Cost basis refers to the original value of a cryptocurrency, such as Bitcoin or Ethereum, for tax purposes. It is crucial for accurately calculating capital gains or losses when you trade your digital assets. In this post, I will walk you through all you need to know about cost basis and its implications for calculating your crypto taxes.
- Cost Basis Definition
- How to Calculate Cost Basis and Capital Gains in Crypto
- When Do I Have to Report my Cost Basis?
- Methods of Calculating Cost Basis in Crypto
- Short-term Vs. Long-term Capital Gains
- How to Track Your Cost Basis
- Best Software to Track Cost Basis and Capital Gains
- Cost Basis for Crypto Forks and Airdrops
- Cost Basis and Mining
- How Cost Basis Is Useful
Cost Basis Definition
When you acquire a cryptocurrency, whether through mining, purchasing it on an exchange, or receiving it as a gift, the cost basis is the value at the time of acquisition.
This value becomes significant when calculating your capital gains tax. Lets take a look at how to calculate this.
How to Calculate Cost Basis and Capital Gains in Crypto
Your cost basis equals the total amount of coins you bought times the original purchase price plus transaction fees.
Cost Basis=volume*purchase price plus any gas fees you paid
When you sell or exchange your digital assets, the capital gain or loss is calculated by subtracting the cost basis from the sale price times volume.
Capital Gains = Number of coins * (price at which you sold - price at which you acquired them)
Example 1: Base case
For example, if you bought one Bitcoin for $9,800 and your transaction fees were $200 then you cost basis would be $10,000. Now say you sold your bitcoin for $15,000.
Your capital gain would be $15,000-$10,000=$5,000.
This extra $5,000 in crypto gains is considered taxable income.
Example 2: Crypto-to-crypto
Say you buy $10,000 worth of Bitcoin.
Assume $0 transaction fees to keep things simple.
Now let’s say you swap all your Bitcoin for ETH when the price of Bitcoin is $15,000.
You are going to have to calculate the capital gains on this transaction as if you first sold Bitcoin for fiat currency and then purchased the ETH with your fiat.
So in this case you would calculate capital gains of $15,000-$10,000=$5,000 and the cost basis for your ETH would be $15,000.
Failing to report the accurate cost basis, either deliberately or by mistake, can result in misreporting your capital gains or losses, which can have serious legal and financial consequences.
When Do I Have to Report my Cost Basis?
Technically it is not the cost basis you report but the capital gains or losses you made during the year.
Note that you only need to report gains or losses if there is a taxable event.
What Is a Taxable Event?
A taxable event occurs when you sell.
So even if your capital assets increase 100x in value you don’t need to report any gains unless you sell. This includes crypto-to-crypto transactions.
Why borrowing is popular
Avoiding tax payments is one of the reasons why borrowing is popular. High crypto earners prefer to take out a loan rather than sell their crypto on a crypto exchange because then they don’t need to pay taxes.
However, they still have to pay interest on the loan as well as the principal eventually.
Make sure you report your capital losses
Also, note that it will benefit you to report any capital losses. In some jurisdictions, you can offset any future capital gains with your capital losses over the next 5 years.
For example, if your tax return crypto losses this year are $30,000 and you make $10,000 in capital gains next year and $20,000 the year after you wouldn’t have to pay any cryptocurrency taxes because the gains are offset by your losses.
Of course, this rule does not apply everywhere and you would need to look into the specific tax regulations of your jurisdiction.
Methods of Calculating Cost Basis in Crypto
There are different cost basis methods in cryptocurrency transactions, each with its own implications for tax reporting and liability.
These methods are
- First-In, First-Out (FIFO)
- Last-In, First-Out (LIFO)
- Specific Identification
- Average Cost
- Highest-in, First-out (HIFO)
Let’s take a close look at FIFO first
#1. FIFO Approach to Cost Basis
The First In, First Out (FIFO) method assumes that the assets purchased first are the ones sold or exchanged first.
This method is widely used and considered the default cost basis method by tax authorities in many jurisdictions.
FIFO is relatively easy to calculate and track, making it a popular choice for individuals with significant cryptocurrency holdings.
Under the FIFO method, the cost basis of the crypto assets sold is determined based on the price at which they were originally acquired.
This means that if you acquired Bitcoin at different prices over time, the oldest Bitcoin in your portfolio would be sold first.
For example, say I bought 1 bitcoin in January 2022, 2 bitcoin in March 2022, and 5 bitcoin in April 2023. Then in August 2023, I decided to sell 1 Bitcoin.
Which bitcoin shall I use to calculate my cost basis? The one I bought first, second, or last?
All Bitcoins are the same. They are fungible with one another so I cannot distinguish between them.
Under FIFO I would input the price of 1 Bitcoin in January 2022 as my cost basis.
Let’s take a look at the LIFO accounting method.
#2. LIFO Approach to Cost Basis
LIFO is the opposite of FIFO.
The Last-In, First-Out (LIFO) method assumes that the assets purchased most recently are sold or exchanged first.
While the LIFO method may be beneficial in certain situations, such as minimizing taxable gains during periods of price appreciation, it is not widely accepted by tax authorities.
#3. Specific Identification Method
The Specific Identification method allows you to track and assign specific acquisition costs to individual crypto assets. This method requires meticulous record-keeping as you need to identify and allocate the exact cost basis for each transaction.
For example, if you purchased ten different bitcoins at various prices, the specific Identification method would require you to assign the specific cost basis for each of the ten bitcoins when you sell or exchange a portion of your holdings.
