Virtual currencies, also known as cryptocurrencies, are treated as property for the purposes of your federal income taxes. That means that gains or losses are subject to the capital gains rules.
Unfortunately, that can mean you will need to keep very detailed books. Every transaction, no matter how small, contributes to your capital gains tax or associated losses. Whenever you sell cryptocurrency for real currency or otherwise exchange it, you must account for the capital gain or loss.
You may also wonder whether your gain or loss is short- or long-term. If you held the cryptocurrency for one year or less before your sale or exchange, it counts as a short-term capital gain or loss. Longer than a year and you have a long-term capital gain or loss. This holding period begins the day after you obtained the cryptocurrency and ends on the date of sale or exchange.
Determining your cost basis
When you calculate capital gains or losses, you are essentially subtracting the amount you paid for the property from the amount you earned in the sale or transfer of that property. You owe taxes or may be eligible for a deduction on the remainder.
The amount you originally paid for it is called your “cost basis.” This includes all commissions, fees and other acquisition costs. Your cost basis can be adjusted into an adjusted basis by adding certain expenditures and subtracting certain deductions.
Your basis may be as little as zero if you received the cryptocurrency as a bona fide gift. It could be calculated somewhat differently if you exchange cryptocurrency for goods or services instead of currency, but the upshot is the same. You must recognize any gains or losses.
You may also have the option of designating what specific units of cryptocurrency you sell or trade. If you are able to specifically identify the units of currency, this could allow you to choose the most favorable basis.
Keeping good records
The key to paying your taxes correctly is keeping good records, and you are required to do so by the Internal Revenue Code. Therefore, you should maintain any and all necessary records to document your sales, receipt, exchanges or other dispositions of your cryptocurrency and its fair market value at each of these events.
Recognizing a cryptocurrency gain or loss is not different, in principle, from recognizing any gain or loss based on the sale or exchange of property. However, the regulations in this area are quick to change. If you have significant earnings or losses from virtual currency, talk to your tax attorney.