By Nilesh K Sudrania, CFA, CPA – Sudrania LLC
If there is one topic that polarized the adult population globally in 2017, it was the surge of Bitcoin and other Cryptocurrencies in general. Governments across the world are discussing how to manage (read regulate) this supposed threat to the traditional central banking system. Then there are influential business leaders either for or against the Bitcoins. Amid all this, there are traders, investors, speculators, you and me who just want to understand and perhaps use the Bitcoin/Cryptocurrencies/Blockchain technology to their advantage. I wrote about some tax questions I heard from many folks. This article is in continuation of that to expand the discussion and cover some issues around portfolio management and reporting as well.
Cryptocurrencies are the financial asset that has their origin in technology. Not just the early users, even current users have a technology background. Nothing wrong with that. However, the problem is that the solutions that were built were not built by experts in investment or portfolio accounting. There are many free google spreadsheets available that’ll let you download your transactions/holdings automatically and give you p&l calculations. Nice! Except, these are not built for professional portfolio management, p&l calculation, and certainly not for tax reporting.
The second hurdle is transparency. Most of the traditional vendors of investment backoffice or accounting services (or fund administration services) are unsure of the risks they take. Lack of controls on the wallets makes things even worse.
The third issue around portfolio management is pricing. While supposedly very liquid asset, there are many exchanges and many times the price of the same cryptocurrency is different (sometimes with a wide margin) on different exchanges. So the valuation of the portfolio is another problem.
Finally, the solutions to these problems are very expensive. For any traditional investment or trading business, such basic reporting would be provided by the brokers. But in this case, there are no brokers who are looking to offer value-added services. Most folks are trading personal capital, or friends and family. So typical asset size does not justify an expensive software solution.
We suggest the following evaluation criterion when you evaluate a system for portfolio management:
i) Ability to keep track of daily transactions
ii) Ability to keep track of daily holdings with market value
iii) Allow multiple methods for taxlots closing to optimize capital gains calculations
iv) Connections with popular exchanges. There are just too many exchanges and new ones opening all the time. If you can get some of the popular exchanges, that should be a good start.
Tax Planning (USA):
Advance/Estimated Tax – Depending on whether it is your direct investment or a pass-through entity, keep a watch on the capital gains time to time (we suggest at least monthly given the volatility) and keep an ongoing estimate of the potential tax liability and make payments of estimated taxes. You may need to liquidate some of the holdings to arrange for enough cash. If you don’t do this, you may be surprised with a large tax liability and perhaps penalties and interest.
Taxable Income – The good news is that not all the money you make is taxable. The cryptocurrencies are capital assets. You don’t count the appreciation as taxable income until you sell/dispose of such capital asset.
Long-Term Capital Gains (or Loss) – If you held these assets for more than one year (that is, one year plus one day), that makes the capital gain on this long-term capital gain. This is good for you since the rates are lower on long-term (can be even 0% depending on your tax bracket).
Minimize ‘Realized’ Capital Gains – You can minimize the capital gains if you plan well. While the most common method is First In First Out, which is saying that you sell the oldest lot first, there are other methods. One is Highest Cost First Out, meaning, you sell the lot that was bought at the highest per unit price. This method should result in lower profits capital gains. In the rising prices scenario, LIFO (Last In First Out) will also give you roughly the same results, but only for a short period.
The new tax law had a proposal to allow only FIFO method going forward. However, that was not part of the final bill, so you still have the freedom to choose your taxlot closing method.
Bitcoin Futures – Recently launched futures on Bitcoins and Index Reference Rates are going to be eligible for IRC section 1256 treatment. That means 60% of the gains are automatically treated as long-term.
Like-kind Exchange – The exchange of one cryptocurrency for another may or may not qualify as the like-kind exchange under IRC sec. 1031.
What can you plan – You can do two things:
1. One is lowering the total amount of capital gains by using the higher cost lots for closing.
2. Second is to try to generate long-term capital gains instead of short term. So even if the amount of capital gains is roughly the same, you pay a lower rate of taxes.
DISCLAIMER: This article is not intended to be any comprehensive tax advice by any means. Please consult your tax adviser for your specific case.
Nilesh Sudrania is the Founder & CEO of Sudrania LLC, a Chicago based investment backoffice solution provider. He is a CPA and a CFA charterholder. Contact: firstname.lastname@example.org or visit www.sudrania.com.