Receiving a tax audit request is common if you have not correctly reported your income and hindsight comes about the importance of COST BASIS in crypto tax payment. While audit requests can vary in content, there are a few typical preliminary questions the IRS will ask about your crypto taxes. When responding to the IRS, the best practice is to answer each request transparently and in an organized manner.
You can expect that they will ask you to disclose all of your accounts, including:
- “All wallet IDs and blockchain addresses owned or controlled by taxpayer.”
- “All digital currency exchanges (DCE) and peer-to-peer (P2P) facilitators (e.g., Coinbase, Paxful or Localbitcoins.com) (foreign and domestic) … with associated user IDs, email addresses, IP addresses, and account numbers relating to those platforms.”
As outlined in record- keeping IRS notice response (Q&A 45), the IRS also requires the following records for every transaction:
- “The date and time each unit of virtual currency was acquired,”
- “The basis and FMV of each unit at time of acquisition,”
- “The date and time each unit was sold, exchanged, of otherwise disposed of,”
- “The FMV of each unit at the time of sale, exchange, or disposition, and the amount of money or the FMV of property received for each unit.”
- “Explanation of the method used to compute basis relating to the sale or other disposition of virtual currency.” (Note that this refers to the crypto accounting method).
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What is Cost Basis in Crypto Tax Payment?
Cost basis is the amount you paid for an investment plus any broker, commission, or trading fees calculated for tax purposes. Often, your cost basis will simply be the original price you paid when you acquired the investment, like shares in a stock, mutual funds, or cryptocurrency. Still, it gets more complicated in some situations. When you sell that asset or investment, you’ll need to know your cost basis to determine whether you have capital gains or losses.
Why is Cost Basis in Crypto Tax Payment necessary?
Learning the cost basis for your investments is essential to determine what you owe for taxes. Trading an asset and realizing a profit or loss on that investment is considered a taxable event. To fully understand the tax consequences for the sale of an asset, you’ll be required to know the original cost basis/ purchase price.
How to calculate Cost Basis in Crypto Tax Payment?
Calculating the cost basis for a taxable account can be daunting when you own a stock, mutual fund, or cryptocurrency and make multiple buys at different prices. Here are the strategies you can use:
First-in, first-out (FIFO) method
The first shares you purchase are treated as the first shares you sell. FOFO is the default method of the IRS and the method most brokerages use to calculate the Cost basis.
Average cost method
You divide the total cost of shares by the number of shares you hold, then use the average as your cost basis. The average cost method option is only for mutual fund sales and specific dividend reinvestment plans.
You cannot use the average cost method to get the basis for individual stocks.
You identify the specific shares or assets you’re selling to your broker. You’ll inform your broker at the time of the sale that you’re using this method, so keep good records to document your basis.
How to Calculate Cost Basis in Crypto Tax Payment
To show how each method works, let’s work out examples.
Assume you own 500 shares of Company Coinbase stock. You purchased your shares of stock for four years:
- January 2019: 100 shares at $10 per share, for $1,000 total
- January 2022: 100 shares at $12 per share, for $1,200 total
- January 2021: 100 shares at $14 per share, for $1,400 total
- January 2022: 100 shares at $16 per share, for $1,600 total
Your total investment amount is $5,200.
In May 2022, you decided to sell 150 of your shares. Here’s how each cost basis method would work.
Example 1: First-In, First-Out (FIFO)
You sell all 100 of the shares you bought at $10 ($1,000) plus 50 of the shares you bought at $12 ($600). Your total cost basis is $1,600.
Example 2: Average Cost
You take your total cost to purchase all of your shares, which is $5,200, and divide it by 400. The formula brings your cost basis to $13 per share. Multiply $13 by the number of shares you’re selling, which is 150. Your cost basis is $1,950.
Example 3: Specific Identification
You choose the specific shares you want to sell. You could sell all 100 of the shares you bought at $16 ($1,600) plus 50 of the shares you bought at $14 ($700). That would make your cost basis $2,320. However, you’ll be taxed at short-term capital gains tax rates because you held the $16 shares for less than a year.
