The IRS is clear that the sale of virtual currency is a tax realization event. This means that a person selling virtual currency will recognize gain or loss on the sale. Additionally, depending on how long the person has held the virtual currency, the gain or loss will be classified as either short-term or long-term capital gains. The rest of this article examines the basics of this type of virtual currency transaction.
The first variable a seller of virtual currency should determine is the taxpayer’s basis in the virtual currency being sold. As discussed in our previous publication on basis, a taxpayer’s basis in property, such as virtual currency, is simply the cost that the taxpayer paid. For example, let’s assume McGee decided to start buying $500 of bitcoin on the first day of each quarter in 2020. On January 1, 2020 McGee purchased $500 worth of bitcoin while the price was at $7,188.46. Through this January 1, 2020 purchase, McGee acquired 0.06955593 bitcoin. McGee purchased another $500 on April 1, 2020 when the price of bitcoin was at $6,671.95. Through the April 1, 2020 purchase, McGee acquired 0.07494061 bitcoin. McGee purchased an additional $500 on July 1, 2020 when the price of bitcoin was at $9,153.95. Through the July 1, 2020 purchase, McGee acquired 0.05462123 bitcoin. Finally, on October 1, 2020 McGee purchased $500 worth of bitcoin at a price of $10,626.60. Through the October 1, 2020 purchase, McGee acquired 0.04705174 bitcoin. McGee’s basis in his bitcoin would be $2,000 ($500 for each of the four transactions).
On April 15, 2021 McGee decided to sell all his bitcoin when the price of bitcoin was at $63,237.00. McGee’s basis in his 0.2461695 bitcoin was $2,000 ($500 for each of the four transactions). McGee would receive $15,567.02 ($63,237.00 x 0.2461695 bitcoin) from the sale of his bitcoin. However, he would not have to pay taxes on the amount of his basis so he could subtract $2,000. Therefore, the taxable portion of capital gains for McGee’s sale would be $13,567.02 ($15,567.02 – $2,000).
The next question is whether the capital gains would be considered long-term or short-term capital gains. Long-term capital gains are taxed at a preferential rate of 0 percent for single individuals whose income is below $40,401 in 2021, 15 percent for single individuals whose income is more than $40,400 but less than or equal to $445,851, or 20 percent for single individuals whose income is more than $445,850. Short-term capital gains are taxed at the taxpayer’s less advantageous ordinary income rate. Thus, being able to sell and get underneath the shelter of long-term capital gains is generally a tax efficient strategy. (Note: For thoroughness, but beyond the scope of this paper, a taxpayer may also have to factor in the 3.8 percent tax on net investment income in addition to the capital gains rate depending on the taxpayer’s modified adjusted gross income).
Internal Revenue Code section 1222 defines a short-term capital gain or a short-term capital loss as the gain or loss on a capital asset that is held for not more than one year. The same IRC section defines a long-term capital gain or a long-term capital loss as the gain or loss on a capital asset that is held for more than one year. The length of time a taxpayer has held an asset is referred to as a holding period. A taxpayer’s holding period can get quite complicated when considering options and the plethora of trading tools that have been created over the years. These issues are discussed in detail in IRC section 1223 and will be explored in later publications.
In the example above, McGee has holding periods beginning on January 1, 2020, April 1, 2020, July 1, 2020, and October 1, 2020. McGee sells his bitcoin on April 15, 2021. Therefore, the portion of the bitcoin acquired on January 1, 2020 and April 1, 2020, 0.14449654 bitcoin, would be considered long-term capital gains and taxed at the preferential rate. However, the portion of the bitcoin acquired on July 1, 2020 and October 1, 2020, 0.10167297 bitcoin, would be considered short-term capital gains and taxed at McGee’s ordinary income rate.
In situations like these, it may be prudent for taxpayers like McGee to let the holding period mature so all the bitcoin positions would be classified as long-term capital gains. While this article references bitcoin, the concepts of this article could be applied to any virtual currency or cryptocurrency. Later articles will examine how every person with virtual currency can tax efficiently dispose of his/her virtual currency positions.
A taxpayer must be aware of the tax implications of selling a position in a virtual currency. If a taxpayer is not careful, the taxpayer may not have the funds to pay the taxes owed to the IRS when the due date comes. Among other items a taxpayer will need to look at the basis the taxpayer has in the virtual currency being sold and whether the capital gains will be considered long-term or short-term capital gains or losses. Before any sale is complete a taxpayer should know the tax ramifications of the decision. Our next article will examine the tax consequences of being paid in virtual currency.
