One of the core components in calculating taxable gains or losses on cryptocurrency transactions in the UK is understanding the concept of 'cost basis'.
This article aims to demystify cost basis methods, offering a clear overview on how to calculate crypto gains in the UK. We’ll look at the concept of share pooling, the same-day rule, the bed and breakfasting rule, and the section 104 pool – all in the context of filing your crypto tax return.
This article is part of our series: UK Crypto Taxes.
What is a cost basis for cryptocurrencies?
Cost basis for cryptocurrencies refers to the original value of a crypto asset for tax purposes. It's used to determine capital gains or losses upon selling or transferring the asset, by comparing the sale price to the initial purchase price. The cost basis, in essence, represents the total investment made in the asset.
Calculating cost basis for crypto
Cost Basis = Sum of the Purchase Price plus any Purchase Fees (including transaction fees, commissions, or other acquisition-related expenses) divided by the total number of units bought.
Here’s an example:
You bought 2 Bitcoin for a total of £50,000 including a transaction fee of 3,5%.
Purchase Price: £48,250
Purchase Fees: £1,750
Total Number of Units: 2
Cost Basis = (£48,250 + £1,750) / 2 = £25,000
How does the cost basis factor into Capital Gains Tax (CGT)?
The cost basis plays a fundamental role in determining your capital gains or losses, which directly influences the amount of Capital Gains Tax (CGT).
The calculation of CGT is straightforward; it's based on the difference between the selling price of the asset and its cost basis. Here's the formula:
Capital Gain (or Loss) = Selling Price - Cost Basis
As previously mentioned, the cost basis includes the initial price you paid for the asset plus any associated acquisition costs. Consequently, the higher the cost basis, the lower your capital gain, which subsequently leads to less tax owed. Conversely, a lower cost basis would result in higher capital gains and, therefore, a larger tax bill.
It's important to note that this calculation isn't just necessary when you've made a profit. If your cryptocurrency's selling price is less than its cost basis, you'll have incurred a capital loss.
While a capital loss might not have been your initial goal, it can still be used to reduce your overall tax liability.
Find out what that means in our guide: Offsetting Crypto Losses.
Also interesting: How to avoid crypto tax in the UK.
What is Share Pooling for Crypto Taxes?
Share Pooling is a distinctive approach to calculating the cost basis for Capital Gains Tax (CGT) which can also be applied to cryptocurrency transactions.
It originated in traditional finance as a method for handling the sale of equities. When you buy shares at different prices and times and then sell some of them, it might be challenging to identify which shares have been sold.
This is where share pooling comes into play. Instead of tracking the cost basis of each unit of cryptocurrency individually (as done in methods like First-In-First-Out (FIFO) or Last-In-First-Out (LIFO)), share pooling involves averaging the cost basis of all units within the pool.
In contrast to the FIFO method (where the oldest assets are assumed to be sold first) or LIFO method (where the latest acquired assets are assumed to be sold first), share pooling provides a mean average cost of all the assets within the pool.
This average cost is then used to calculate capital gains or losses when a portion of the assets is sold.
Here's the formula to calculate the average cost per unit:
To understand this better, let's imagine you bought 1 Bitcoin at £30,000, another at £35,000, and another at £40,000. If you were to sell 1 Bitcoin, under share pooling, the cost basis would be the average cost of all Bitcoins in the pool.
So in this case, it would be (£30,000 + £35,000 + £40,000) / 3 = £35,000
Additional Cost Basis Rules
HMRC defines three additional rules for the share pooling system which further impact your cost basis calculation:
- the same-day rule
- the 30-day rule or "Bed and Breakfasting rule"
- and the Section 104 Pool
The Same-Day Rule
The same-day rule is one of the essential regulations that govern the share pooling method in the UK. This rule helps in determining the cost basis of your cryptocurrencies when multiple transactions occur on the same day.
The same-day rule states that if you buy and sell the same type of cryptocurrency on the same day, the cost basis for calculating capital gains tax (CGT) is the cost of the crypto acquired on that day.
This is irrespective of any other units of the same cryptocurrency that you might have purchased earlier and exist in your share pool.
The Sense Behind It
The sense behind the same-day rule lies in its effort to prevent 'bed-and-breakfasting' – a practice where investors sell their assets at the end of the trading day and re-purchase them the next morning to realize a capital loss and subsequently, a lower tax liability. By forcing the use of the same day's purchase price as the cost basis, the same-day rule discourages this form of tax avoidance.
When It Applies
This rule applies across all forms of capital assets, including cryptocurrencies, and is used in conjunction with the 30-day rule and Section 104 pooling to calculate CGT in the UK.
If the quantity sold exceeds the quantity bought on the same day, the investor must proceed to the next rule.
Same-Day Rule Cost Basis Example
Here's an example for better clarity: let's say you bought 1 Bitcoin a few months ago for £30,000, and it is now worth £40,000.
If you buy another Bitcoin for £42,000 on the same day that you sell one, the same-day rule dictates that the cost basis for CGT calculation is £42,000, not the earlier £30,000.