You could keep the $16 shares and sell all 100 of your $14 shares ($1,400) plus 50 of the shares you bought for $12 ($600). Your cost basis would be $2,000. Generally, you want a higher cost basis since it will reduce your capital gain and hence your tax, but this method could pay off if you’re taxed at long-term capital gains rates.
Calculating Cost Basis for Cryptocurrencies
If you sold, spent, or traded crypto in 2021, you probably have a few questions about how the trades impact your tax implications this year. You’d likely owe taxes on capital gains if you made money from any crypto transactions. Calculating your crypto’s cost basis is the first step in determining how much you owe.
This section represents the Coinbase stance on IRS guidance received, which may continue to evolve and change. None of this should be considered tax advice or an individualized recommendation.
Two methods to Calculate your Cost Basis and Capital Gains
1. Cost basis = Purchase price (or price acquired) + Purchase fees.
2. Capital gains (or losses) = Proceeds − Cost basis
Let’s work out the formula in a simple example:
Assuming you initially bought Ethereum for $10,000 (including $35 in transaction fees). Even though you only hold $9,965 worth of crypto minus fees, your total cost basis is what you paid to acquire that crypto. For this instance: $10,000.
Then a few years later, prices went up, and you sold and received $50,000 in proceeds. Your capital gains will be $50,000 – $10,000, or $40,000. Platform fees you pay as part of the sale are subtracted from your proceeds.
Now let’s try a more complex example:
Let’s say you traded one crypto for another, like swapping BTC for ETH. You sell BTC and then use proceeds from the trade to buy ETH. Note that swapping one crypto for another is two separate transactions. For this case, first, selling BTC, for which there is a gain or loss, and second, purchasing ETH.
In our example, the total amount you paid for your ETH, including the transaction fees, would be its cost basis.
Let’s add some numbers: you bought BTC for $10,000, including transaction fees, and sold it for $50,000 with no fee. Then you use the money to buy $50,000 worth of ETH coins, including a fee. You will be required to pay capital gains taxes on your BTC using a cost basis of $10,000, and for your ETH, a cost basis of $50,000.
Keeping records is key
Simply put, the higher the cost basis of the crypto you are selling, trading, or spending relative to the number of proceeds you receive, the smaller your capital gain and the less tax you’ll pay.
It’s good practice to keep careful and detailed records of all your crypto transactions. Coinbase users can sign in to find transaction data and a report on their gains and losses.
If someone gifted shares to you, your cost basis is the cost basis of the original holder who gave you the gift. If the current market price of the shares is lower than when someone gifted the shares, the lower rate is the cost basis. If the shares are inherited, the cost basis for you as the inheritor is the current market price of the shares on the date of the original owner’s death.
Many factors will affect your cost basis and, eventually, your tax basis when you decide to sell. Please consult a tax advisor, accountant, or lawyer if your true cost basis is unclear.
Calculating the cost basis of Futures Contracts
For futures, the cost basis is the difference between a commodity’s local spot price and the future’s associated price. For instance, if a particular futures contract is trading at $3.50, while the current market price of the commodity today is $3.10, there is a 40-cent cost basis. If the reverse were true, with the future contract trading at $3.10 and the spot price being $3.50, the cost basis would be -40 cents, as a cost basis can be positive or negative depending on the market prices.
The local spot price represents the prevailing market price for the underlying asset, while the price listed in a futures contract refers to the rate at a specified point in the future. Futures prices vary from contract to contract depending on the month they expire.
As with other investment mechanisms, the spot price fluctuates depending on prevailing market conditions. As the delivery date approaches, the spot price and futures price shift closer.
How Stock Splits affect Cost Basis in Crypto Tax Payments
If a company splits its shares, this will affect your cost basis per share but not the actual value of the original investment. Companies perform a stock split to increase the number of their shares to boost the stock’s liquidity. Suppose the said company issues a 2:1 stock split where one old share gets you two new shares with an original investment of $1,000. You can calculate your cost basis per share with two methods:
- Take the original amount i.e.$10,000 and divide it by the new number of shares you hold (2,000 shares) to arrive at the new per-share cost basis of $5.
