Many individuals have accumulated a great fortune due to the success of one cryptocurrency. While not advocating any position on the theory, many wealth advisors would tell individuals in such a position that diversifying the crypto portfolio may be the best plan moving forward. However, individuals considering such a decision must think about the tax ramifications. The rest of this article will examine the tax implications diversifying a crypto portfolio into other crypto assets may have on an individual.
As we have discussed in a previous article, all crypto assets are considered property by the Internal Revenue Service. Furthermore, when a crypto asset is either sold or exchanged an individual will have to recognize capital gains or losses on the transaction. Applying these two principles together when an individual exchanges one cryptocurrency for a different cryptocurrency the individual will recognize capital gains or losses on the transaction. Therefore, diversifying a bitcoin position into ether or litecoin would require the individual to recognize capital gains or losses and vice versa.
Let’s look at an example to illustrate the point. On July 21, 2019 McGee thought it would be funny to say he was a dogecoin millionaire so he purchased one million dogecoins in exchange for $3,000. McGee largely forgot about his dogecoin but recently saw a meme that reminded him of his dogecoin. He was shocked when he looked at the dogecoin price and saw it was trading at $0.333018 per coin. This made McGee’s dogecoin position worth $333,018! Nervous about the volatility of all virtual currency, McGee thought diversifying his dogecoin into other crypto assets may be a wise decision.
McGee decided to exchange $111,006 of his dogecoin position into bitcoin when bitcoin had a price of $55,000 and another $111,006 of his dogecoin position into ether when ether had a price of $2,500. As a result, McGee now has 333,334 dogecoins worth $111,006, 2.01829091 bitcoins worth $111,006, and 44.4024 ether worth $111,006. Unfortunately, McGee also now has a large tax bill due.
McGee originally had a basis of $3,000 in his dogecoin. However, he exchanged one-third of his dogecoin for bitcoin. Therefore, one-third of his dogecoin basis, $1,000, would be used to determine how much long-term capital gains were due as a result of that transaction. McGee’s bitcoin at the time of exchange was worth $111,006 so the amount of long-term capital gains he would owe is $110,006 ($111,006 – $1,000). Using the exact same logic, he would also owe $110,006 ($111,006 – $1,000) in long-term capital gains on his ether transaction. McGee would have a total of $220,012 in long-term capital gains as a result of the two transactions. Furthermore, after the two exchanges McGee would have a basis of $1,000 in his remaining 333,334 dogecoins, a basis of $111,006 in his 2.01829091 bitcoins, and a basis of $111,006 in his 44.4024 ether.
Individuals exchanging their crypto positions into other crypto positions must recognize capital gains or losses on such transactions. Therefore, before one exchanges one crypto asset for a different crypto asset, the individual must consider the tax ramifications. Unless the crypto asset is part of an individual retirement account (IRA) an exchange of one crypto for another crypto will cause the taxpayer to recognize either capital gains or losses. It may be worth exploring an IRA setup with crypto in a later publication. If you have any questions regarding the topics discussed in this article, please contact us.
