Taxing Crypto: The Ultimate Guide Unveiled – Avoid Costly Mistakes!

If you thought that by getting involved in crypto trading you might save yourself from paying taxes, then you are going to be disappointed. While this scenario can still be true in some countries, where tax reforms haven’t been made for crypto trading, the downside is that those countries have labeled crypto trading an illegal activity, which means you are not allowed to get involved in this activity, otherwise if found guilty, you would be forced to face legal consequences. In many countries where crypto trading, buying, and selling crypto is allowed, they are considered taxable events. 

How much tax you have to pay depends on where you live. Each country that taxes crypto, has its own tax laws, rules, and ratios that they apply to crypto. Generally, to calculate your taxes, you must consider your capital gains and losses. You may also be eligible to pay income taxes on your crypto holdings if you are receiving crypto as a form of payment.

Some crypto activities, however, are not considered to be taxable events:

• Buying cryptocurrency with fiat currency (dollars, euros, pounds, etc.) is not considered a taxable event. There are exceptions to this case. If purchase a crypto where the price is lower than the fair market value of the purchased coin then you might be eligible to pay tax on it.
• Donating cryptocurrency to a tax-exempt organization might save you from getting taxed. 
• Giving cryptocurrency as a gift to someone under a certain limit is also not a taxable event.
• Transferring cryptocurrency from one wallet account to another is also not a taxable event, as long as both these wallet accounts are owned by the same person.

So, if you are using cryptocurrency in this capacity you might save yourself from getting taxed on your crypto holdings. On the other hand, the activities we are going to mention now will be taxed by the authorities: 

• Selling your cryptocurrency for Fiat.
• Crypto Staking or Crypto Mining are considered taxable events.
• Getting your salary in the form of crypto. This is an income-generating event, which means income tax will be charged on it. 
• Receiving airdropped tokens.
• Trading one type of cryptocurrency for another.
• Receiving interest or yield in crypto. 

Now that we know which scenarios are considered taxable events and which are not, the next question is how to calculate the value of the tax, that you must pay. One conventional way is to use Crypto Tax Software, which will help you in calculating the amount that you must pay in taxes. 

How does Crypto Tax Software work?

There are several crypto tax software available online that you can use to calculate the taxable amount. We will look into the strategies applied by different software when they calculate your tax amount. Several methods or formulas are stated on different platforms used by their tax calculating software to determine the value of tax to be assessed. These formulas come to be termed Cost Basis Formulas for tax software users. 

FIFO (First in, First out)

The most common method to use when calculating your taxable amount is the FIFO method. In this valuation method, the first crypto asset you buy will also be the first one you sell. If you have made a profit in this transaction then the difference in the amount will be the figure on which the tax is calculated. 

Example Scenario

Suppose you bought $2500 worth of ETH as your first purchase. When you plan to sell it, the value of ETH has increased to $3500. The profit you make is $1000. That profit made is called capital gain. The value of the capital gain is the amount on which the software will calculate tax.

LIFO (Last in, First out)

The LIFO method takes into consideration your most recent crypto purchase, which you also sell first. When you sell your cryptocurrency, the LIFO method calculates the capital gains you have made on that purchase. If the selling price is greater than the purchase price then it means you have made capital gains on your purchase.

Example Scenario

We will use the same scenario mentioned in FIFO. Here a trader buys ETH worth $2750, which was his most recent purchase, and sells it at $3500. Using the LIFO method, the capital gain made by a user is $750, which is their taxable amount. This method resulted in a trader gaining $250 more capital gains than FIFO.

(HIFO) Highest Cost, First Out

In the HIFO method for calculating cryptocurrency gains or losses, a trader starts by selling the cryptocurrency that they acquired at the highest cost or that is the most expensive in their portfolio. This means that they consider the costliest assets as the first ones to be sold. Similar to the LIFO method in the example scenario we have seen above, using the HIFO method would yield the same profit for the trader.

(LCFO) Lowest Cost, First Out

In LCFO, a trader sells the minor expensive crypto asset first. The difference in the sale price and buying price of that crypto asset determines the taxable gains or losses.

(ACB) Average Cost Basis

In ACB, we calculate the average cost for all assets by adding the total amount paid by a trader to buy crypto assets and then dividing it by the number of coins/tokens.

(Spec ID) Specific Lot Identification 

Pick out the crypto asset you want to sell using TXN (transaction number assigned to a particular crypto trade) numbers.

(LGUT) Loss Gain Utilization

In this method, a trader uses the cost basis that would first result in the most significant loss.

Crypto Tax Rates 

Several countries have their tax rates which they employ when calculating your taxable amount. Here we will look at the example in the United States, where their tax regulatory authority, the IRS has given the figures on the amount of tax you will be charged on your short-term and long-term crypto gains.  

Cryptocurrency tax rates for the year 2023 on Long-term gains.

Cryptocurrency tax rates for the year 2022 on Short-term gains.

The objective of showing this table is to give you a working knowledge and understanding of what to look forward to when you make capital gains on your crypto earnings. Each country has its crypto tax laws and you should familiarize yourself with the rules that are defined in your country.  

Closing thoughts

Calculating your taxes correctly and paying them is your utmost responsibility as a citizen of your country. This is also a very technical process and not everyone can understand the workings of tax calculation. So, if you are not up to the mark then you should hire professional tax advisors who will complete this task for you. Making mistakes on your tax returns may result in you getting penalized heavily by the relevant authorities.