO).
The cost basis is the initial value paid to buy a token or the value at which the token was received (price multiplied by the number of units), plus any entry and acquisition costs, which could include transaction and commission fees.
The cost basis is essential for calculating the value of crypto assets of any tax distinction, including investment income, non-investment income, gifts, and donations. Crypto investors tend to deal with a huge variety of cost bases due to characteristic market volatility and fluctuating transaction fees.
The sale price is the final value at which a token is liquidated into cash or swapped for another crypto (price times number of units), minus exit and selling costs, which could include transaction and commission fees. The sale price comes into play only when capital gains or losses need to be calculated—or, in other words, when the crypto is taxed as investment income.
Capital Gains and Losses
Capital gains or losses apply only to cryptocurrencies that are part of discretionary trades taxed as investment income, when a crypto is bought and sold for cash and when it is converted between two different assets. The capital gain or loss is the sale price minus the cost basis of a traded position and is also referred to as the return on investment (ROI).
First-in, First-out (FIFO) and Last-in, First-out (LIFO)
Capital gains or losses are calculated for a succession of crypto trades with a series of cost bases starting from the first units of the asset that were purchased. The LIFO approach starts with cost bases from the last units. If an investor chooses the FIFO approach, they cannot use the LIFO approach, or vice versa.
Communicating Complex Concepts
Taxation is filled with complex subjects that tax advisors should break down clearly. That way, clients investing in crypto won’t need to clarify the same issues repeatedly and can make judgment calls that will benefit them the most over time. Starting small could help lay the groundwork. Educate clients on basic concepts, then work your way up to more advanced concepts.
Offering examples with hypothetical numbers can be a good way to begin to illustrate how a tax subject works. For instance, you can say, “If someone bought $10,000 in Bitcoin and sold it for $15,000, they have to pay taxes on that $5,000 in profit,” to help a client understand the concept of capital gains.
From there, the examples can be tailored to a client’s particular tax situation. Numbers can be adjusted to reflect specific crypto holding amounts. Calculations can be drawn out with the assistance of visual aids and software programs, such as drawing boards, educational videos, and tax calculators.
Clients may find tax forms intimidating and need an expert to distill them. Walking through the tax forms step by step along with the state, territory, or federal tax agency’s corresponding instructions could eliminate confusion that clients will likely have when they try to fill them out.
The more complicated examples demanding demonstrative teaching aids will likely involve explaining how to calculate capital gains or losses across multiple crypto assets, multiple tax distinctions, such as investment and ordinary income, and using the first-in, first-out (FIFO) or last-in, first-out (FIFO) approaches.
Here are some examples for illustrating some of these advanced concepts:
Multiple Tax Distinctions
A crypto gift of $1,000 of bitcoin would incur a taxable capital gain of $1,000 if it is converted into $2,000 of ether.
If it is held long-term as bitcoin, it would be recognized as ordinary income. But if it is sold—for example, when the bitcoin reaches $3,000—that gain would be taxed depending on how long the gift was held. Short-term capital gains are taxed at ordinary income rates, but long-term capital gains are subject to a lower tax rate.
Multiple Crypto Assets
If an investor bought bitcoin for $10, then swapped the bitcoin for $13 of ether, then swapped the ether for $14 of Litecoin, then sold the Litecoin for $11 of cash, the capital gains would be $3 ($13 ETH – $10 BTC) + $1 ($14 LTC – $13 ETH) + -$3 ($11 USD – $14 LTC) = $1. The capital gains—or losses in the last trade—are calculated at each conversion by subtracting the cost basis from the sale price.
First-in, First-out (FIFO) and Last-in, First-out (LIFO)
If an investor buys 10 bitcoins worth $50, then later buys 10 more bitcoins worth $100, then later buys 10 more bitcoins worth $200, then sells 15 bitcoins worth $60:
(a) The FIFO approach would assume a sale price of $60 and, for the first 10 bitcoins cashed out, a cost basis of $50 (from the first 10 bitcoins that were purchased), netting $10 in capital gains. For the remaining 5 bitcoins cashed out, a cost basis of $100 (from the following 5 bitcoins that were purchased), netting $40 in capital losses; resulting in a total capital loss of $10 + -$40 = -$30.
(b) The LIFO approach would assume a sale price of $60 and, for the first 10 bitcoins cashed out, a cost basis of $200 (from the last 10 bitcoins that were purchased), netting -$140 in capital losses. For the remaining 5 bitcoins cashed out, a cost basis of $100 (from the previous 5 bitcoins that were purchased), netting $40 in capital losses; resulting in (iii) a total capital loss of -$140 + -$40 = -$180.
Crypto exchanges domiciled in the U.S. are legally required to report account activity on customers who profited at least $600 on their trades every year. Exchanges send documents with this information, Form 1099-B, Form 1099-K, and Form 1099-MISC, to the IRS and the customer at the end of the tax year.