This means that your capital gain is actually a capital loss of -£2,000, reducing your tax liability.Cost basis: £42,000
Capital gains: £40,000 - £42,000 = -£2,000 (Loss)
The 30-Day Rule / Bed and Breakfasting Rule
The 30-day rule states that if an individual sells an asset (such as a share or cryptocurrency) and buys the same asset back within 30 days, the purchase cost of the newly acquired asset must be used as the cost basis for the sold asset.
Essentially, it means that the newly acquired asset's purchase cost takes precedence over the average share pool cost in determining the capital gain or loss on the sale.
The Sense Behind It
The origin of the term "Bed and Breakfasting" paints a vivid picture of the reasoning behind this rule. Investors used to sell assets at the end of the trading day and buy them back the next morning, essentially taking them to "bed and breakfast."
This was done to realize a capital loss that could offset capital gains and thereby reduce tax liability.
By introducing the 30-day rule, the government aimed to prevent this kind of tax avoidance. It ensures that short-term trading maneuvers do not enable investors to artificially manipulate their cost basis and thus their CGT obligations.
When It Applies
The 30-day rule applies to all financial assets, including shares and cryptocurrencies, subject to CGT in the UK. It is triggered when the following two conditions are met:
- Selling an Asset: The rule applies when an individual sells an asset at a loss, whether to realize the loss for tax purposes or for any other reason.
- Repurchasing Within 30 Days: The individual then repurchases the same asset within a 30-day window following the sale.
If both these conditions are met, the cost basis for the sold asset is determined by the purchase cost of the repurchased asset rather than the average cost within the share pool.
If the quantity sold exceeds the quantity repurchased within this timeframe, the investor must proceed to the final rule.
30-Day Rule Cost Basis Example
Our previous example was extended to show the application of the 30-Day rule.
Transactions 1 and 2: As before, straightforward purchase transactions.
Transaction 3 (Sale of 2 BTC): Initially, the same-day rule applies to 1 BTC of the 2 BTC sold, resulting in a cost basis of £42,000 for that part.
Transaction 4 (30-Day Rule): Since 1 BTC is purchased within 30 days after the sale in Transaction 3, the 30-day rule is triggered. The cost basis for the remaining 1 BTC sold in Transaction 3 is taken from Transaction 4, not from the older Transaction 1. This results in a cost basis of £43,000 for the remaining 1 BTC sold.
Cost basis: £42,000 (from Transaction 2) + £43,000 (from Transaction 4) = £85,000
Capital gains: £80,000 - £85,000 = -£5,000
The application of the 30-day rule has effectively "matched" the remaining 1 BTC sold in Transaction 3 with the purchase in Transaction 4, rather than the older purchase in Transaction 1.
This reflects the intention of the 30-day rule to prevent the manipulation of capital gains through the rapid sale and repurchase of assets. It shows how the timing and order of transactions can have significant effects on the calculation of capital gains or losses for tax purposes.
Section 104 Pool
The Section 104 Pool is a method to calculate the cost basis of assets that have been held over various periods and at different costs. Essentially, it averages out the acquisition costs of assets that aren't covered by the same-day rule or the 30-day rule.
In the context of cryptocurrencies or shares, when an asset is sold, the cost basis isn't taken from a specific purchase but instead is derived from the average cost of all the assets within the Section 104 Pool.
Here's how it's calculated:
The Sense Behind It
The rationale for the Section 104 Pool is to simplify the process of calculating Capital Gains Tax over multiple transactions. Without this rule, tracking the cost basis for individual assets acquired at different times and prices would become highly complex and cumbersome, especially for active traders or long-term investors with a large portfolio.
The Section 104 Pool rule helps in offering a streamlined and standardized approach to tax calculation by eliminating the need to associate the sale of assets with specific purchase transactions (outside the confines of the same-day and 30-day rules).
When It Applies
The Section 104 Pool applies to assets that fall outside the purview of the same-day rule and the 30-day rule. Here's when it typically comes into play:
- Long-Term Holdings: When assets have been held for a more extended period (beyond 30 days) and were not part of any same-day buy-and-sell transaction.
- Multiple Acquisitions: When an individual has made multiple purchases of the same asset at different times and prices, the Section 104 Pool helps average out these costs to determine a unified cost basis.
- Cryptocurrencies and Shares: This rule is particularly relevant to shares and cryptocurrencies in the UK, simplifying the CGT calculations for these fluctuating and frequently traded assets.
Section 104 Pool Cost Basis Example
Transactions 1-3: These purchases contribute to the Section 104 pool. The total amount in the pool is 2.5 BTC, and the total cost basis is £30,000 + £35,000 + £10,000 = £75,000.
Transaction 4 (Sale of 1.5 BTC): The sale draws from the Section 104 pool. The cost basis for this sale is calculated based on the average cost of the BTC in the pool.
Transaction 5: This is another purchase that contributes to the Section 104 pool, but since it occurs after the sale in Transaction 4, it does not affect the cost basis of that sale.
Average cost per BTC = Total cost basis / Total amount in the pool = £75,000 / 2.5 = £30,000Cost basis for 1.5 BTC = £30,000 * 1.5 = £45,000
Capital gains for the sale = (Sale price * Amount) - Cost basis = (£50,000 * 1.5) - £45,000 = £75,000 - £45,000 = £30,000
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