3 Deadly Mistakes to Avoid When Doing Taxes on Your Crypto
Nowadays, the issue of cryptocurrency taxation is more relevant than ever. Because we live in the era of information technology, it is important for each of us to understand what is meant by virtual assets and their taxation. Unfortunately, it is impossible to answer this question unequivocally, since each country has its own vision of cryptocurrency taxation. Moreover, the very concept of cryptocurrency differs from country to country, but in some places, it does not exist at all.
In this article, we will consider the most common cryptocurrency tax mistakes and how to avoid them.
More and more countries are taking steps to recognize cryptocurrencies. U.S. authorities have developed a regulatory system that implements the 2014 guide and its updated 2019 version. However, there are still things to work on.
The problem is not the amount of taxes, but the process itself. Every sale of cryptocurrency that brought profit to a citizen or business is subject to taxation. Citizens are obliged to indicate on their tax returns the rate at the time of acquisition and sale of their coins. It does not matter exactly how someone received their coins. Whether it is a salary or a regular money transfer, at the time of withdrawal to fiat, you have to pay for everything.
For example, someone received a money transfer at the moment when the cost of BTC was $3,500. He/she later sold it for $4,500, making a profit. This created a taxable event. The puzzle here is the timing. In early November, a U.S. student “hit” the $400,000 tax bill on investment in cryptocurrency. According to him, in May 2017, he bought ETH for $50 per token. The cryptocurrency began to rise in price by leaps and bounds, and, as a result, he had $125,000 in his account. The student reinvested this money in an ICO, and, by the end of December, the total portfolio was already worth $880,000.
In 2018, his fortune collapsed to $125,000, which is still very good, given the amount of the initial investment. But as soon as the student completed his tax return for 2017, the authorities calculated $400,000 in profit for tax purposes. According to his statements, he did not withdraw cryptocurrency to fiat, and traded only between tokens.
The cryptocurrency tax system in the United States is complex and incomplete. In 2019, the IRS released a new guide, which the crypto community hoped would simplify taxation. However, the manual mainly focused upon forks and airdrops, and revealed that the IRS itself did not quite understand the meaning of the terms. Clearly, this is not the last guide the IRS will issue.
3 Mistakes to Avoid When Calculating Tax on Crypto
How to get out of crypto tax labyrinths and avoid troubles with the IRS? How can you avoid errors on your tax report when filling in transactional data? Let’s see which mistakes you should avoid in the first place.
1. Not Including Crypto Activities from Previous Years
It may seem like common sense to include only your recent crypto activity when filing annual taxes. After all, why are previous years relevant, especially if you have already reported them?
Unfortunately, the inclusion of your entire trading history is mandatory when filing taxes on cryptocurrency. This is due to the financial concept known as base value. The cost basis is the initial value of an asset when it was acquired by its current owner. Since cryptocurrencies can vary significantly in value over relatively short periods of time, the only way to accurately determine the value basis of a coin is to incorporate your past trading activity. Without this, your reports will be invalid. If you have not kept records, you can use tax encryption software to correct your calculations. The good news is that revising your previous years can actually help you save a lot on your taxes if the records show that you had losses.
2. Ignoring Crypto Losses
While crypto gains are taxed, crypto losses can be used to decrease your tax bill. Many cryptocurrency investors and traders do not know that filing incurred losses on crypto can really save them a fortune. This is a rather common mistake that can cost for taxpayers a lot if they do not use a reliable method of reducing taxable profit from capital gains. It is important to remember that crypto losses work just like other property losses. This means that if you incur any losses as a result of any crypto transactions throughout the year, you can use these losses to compensate for capital gains and pay lower taxes in general. In fact, you can not only compensate for all capital gains, you can also use these losses to offset up to $3,000 in regular income. Another good thing is that at the time of this writing, the Wash Sale Rule doesn’t apply to crypto, which means you can sell your coin at a loss on December 31st and buy it back on January 1st, then use that cash however you want.
3. Inconsistent Cost-Based Methodology
The most widely-used cost basis method is first-in-first-out (FIFO): when the coin that was bought first is also sold first. This method is the most recommended; in fact, it is the default calculation mode. Some people, however, calculate the cost basis of their coins using the last-in-first-out method: the last coin bought will be the first coin sold. Though any of these methods is suitable for use when completing your crypto taxes, it is worth noting that they can lead to different outcomes in terms of capital gains.
Ultimately, the choice of method is left to each trader, but as soon as you start using one method, you are stuck. The IRS does not allow you to change the method used between applications (or at least not easily). If you decide to use a method that does not work for you, you will have to physically send a request to the IRS asking for permission to switch to another method, and there is no guarantee that they’ll answer your request in a reasonable amount of time.
So, nothing is impossible when it comes to successfully collecting all the data and recording it yourself, but it can be a tedious process. At the same time, it has many potential points of failure. For traders who simply do not have the time or opportunity to calculate and file their own taxes, there are accounting professionals who specialize in taxes related to cryptocurrency. It would be wise not to exclude professional accountants or tax firms, especially those who specialize in cryptocurrency.
ZenLedger’s Intuitive Tax Tool
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Originally published at https://medium.com on May 20, 2020.