Taxes on cryptocurrencies has been a hot topic for several years, and it’s certainly not an easy task to navigate all the different rules and regulations involved. When it comes to taxes on margin and derivatives trading, things start to become even more complicated.
Because tax authorities like the IRS (USA), the ATO (Australia), and CTA (Canada) are now actively sending out tax warning letters to crypto traders, it has become even more important than ever before to understand how to stay compliant with tax reporting to avoid fines or penalties. If you have ever traded on exchanges like BitMEX, Binance, Bybit, FTX, or Kraken, this guide is for you.
Now, first let’s grab a cup of coffee, then sit back and read!
Derivatives vs. Margin Trading
We should start by defining what derivatives and margin trading actually are. These two terms are often being used interchangeably, but the way they work is actually quite different. What makes this even more confusing, is that several exchanges offer both types of trading today.
Derivatives and margin trading are similar in the way that you have the ability to trade for larger position sizes than the actual value of the funds sitting in your account. For example, if you have a total of $1,000 in your exchange account, you can often buy bitcoin worth $2,000, $5,000, or even as much as $100,000 in the case of derivatives trading.
This is obviously very tempting for many traders as it provides opportunities for even larger profits than normal. The downside is that the risk is also increased, and you may end up losing all the funds in your account if the price moves in the opposite direction of your bet.
What is Margin Trading?
Margin trading allows you to trade larger positions by borrowing funds from either the exchange itself or the exchange’s users. This leads to potentially larger profits, but also an increased risk of losing all your funds.
Margin Trading Explained
When you are trading on margin you are actually borrowing funds to buy or sell an asset. By raising your buying power, you have now an increased opportunity to make more profit, but the associated risk is also amplified. The funds are borrowed from either the exchange itself or from other exchange users. The amount borrowed also incurs an interest that you need to pay back later.
It’s important to have a good grasp of the terminology used in margin trading. Most exchanges allow borrowing funds as a fixed multiple of your account’s available balance. For example, if your account balance is $1,000, and you borrow a total of $3,500, you have now leverage of 3.5x. Each trade you make will result in either a gain or loss. The gain/loss is calculated as the difference between the value of your position when closing and opening the trade:
closing value – opening value
opening value – closing value
Buying an asset on margin is also referred to as going long while selling an asset is going short. Let’s look at an example to better understand how margin trading works and how your gain/loss is calculated:
Example 1: Margin trading with bitcoin
You think there is a high probability that bitcoin will increase in price over the coming days, so you want to make a big bet with the hope of receiving a large profit in return. You have a total of $2,000 in your account, and then you discover that the exchange offers margin trading with leverage up to 5x. This allows you to trade for as much as $10,000 without depositing more funds.
Next, you decide to buy bitcoin worth $8,000 (4x leverage) when the price is $10,500 per BTC. Two weeks later, the price has gone up to $11,700, and you decide to sell everything you bought earlier. This is how you would calculate the profit from this trade:
$8,000 (= 0.762 BTC)
$8,915 (0.762 * 11700)
$8,915 – $8,000 = $915
You have now made a total profit of $915 by going long BTC with 4x leverage.
Taxes on Crypto Margin Trading
The existing tax rules applicable to derivatives and margin trading are very complex and the tax treatment depends on many factors. While these rules have been issued for traditional markets in the past, there is very little to no guidance issued specifically for cryptocurrencies. In fact, most tax authorities including the IRS in the USA have not even made any public comments about the applicable tax treatment. However, most CPAs and other tax professionals seem to be in somewhat agreement that gains and losses arising from cryptocurrency trading should be treated as capital gains.
Normally, when you are trading an asset like cryptocurrency, you need to calculate capital gains for each transaction. This is not the case for margin trading where you are actually not taxed on any of your transactions directly. Instead, you are only taxed on either the gain or loss that results from your trading activity as just mentioned. We will look closer at this in the next Sections below.
How to calculate and report gains
You can make a trading gain in two ways: Either from buying a cryptocurrency (going long) and then later selling at a higher price or from selling (going short) and then later buying back at a lower price. In both cases, closing the position is a taxable event and you need to report the resulting gain on your tax return as a capital gain.