- Take your original cost basis per share ($10) and divide it by the split factor of 2:1 to arrive at a cost basis of $5.
How to Save while Paying Taxes
After knowing the correct procedure in calculating cost basis, here’s the gamechanger – ways of saving while paying taxes. In some countries, you can also offset losses against ordinary income up to a certain amount. Make sure to check your country’s crypto tax laws to see if this is the case where you live. Here are some common methods of saving your hard-earned crypto while not subverting the law and being made to pay fines.
- Hold on – This strategy requires you to hold you crypto investment for at least one year before selling.
- Tax-free thresholds – According to the IRS, if your total income is under $41,676 a year, you’ll pay no Capital Gains Tax. For married couples filing jointly, the limit is $83,351 a year.
- Offset gains with losses – If your net capital loss is more than $3000, you can carry the loss forward to later years. If you consciously use this to your advantage, this is called tax-loss harvesting.
- IRA, pension or annuities fund investment – In the US, self-directed IRAs are special IRAs that allow you to invest in unique assets, such as crypto, real estate and precious metals. Any trading of bitcoin or other cryptocurrencies within the account wouldn’t be subject to capital gains tax
- Annual gift tax exclusion – American taxpayers enjoy an annual $16,000 gift tax exclusion, which applies to each person you give a gift to. Gifts valued at more than $16,000 would potentially subject you to gift taxes of 40% – but only if you’re over the lifetime gift tax exemption of $12.06 million.
- Change your tax rate – You can perfectly time crypto disposal to coincide with a strategic salary cut, retirement, or pausing employment to go back to school to move to a lower tax rate.
- Donate to charity – In the United States, Check a charity’s 501(c)3 status with the IRS’ exempt organization database. A charity must have 501(c)3 status if you plan to deduct your donation on your federal taxes.
- Offload crypto assets to your spouse – Ownership of assets can be transferred between partners so that both of your annual CGT allowances can be used against gains. This effectively doubles the CGT allowance for married couples and civil partners. As per the HMRC, to use this benefit you can’t be separated or living apart.
- Invest in an opportunity-zone fund – Investing in an Opportunity-Zone fund allows taxpayers to defer, and even reduce, capital gains taxes if they put the proceeds from the sale of say, a stock or business, into a fund created to promote investment in an economically disadvantaged area
- Use a crypto tax calculator to spot unrealized losses – Turning gains into realized losses with the use of a good tax calculator can offset against your capital gains to reduce your tax bill. This is also known as tax loss harvesting
Your savings on crypto taxes will depend on your particular circumstances. Find which rules apply to you based on your country’s tax guidance. For American citizens, the IRS have these guidelines.
Most crypto investors who make a good-faith effort to report their crypto taxes will never face a crypto tax audit. However, tax and regulatory agencies around the world are turning their attention to crypto as an underreported source of income, so it’s not unreasonable to expect there may be a rise in crypto tax investigations on the horizon.
If you receive an audit request, don’t panic. While the audit letter may have many questions, requests for transaction histories, and a quick two-week deadline, you likely have all the information available in your crypto tax software accounts.
The IRS generally audits up to six years back, so you should store your records for that long or longer, either in a crypto tax calculator or your own files. When responding to the IRS, the best practice is to answer each request transparently and in an organized manner. Take heed that if you’re an American citizen, US tax laws apply to all your income, whether conducted in the US or anywhere global.
Every time you buy a stock or cryptocurrency, you start a paper trail that will directly impact your taxable income. But when it comes to selling assets and paying taxes, calculating cost basis and good records will decide your tax burden. The hard part is deciding which asset lot to sell to lower capital gains taxes. (Read the FAQs to learn more).
Therefore, keeping good records is key going forward. Many brokers and crypto exchanges let you download your transaction statements with all your cost basis information. Keeping your separate records is good to practice too.
Remember, investing aims to get the best after-tax return over time. If your records are accurate and updated, you only have to choose the shares with the basis and holding period that give you the best results (Cost basis) now and in the future.