Addressing Common Client Questions
Expect clients to pose a number of questions about a subject as nuanced as cryptocurrency taxes. Being ready to clarify the most common questions can help quickly smooth over most concerns. That can be achieved by doing research ahead of time and identifying which issues are mentioned often.
Here are some questions that frequently pop up regarding cryptocurrency taxes:
How much will I owe in taxes on my cryptocurrency holdings?
Clients might want financial advisors to exercise an outcome-based approach and give them a concrete perspective on their tax obligations. These numbers don’t need to be exact but should provide an estimate of the client’s tax rate.
Are taxes calculated differently for each cryptocurrency asset?
Cryptocurrencies are taxed based on their origins, not their names. A single crypto asset, like bitcoin or ether, could be taxed differently if it came from different sources. Multiple crypto assets, popular or niche, could be taxed similarly if they came from similar sources.
The tax rate specific to the source will apply to only the amount of crypto that came from the source at a given time. Taxes calculated across different sources are then added up to determine the overall tax owed. Sources include exchanges, mining, staking, interest, airdrops, and family and friends.
How can I reduce the cryptocurrency taxes I owe?
Clients look for cost-cutting measures in their everyday budgets, spending habits, and tax liabilities. Knowing the ins and outs of as many applicable tax codes, investment products, and financial mathematics as possible will help elucidate the most effective tax-saving strategies and prevent oversight of options that could have been taken into consideration.
Clients may be interested in mitigating their crypto tax liabilities with tax-deferred savings accounts and tax-free savings plans. Crypto transactions placed through a traditional individual retirement account (IRA), Roth IRA, 401(k), Health Savings Account (HSA), and Flexible Spending Account (FSA) are not taxable.
Providing Tax Planning and Compliance Services
While a financial advisor’s job is to provide guidance, not every responsibility falls on their shoulders. Financial advisors are there to give general advice, tips, and pointers to improving financial health with a holistic view, not to perform accounting down to an exact number, submit taxes on behalf of a client, project every tax arbitrage potential, and act as counsel parsing the law.
It’s virtually impossible to provide effective financial planning services without doing some math. For example, there could be a cost-effective breakeven point to assess between the tax savings plus brokerage fees charged on a crypto IRA, vs. the tax costs plus transaction fees of crypto traded on an exchange.
However, tax calculations and projections will need to be examined with conclusive detail and officially signed off by a certified tax professional. Financial advisors can refer clients to licensed accountants, actuaries, auditors, and lawyers to establish and forecast precise numbers and legal compliance. It is especially practical for heavy crypto investors to hire an accountant to finalize their taxes—and an auditor if the investments are for a business or a fund.
Anticipate your client’s needs while balancing and communicating your broadly defined duties as a financial advisor. The goal is to act as a structured starting point and springboard for more intermediate and advanced financial planning ideas and processes.
Anyone can calculate taxes with crypto tax preparation software, which can automatically calculate taxes and extract data uploaded from more than one crypto wallet, exchange, and blockchain. Using software may be unavoidable if a client handles a high volume of crypto transactions. Day traders and fund managers may place hundreds or thousands of trades a month.
Resources for Further Information
Cryptocurrency is still relatively new, and regulation around it is evolving. Staying up to date on the market and how it is taxed is critical to assisting clients investing in it.
The best sources of recent and timely tax information are tax agencies. The IRS and state and territory tax departments have FAQ pages and webpages discussing digital asset tax accounting and related publications.
Major cryptocurrency exchanges and cryptocurrency news sites have blog posts and news articles with the latest changes and materials about cryptocurrency taxation. However, it is more accurate and comprehensive to get the information straight from the source: the tax regulators and other regulatory bodies.
Can I Identify Specific Batches of Coins I Sold?
Yes, IRS rules allow you to point out which specific units of crypto were sold. To do so, you must identify the unit by an identifier or transaction record. Parceling out specific batches can be helpful if you sold crypto across different cost bases and want more discretion in calculating capital gains or losses.
Which Tax Forms Are Used to Report Crypto?
State tax forms vary, but federal tax forms are identical at the IRS. For individual tax returns, investment income is reported on Form 1040, Schedule D and Form 8949. Ordinary income is reported for employee work on Form 1040 and for contractor work on Schedule C, Part I with self-employment income and other compensation. Gifts, including receipts of crypto donations, are reported on Form 709. Donors of crypto can deduct the donations on Form 1040, Schedule A. Income is reported on Form 1120 for corporate tax returns and on Form 1065 for limited partnership fund returns.
What If I Don’t Know the Cost Basis for My Crypto?
The cost basis of a cryptocurrency transaction, if it isn’t clear, may need to be treated as $0 when it is sold. That means paying capital gains tax on the full proceeds from the sale.
The Bottom Line
Cryptocurrencies are taxed in myriad ways, presenting various tax savings permutations that can be brought into focus and customized for individual clients with broad guidance from a financial advisor or specific, expert advice from a tax advisor.