This is Part Two in a Seven Part Series Covering Taxation of Bitcoin for US Citizens
Written by Tyson Cross a Tax Attorney based in San Diego
Part One – Tax Realization of Bitcoin Gains
Part Two – Tax Recognition of Bitcoin Gains You are Here
Part Three- Tax Character of Bitcoin Gains
Part Four – Tax Losses and Bitcoin
Part Five- Tax Deductions Related to Bitcoin
Part Six- Tax Record Keeping related to Bitcoin
Part Seven- Bitcoin Foreign Account Reporting Requirements
#7: How do I calculate my gain or loss?
Gain or loss is calculated first on each bitcoin transaction, then on an aggregate basis by combining all your gains and losses to produce a net figure. Your tax preparation software will automatically perform these calculations, so the actual mechanics aren’t really necessary for you to understand. However, you’ll have to know the basics in order to enter the correct information into the software.
Basically, gain or loss is computed by taking the sales price of each bitcoin and subtracting its cost. The technical terms are “amount realized” and “basis.” Although simple in concept, determining amount realized and basis can be quite complex, as we’ll see below.
#8: What is my Basis?
Generally, basis is equal to cost. If you purchase 1 BTC for $500, then your basis is $500. You can also add to this amount any acquisition costs like broker commissions or wire transfer fees. So, let’s assume a 1% fee and a $5 wire transfer fee. This would mean your basis is $500 + $5 + $5 = $510.00. If you later sell that bitcoin for $900, your gain would be [$900] – [$510] = [$390].
#9: How do I determine my basis in each bitcoin?
If you’ve acquired bitcoins at different times and at different prices, then determining your basis can be quite complex. This is because bitcoins are fungible. Once a bitcoin is purchased, it becomes indistinguishable from the other bitcoins stored in the same wallet or account. In a subsequent sale or exchange, there is no way to trace the cost or acquisition date of the bitcoin being transferred out.
Contrary to what you might have heard, it is not acceptable to arbitrarily choose the bitcoin with the highest cost or most preferable tax impact. The IRS requires you to use a system with rules that will produce a reasonable and consistent result. The default system (and the one generally preferred by the IRS) is to assume that your bitcoins are sold in the order they were acquired. Thus, the first bitcoin you purchase is assumed to be the first bitcoin you sell. This is called the FIFO method (“First in, First Out”).
There are some other methods available, such as LIFO (“Last In, First Out”) and Average Cost Basis, but it’s not clear if bitcoins are eligible for these alternatives. So, I would caution against using any system other than FIFO without guidance from a tax advisor or instructions from the IRS. Note: If bitcoins are classified as a foreign currency, then it becomes possible to use any method you want, as long as the chosen method is reasonable, you use it year-to-year, and it does not always give you the bitcoin with the highest cost available. As discussed below, it is still uncertain whether bitcoins can qualify as a foreign currency, so again I must urge caution in deciding to take this position.
I’ll note that it’s theoretically possible to avoid this problem altogether if you keep every single bitcoin purchase in separate wallets or accounts. This would allow you to trace the actual cost of each bitcoin you later sell or exchange, alleviating the need for the FIFO (or alternative) method.
Either way, determining cost will require some detailed record keeping. I will discuss record keeping in more detail below, but remember that the burden to prove basis is on you. The IRS will not give you the benefit of the doubt here. If you cannot prove the cost of each bitcoin, they will assume it was $0. Obviously you don’t want that to happen, so keep good records of your bitcoin purchases.
#10: What if I mined my bitcoins, what is my basis then?
This is a very difficult question to answer with any degree of certainty. The problem is that bitcoin mining is a completely unique activity that yields an even more unique product. To reach an answer, one must resolve some difficult tax issues. Namely, what is bitcoin mining and how do we classify the bitcoins it produces?
Unfortunately, addressing these two issues would be a lengthy and detailed article in itself, so I cannot fully address them here. Suffice it to say that bitcoin miners have some uniquely challenging tax issues to resolve and will need a very competent tax advisor to make sure their gains are properly reported.
Not to leave you without any guidance whatsoever, the answer will most likely depend on the size and scope of your mining activity. Large scale miners should probably treat themselves as a manufacturing business, and the bitcoins they produce as inventory held for sale to customers. Such bitcoin miners would not determine their gains in the same manner as normal investors. They would compute income at the end of the year by figuring their total sales and then subtracting “cost of goods sold.” The latter would take into account the cost of producing bitcoins, such as electricity. Other expenses, like depreciation on the mining rig, would presumably be deductible as an ordinary business expenses. Obviously this implicates some complex accounting rules that are far beyond this post. A tax advisor with some knowledge of these rules would be needed to accurately determine your tax liability.
Smaller mining operations can probably treat their mining as an “activity for the production of income,” as opposed to a manufacturing business. In such a case, they would follow the same rules for determining gain or loss as normal investors. I suspect their basis in this case would be determined by allocating their mining costs on a pro rata basis, assuming they can reasonably track and allocate such expenses (like electricity). The safest and most conservative approach, on the other hand, would be to use a basis of zero. Depreciation and other indirect expenses would likely be deductible as an itemized expense, similar to a general investor (see below).
I must emphasize that neither of these treatments is a perfect fit. I expect different tax advisors to reach different conclusions on the correct treatment. The goal in any case is to use the best method of matching income to expenses, whatever that is. Presumably the IRS will respect your chosen method as long as you can convincingly argue that it is the best at accomplishing this goal.