Example 2: Trading gain from a short position
You short bitcoin at $12,500 by selling 2 BTC using 5x leverage. You close the position three days later at $11,900 per bitcoin. Your opening value is $25,000, while the closing value is $23,800. You will return the 2 BTC originally borrowed after closing the position, and the resulting taxable gain can be calculated this way:
$25,000 – $23,800 = $1,200
This gain should be reported as a capital gain on your tax return. If you are from the US, this should be reported on Form 8949 with a cost basis equal to $0, total proceeds of $1,200, and a capital gain of $1,200.
How to calculate and report losses
Similar to margin trading gains, trading losses can occur from two different scenarios: Either from buying a cryptocurrency (going long) and then later selling at a lower price or from selling (going short) and then later buying back at a higher price. Closing the position is a taxable event in both cases and you are allowed to report the resulting loss on your tax return as a capital loss.
Example 3: Trading loss from a long position
You buy 100 Litecoin at $75 with the expectation of the price to go up so you can make a profit. Instead, the price of LTC falls to $70 the next day, and you decide to close the position and take the loss. In this case, your opening value is $7,500 while the closing value is $7,000. The resulting capital loss can be calculated this way:
$7,000 – $7,500 = ($500)
You should report this is a sell transaction with a cost basis equal to $500, total proceeds of $0, and a capital loss of $500.
What Are Derivatives and Futures?
Derivatives trading is similar to margin trading in the way that you get increased buying power through the use of leverage, but instead of buying or selling the actual asset, you are trading what is referred to as derivatives contracts. The value of each contract is either based on or derived from the real asset it represents. In the world of cryptocurrencies, you can trade derivatives representing multiple different coins including Bitcoin, Ethereum, Binance Coin, and Chainlink.
The most popular type of derivatives is futures contracts which let traders speculate on price movements similar to margin trading. In contrast to traditional investing, you do not own the asset when buying derivatives. Instead, you simply own a contract that you later can sell at a higher or lower price with the goal of making a profit.
Taxes on Crypto Derivatives Trading
Because of the complicated tax environment surrounding derivatives as explained earlier, the conservative approach for traders is to report all gains and losses from cryptocurrency trading as capital gains. The same calculation methods already discussed for margin trading are also applicable for derivatives trading such as futures contracts. This means that you need to calculate the gain/loss arising from each closed position and report this as capital gains on your tax return.
The 3 Most Important Steps to Take
If you have ever been trading cryptocurrency derivatives or margin trading, there are three important steps you need to make sure you do.
Step 1: Keep records of your transaction history
Almost all exchanges let you export either a CSV or XLSX file containing your entire trading history. It’s important to always keep records of the transaction history in case you ever get audited by a tax authority like the IRS. You also need this data to do the next step below.
Step 2: Calculate gain/loss for each closed position
For every closed position, you need to calculate the resulting gain/loss. We have already explained how to do this with three real-world examples earlier in this guide. If you don’t want to do this manually yourself, you can use Coinpanda to automatically keep track of all your crypto transactions and calculate the resulting gains from margin and derivatives trading.
Step 3: Report the capital gains each year
The final step is to stay compliant and report your taxes each year. It has become both very difficult and risky to avoid reporting taxes from cryptocurrency trading because tax authorities are now getting data containing personal details directly from several exchanges. If you avoid reporting and paying your taxes, you risk getting fines and penalties down the road which could have a significant impact.
Cryptocurrency Tax Software
If you have been trading cryptocurrency on different exchanges and don’t want to spend several days calculating your taxes manually in Excel, you can use a cryptocurrency tax solution to consolidate all transactions and generate your tax documents in under 20 minutes.
Coinpanda is a crypto tax software that has become very popular in a short time and is used by thousands of cryptocurrency investors today to automatically keep track of all transactions. If you have traded on exchanges like BitMEX, Bybit, FTX, Binance, Kraken, or Bitfinex, simply connect your exchange accounts using API keys and all transactions will be imported automatically.
You can sign up for a 100% free account first to see if the software can help you with reporting your crypto taxes.
If you want to learn more about how cryptocurrencies such as bitcoin are taxed, please refer to our in-depth tax guide that is regularly updated: