The concept of basis is one of the most fundamental underpinnings of the United States tax system. Basis assigns a value to a taxpayer’s property or investment and is used to calculate any gains or losses that occur when a taxpayer takes certain actions. Consequently, understanding how basis works for virtual currency is vital for almost all transactions in the space. This article examines the most fundamental concepts of basis as it relates to virtual currency.
As discussed in a previous publication, virtual currency is considered property and general tax principles apply. Fortunately, a taxpayer’s basis in positions of virtual currency will generally be what the taxpayer paid for the virtual currency. This is referred to as cost basis a concept which is codified at I.R.C. section 1012.
A simple example will flesh out the concept of cost basis. McGee buys $500 worth of bitcoin, $200 worth of ether, and $50 worth of Dogecoins. McGee’s basis in his bitcoin position is $500 as that was the cost of his bitcoin. If his bitcoin’s value appreciates to be worth $2,000, his cost basis would still be $500 which would matter when determining any gain or loss when he has a tax realization event. Similarly, McGee’s basis in his ether would be $200 and his basis in Dogecoin would be $50.
When a taxpayer has multiple transactions of the same virtual currency, the taxpayer’s basis in each underlying transaction will be different. So long as the taxpayer can specifically identify his/her transactions, there will be a tax efficient way to dispose of part of the taxpayer’s crypto positions. If a taxpayer is unable to identify specific units of his/her crypto positions, the taxpayer will be stuck using the FIFO (first in, first out) method of accounting. Using the FIFO method an individual would have to assume that he/she disposes his/her crypto beginning with the earliest unit of crypto acquired. The FIFO method would almost certainly lead to an inefficient tax distribution of an individual’s crypto. Unfortunately, many crypto on-ramps have poor recordkeeping features and crypto participants have been faced with the task of recordkeeping. Therefore, taxpayers, particularly those with multiple crypto transactions, should keep meticulous records.
For example, let’s assume McGee decided to start buying $500 of bitcoin on the first day of each quarter in 2020. Each one of McGee’s purchases would have a basis of $500. However, the current value of each transaction expressed in the current value of bitcoin would be dramatically different. 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.
All four of the bitcoin purchases above would have a basis of $500. However, as the price of bitcoin fluctuates each of the transactions will have a unique current value. The current value of each transaction is the current price of bitcoin multiplied by the total number of bitcoin in the transaction. If McGee decides to sell his bitcoin in the future, he will have to factor in more than just basis when making that decision. In the future, we will continue to explore the intricacies of this example and how McGee can make the most tax efficient decision.
Cost basis is that simple. Future articles will explore more complicated basis concepts and discuss what occurs when a taxpayer sells his/her position in a virtual currency.