#11: What if I received my bitcoins as payment, what is my basis then?
If you sell goods or services and accept bitcoin as payment, your basis in those bitcoins is equal to their price on that day. You would determine this by using the average price of bitcoin on a major exchange for that day. Thus, if you sold a laptop for 1 BTC on November 1st, your basis in those bitcoins is equal to the average price of 1 BTC on that day.
The choice of which exchange to use for this purpose (e.g. Mt. Gox, Bitstamp, etc.) is up to you. Whichever exchange you choose, though, you should have a reasonable explanation for your choice. You should also stick with that choice when computing your gains in the future. Arbitrarily picking exchange prices that best suit your tax interests will not be acceptable to the IRS in a subsequent audit.
#12: What if I received my bitcoins as a gift, what is my basis then?
It depends. Generally, you inherit the basis of anything given to you as a gift. This means you would take the same basis as the friend who gave you the bitcoins. However, an important exception applies if the friend’s basis was more than the market value of the bitcoins at the time of the gift (i.e. the bitcoins had a built in loss).
In that case, you would wait to determine your basis until you sell or exchange the gifted bitcoins in the future. When the time comes, you would use the following rules:
- First, calculate your gain/loss using your friend’s basis.
- If this results in a gain, then the default rule applies and nothing changes.
- If this results in a loss, however, then you do not inherit your friend’s basis. Instead, you must use the market value of the bitcoins on the date of the gift and recalculate your gains/loss.
- After recalculating, you must check if you still have a loss. If yes, then proceed with using the market value as your basis. However, if the recalculation results in a gain, then the tax law says to ignore the gain and report nothing. To be clear, you have no gain or loss in this situation.
Now that last point might confuse many readers, so here is an example to demonstrate. Assume you received bitcoins worth $750 at the time of the gift. Your friend’s basis was $1000. This triggers the exception discussed above and you have to wait until you sell the bitcoins in the future to determine your basis. Consider three alternative sale prices:
- Sale Price = $1200. Using your friend’s basis of $1000, this creates a gain of $200. Therefore, you inherit your friend’s basis and have a realized gain of $200. No problem.
- Sales Price = $600. Using your friend’s basis of $1000, this creates a loss of $400. Therefore, you cannot inherit your friend’s basis. Instead, you must use the value of the bitcoins on the date of the gift, which was $750. Therefore, you have a loss of $150. No Problem.
- Sales Price of $900. Using your friend’s basis of $1000, this creates a loss of $100. Therefore, you cannot use your friend’s basis. Instead, you must recalculate your gain/loss using the value of bitcoin on the date of the gift. Now you have a gain of $150. Therefore, you disregard the sale and have no gain or loss to report.
This is perplexing tax treatment. It might help to think of this rule as preventing your friend from shifting bitcoin losses to your tax return. This is why you get to inherit his basis only if it would create a gain on the subsequent sale. If not, then the amount of his loss is extinguished and you get to recognize only the amount of loss that accrued after the gift occurred. This also explains why you would have no gain or loss if the market price of bitcoin has increased since the time of the gift but is still less than your friend’s original basis.
In any case, when receiving bitcoins as a gift, make sure to ask the person what his or her basis was in the bitcoin, as well as their acquisition date (which you always inherit). Lastly, write down the date of the gift and the market price of bitcoins on that day.
#13: How do I determine Amount Realized (i.e. Sales Price)?
This depends on the transaction and if you sold bitcoins for cash or exchanged them for goods/services.
In the case of a sale, amount realized is equal to sales price, less any selling costs you incur in the transaction (like commissions or wire transfer fees). So, if you sell a bitcoin for $900 and incur a 1% transaction fee, your amount realized is $900 – $9 = $891.00.
If you exchanged bitcoins for goods or services (instead of selling them), then amount realized is more complicated. This is essentially a barter transaction, where the default rule is to use the fair market value of the goods or services received in the exchange. For example, if you purchased a laptop on November 29th with bitcoins, your amount realized would be equal to the Fair Market Value of the laptop on that date. The easiest way to determine Fair Market Value is by reference to the sales price, although an alternative method can be used if it yields a more accurate value.
Presumably, the sales price of most goods or services will be denominated in dollars (even though payment is made in bitcoin). Thus, if the laptop’s price was $1,500, you can safely assume that its FMV was also $1,500 (which would then be used as your amount realized). If the sales price is denominated in bitcoin (instead of dollars), then you’ll have to convert it into dollars using the average exchange price on that day. As mentioned above, the choice of which exchange to use for this purpose (e.g. Krakken, Bitstamp, etc.) is up to you. The most conservative option would be to use the price from the exchange that you purchased the bitcoin in the first place. Whichever exchange you choose, you should have a reasonable explanation for your choice. You should also stick with that choice when computing your gains in the future. Arbitrarily picking exchange prices that best suit your tax interests will not be acceptable to the IRS in a subsequent audit.
Gain is determined by subtracting basis from amount realized. Basis is generally equal to cost, but special rules must be followed (such as FIFO) if your bitcoins are mixed together. Amount realized is generally equal to the sales price. If you bought goods or services instead of selling your bitcoins, then amount realized is equal to the FMV of the property/services received.
Continue to Part 3 Tax Character of Bitcoin Gains, Capital Gains, Definitions etc.