1. Understand Cost Basis
The cost basis is the original value of your cryptocurrency at the time of purchase, including any associated fees. This is the amount you paid for each crypto asset, and it will be used to calculate your gains or losses when you sell or trade.
2. Identify the Sale Price
When you sell, trade, or spend cryptocurrency, you’ll need to determine the asset’s fair market value (FMV) at the time of the transaction. The FMV represents the sale price, and it is typically calculated in fiat currency, like USD or EUR.
3. Calculate Capital Gains and Losses
To determine whether you’ve made a gain or loss, subtract the cost basis from the sale price.
- Capital Gain: If the sale price is higher than the cost basis, the difference is considered a gain.
- Capital Loss: If the sale price is lower than the cost basis, the difference is a loss.
Formula:
Capital Gain/Loss=Sale Price−Cost Basis\text{Capital Gain/Loss} = \text{Sale Price} – \text{Cost Basis}
For example:
- Cost Basis: You bought 1 Bitcoin at $20,000.
- Sale Price: Later, you sell 1 Bitcoin for $25,000.
- Capital Gain: $25,000 – $20,000 = $5,000
4. Short-Term vs. Long-Term Capital Gains
Tax authorities often differentiate between short-term and long-term capital gains, as they may have different tax rates:
- Short-Term: Assets held for less than one year before being sold or traded. These are generally taxed at your ordinary income tax rate.
- Long-Term: Assets held for more than one year before sale. Long-term gains often qualify for a lower tax rate.
5. Calculating Gains on Crypto-to-Crypto Trades
When you trade one cryptocurrency for another, it’s treated as if you sold the original crypto. You need to calculate the capital gain or loss by using the FMV of the new asset at the time of the trade as the sale price.
For example:
- You traded 1 Bitcoin for 10 Ether.
- Original Cost Basis: 1 Bitcoin was purchased at $15,000.
- FMV of 10 Ether at the time of trade: $20,000.
- Capital Gain: $20,000 – $15,000 = $5,000 gain.
6. Using the Average Cost Basis for Multiple Purchases
If you purchased the same cryptocurrency at different times, tracking the cost basis can become complex. Most tax authorities allow for different methods, like First In, First Out (FIFO), Last In, First Out (LIFO), or Specific Identification.
Example with FIFO:
- Transaction 1: Bought 1 Bitcoin for $10,000.
- Transaction 2: Bought another 1 Bitcoin for $12,000.
- Sale: Sold 1 Bitcoin when it was worth $15,000.
- Using FIFO, your cost basis for the sold Bitcoin would be $10,000, resulting in a gain of $5,000.
7. Accounting for Crypto Fees in Calculations
Transaction fees can be included in your cost basis or deducted from your sale price. For example:
- If you bought 1 Bitcoin for $20,000 and paid a $100 transaction fee: Your cost basis would be $20,100.
- If you sold 1 Bitcoin for $25,000 and paid a $100 selling fee: Your sale price would be $24,900.
8. Recording and Reporting
To simplify tax reporting, keep accurate records of every transaction, including:
- Date of acquisition and sale
- Cost basis and sale price
- Fair market value at the time of each transaction
- Transaction fees
Using crypto tax software, such as CoinTracker, Koinly, or TokenTax, can automate these calculations and help track gains and losses accurately.