This methodology is pretty much a no-go with crypto because cryptocurrencies are fungible with one another meaning there is no way to distinguish one from the other.
#4. Average Cost Method
The Average Cost method involves calculating the total cost of all your cryptocurrency holdings and dividing it by the total number of assets.
This method allows you to arrive at an average cost basis per unit of the digital asset.
For example, if you acquired three Bitcoins for $10,000, $12,000, and $15,000, the average cost basis would be $12,333.33.
So when you sell or exchange a portion of your holdings, the cost basis is determined based on this average cost.
#5. HIFO cost method
A less common alternative that benefits holders the most is the HIFO cost method. In this case, when selling your crypto you would calculate the most expensive purchase as your cost basis. For example, say I buy 1 ETH for $2,000 in year 1 and I buy another one for $1,500 in year 2. Then say that I sell one ETH in year 3 for $1800. In this case, I would use $2,000 as my cost basis and my capital losses would be $1,800 – $2,000=$200
Apart from the accounting methodology used it also matters when you sell.
Short-term Vs. Long-term Capital Gains
Some countries such as the US distinguish between short-term and long-term capital gains. Short-term gains occur when you buy and sell within a tax year.
Short-term capital gains rely on your income bracket whereas long-term gains have a separate bracket.
How to Track Your Cost Basis
Things can get a little tricky when calculating your cost basis. If you are just getting started with crypto then your life will be made easy if you just use one exchange.
This way you can look at the history tab of your exchange to check the acquisition cost of your assets. However, some exchanges only allow you to look back a few months.
So you may want to note down acquisition costs manually. This includes recording the date of acquisition, the amount acquired, the price paid, and any relevant transaction fees.
In theory, tax authorities will then check your transactions on the blockchain. I can’t imagine any tax office can do that currently. But in any case better to stay on the safe side.
Another alternative is to use crypto tax software. Websites such as Koinly.io, Taxbit.com, and others allow you to connect your wallet and exchanges via API and calculate your tax reporting for you.
Best Software to Track Cost Basis and Capital Gains
Koinly is a website that allows you to connect your exchange and wallet accounts to their platform.
Opening an account with Koinly is easy. You just need an email address.
Next, you need to hook up the exchanges and wallets that you use. Koinly will instruct you on how to connect to each via their API.
If you use many exchanges like I do this part is time-consuming.
However, it is the only way to do your tax returns properly as there is no way you can manage it all manually.
I managed to get a rudimentary report from Koinly without paying.
Subscriptions are tiered according to the number of transactions you made. So you can pay anywhere between 40 and 250 bucks.
You can also choose to have an expert review your transactions for an extra $500.
Coinledger is another popular crypto tax reporting software.
It is rated highly on Trust Pilot where users are reporting good customer support and ease of use as the top criteria for continuing to use them.
In terms of pricing, they have a similar tiered pricing structure to Coinly. They also produce a number of reports:
- IRS Form 8949
- International Tax Reports
- Income Report
- Capital Gains Report
- Audit Trail Report
- Tax Loss Harvesting
Plus they integrate with other tax reporting tools such as
- TurboTax Online
- TurboTax Desktop
- H&R Block Desktop
#3. Turbo Tax Crypto
Turbo tax is ranked No 1 on Forbes because it allows you to file a full tax report via their platform. Pricing is a flat $129 per year and covers all taxes not just crypto.
Check out TurboTax for more.
Tax is another crypto tax reporting software. It receives poorer quality reviews on Trust Pilot. The biggest complaint is the poor customer service and reporting getting messed up.
Find out more about TaxBit here.
Cost Basis for Crypto Forks and Airdrops
When reporting your cost basis you should also consider any hard forks or airdrops.
A hard fork happens when a digital currency splits into two separate chains, resulting in the creation of a new virtual currency. Do not confuse hard forks with soft forks which are an upgrade to the blockchain but do not create new virtual currencies.
An airdrop occurs when a cryptocurrency project distributes free tokens to existing holders.
In both cases, tax authorities will consider this ordinary income that needs to be taxed accordingly. You will therefore need to declare it in your tax forms.
In both cases, the cost basis of the original cryptocurrency should be allocated between the original asset and the newly created asset(s) based on their fair market values at the fork or airdrop.
Cost Basis and Mining
If you are mining crypto then your mining rewards are considered self-employment income.
In the United States the Internal Revenue Service (IRS) taxes mining coins as both income tax and self-employment tax.
The cost basis is used to calculate capital gains when you eventually sell your mined rewards. Your cost basis will equal the value of the coins at the time of receipt.
How Cost Basis Is Useful
There are two main benefits to knowing your cost basis
- Determine your tax liability when you sell your digital assets. By knowing your cost basis, you can calculate the capital gain or loss
- Helps you keep track of the profitability of your investments and evaluate your portfolio performance.
What is zero cost basis in crypto?
Zero cost basis is when you receive crypto for free like newly minted crypto or airdrops. In this case you crypto is valued at the fair market price on the day you receive it and it is taxed as extra income.
What if I don't know my cost basis?
If you don't know your costs basis then many tax jurisdictions require that you report it as zero. Since this is not in your interest it is best you use a crypto tax reporting software to help you identify the cost basis of your purchase.
Do I pay tax on staking?
Staking rewards are considered income when you receive them which means you will have to pay income tax on them even if you didn't sell any. You will also need to pay capital gains tax if you eventually sell.
Is staking considered income?
Yes staking returns are considered income upon receipt.
Where do I report cost basis in crypto?
You don't report the cost basis per se in your tax filings. Instead you report the capital gains or losses. You can report these in schedule d of your tax forms.
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