Although this may seem nonsensical, due to the way cryptocurrencies are taxed and the volatility of the cryptocurrency markets, this situation has unfortunately occurred for a few crypto traders.
An example of the way it usually happens is as follows:
- An investor purchased bitcoin when it was at a low price, let’s say they bought 5 bitcoin at $1,000 each in April 2017
- The investor held the bitcoin until it increased tremendously in price. They then heard about smart contracts on the ethereum blockchain, so they wanted to invest in ethereum. They exchanged their 5 bitcoin for 100 ethereum tokens when bitcoin cost $10,000 per token and ethereum cost $500 per token in December 2017
- This means the investor has made a taxable gain of $9,000 per bitcoin ($45,000 total)
- The investor believes in the long-term value of ethereum, so decides to hold the tokens for the foreseeable future.
- Fast forward to December 2018. The investor is calculating their tax return for the 2017/2018 tax year. The ethereum has decreased in price tremendously to $70 per token, meaning the investor’s entire portfolio is currently worth $7000.
- When calculating the capital gains tax owed to the IRS, the investor has $45,000 in cryptocurrency capital gains.
- As the investor has a high income from their job, their tax rate is 20% Therefore, the tax to pay on the $45,000 from disposing of their bitcoin is $9,000. The current value of the ethereum they hold is $7000. Therefore, their portfolio is currently $2,000 less than their tax bill for the 2017/2018 tax year.
- There is a silver lining however. The investor now has an unrealized loss on his ethereum investment of $43,000. If the investor were to sell their ethereum tokens now and realize this loss (called tax-loss harvesting), it could help to greatly reduce their tax bill for the current tax year, and potentially allow them to claim up to $3,000 of the losses against taxable income (we advise speaking to a certified tax professional in this scenario as it can become complex when claiming losses from cryptocurrency transactions).
Although this is quite a simplified scenario, similar ones have occurred. Due to the way the cryptocurrency market has performed in recent years and how the tax years fall, it is much more common than people would expect.
If this situation does happen to you, we recommend seeking the advice of a certified tax professional as it is often possible to come to an agreement with the IRS overpayment terms and installments.
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Disclaimer: This article is intended as an informative piece. This is not accounting or tax advice. Please speak to a qualified tax professional about your specific circumstances before acting upon any of the information in this article.