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Taxation of Cryptocurrency
The explosive growth in cryptocurrency as a digital asset is naturally followed by an equal need to understand the tax implications of cryptocurrency transactions. There is a lot of financial interest in crypto but many people don’t seem to understand exactly what cryptocurrencies are. Likewise few seem to have a handle on the tax implications of crypto transactions.
The first cryptocurrency, Bitcoin, came into being in 2009 and is coming up on its teenage years. Lest we find our crypto transactions as unruly as teenagers are alleged to be, a brief primer on their taxation is in order. The Internal Revenue Service (IRS) offers guidance through IRS Notice 2014-21. Here is a top-level view of the taxation of these increasingly popular digital assets.
Key Takeaways
- The popularity of cryptocurrency as a digital asset has been followed by the need to understand the implications of crypto taxes
- Crypto taxes are applicable in different cases such as: When you make transactions involving cryptocurrency, when you you trade one cryptocurrency for another, if you receive payment in the form of crypto and also if you mine cryptocurrency as a business
- For individuals investing in crypto, it is important that you know and understand the rules, so as to avoid unnecessary taxation. If you're unsure of the tax implications, consult a financial advisor who is conversant with cryptocurrency taxes
Disclaimer
The contents of this article are for educational purposes only. They are not intended to be a source of professional financial advice. You will find experts on financial planning, financial management, and real estate here. More on disclaimers here.
For many people, the taxation of these assets is as mysterious as the assets themselves. Take a look at the following features of cryptocurrencies.
Treatment as Property
The Internal Revenue Service (IRS) treats cryptocurrency as property for tax purposes, which means that transactions involving cryptocurrency are subject to term capital gains and crypto taxes. As with other property, you recognize gain or loss on the sale or exchange of cryptocurrency for cash or another property. There are some positives, as well as some negatives, for crypto investors.
If you sell or exchange crypto that you have held for over one year, it is a long-term capital gain and currently receives favorable tax treatment.
If you sell or exchange crypto that you have held for one year or less, it is a short-term gain, which is treated as ordinary income for tax purposes. You do not get favorable tax treatment for short-term gains.
There is still a little silver lining, you can net these gains as you would other gains, using losses to offset your gains. You are still limited to a net total loss of $3,000 for any tax year; losses in excess of that amount cannot be used to offset other income and need to be carried forward
Specific Identification
In the evolving world of crypto taxation, specific identification remained for a time the much-hoped-for yet much-missing piece.
Many people are familiar with specific identification from their stock transactions. You can use specific identification to deem the sale of whatever shares of a particular stock best suits your tax needs. You do not have to do “first in first out” or “last in last out.”
Instead, you can select the ones most to your liking. Generally those with the highest cost basis and therefore the lowest taxable gain.
Though specific identification did not come in Notice 2014-21, the IRS, through its FAQ section, does provide guidance that specific identification can be used. To use specific identification, the taxpayer needs to have detailed records to support the identification of the units; most crypto tax software should be able to handle this record keeping for you..
Crypto-to-Crypto Transactions
If you trade one cryptocurrency for another, you must report the transaction as a sale and pay taxes on any capital gains.
Coin-to-coin exchanges are not eligible for preferential section 1031 like-kind exchange treatment. Though this was doubtful before, the Tax Cuts and Jobs Act of 2017 made this explicit.
To be clear on what this means; if you exchange your crypto for another crypto at fair market value, it is a potentially taxable event. If you had gain or loss in your original crypto, you need to recognize that gain at the time of the exchange; the basis does not transfer to the new coin. You cannot exchange one coin for another coin and defer the taxation.
Income Is Income
If you receive payment in the form of crypto, it is taxable as if it were received in cash. For example, if an employer pays your wages to you in cryptocurrency, it is taxable just as if they had paid you in cash on that date.
It’s the same if you are self-employed. If you receive self-employment crypto income, it is no different than if you received it in cash from a tax standpoint. You receive the dollar equivalent as income on that date, and that dollar equivalent becomes the basis in your crypto asset if you hold the crypto you received as payment for your goods or services.
You cannot escape or postpone the recognition of income by receiving it in the form of cryptocurrency.
Capital Gains Taxes
Capital gains taxes are a type of tax that is levied on the profit earned from the sale of an asset, including cryptocurrency. When you sell cryptocurrency for more than you paid for it, you realize a capital gain, and you may owe capital gains taxes on that gain. The amount of tax you owe will depend on a number of factors, including how long you held the cryptocurrency and your tax bracket.
Capital Losses
Capital losses are losses that occur when you sell an asset for less than what you paid for it, and they can be used to offset capital gains for tax purposes. When it comes to the taxation of cryptocurrency, capital losses can be used to offset capital gains from the sale of cryptocurrency, as well as gains from other capital assets, such as stocks or real estate. You may be able to use capital losses to offset capital gains and reduce your tax liability.
Capital losses are losses that occur when you sell an asset for less than what you paid for it, and they can be used to offset capital gains for tax purposes. When it comes to the taxation of cryptocurrency, capital losses can be used to offset capital gains from the sale of cryptocurrency, as well as gains from other capital assets, such as stocks or real estate. You may be able to use capital losses to offset capital gains and reduce your tax liability.
Reporting Requirements
If you buy or sell cryptocurrency, you are required to report those transactions on your tax return. If you receive cryptocurrency as payment for goods or services, that income is also taxable and must be reported.
The IRS treats cryptocurrency as property for tax purposes, which means that transactions involving cryptocurrency are subject to reporting requirements similar to those for other types of property.
Mining cryptocurrency
If you mine cryptocurrency as a business, you need to report the income on your tax return. The income is subject to self-employment tax, and you may be able to deduct expenses related to the mining activity, such as electricity and equipment costs.
Hard Forks and Airdrops
A hard fork occurs when a cryptocurrency's blockchain is split into two separate chains. If you hold the original cryptocurrency at the time of the hard fork, you may receive an equivalent amount of the new cryptocurrency. The value of the new cryptocurrency received as a result of a hard fork is considered income and is subject to taxation at the fair market value on the date it is received.
An airdrop occurs when a cryptocurrency issuer distributes tokens or coins to the wallets of individuals who hold a specific cryptocurrency. The value of the airdropped cryptocurrency is considered income and is subject to taxation at the fair market value on the date it is received.
Practical Considerations
The basics of crypto taxation are not overly complex or difficult. There are, however, practical considerations for users of crypto.
If you are going to be making frequent payments or exchanges of crypto, it is important to make sure you are using tax software that captures your transactions and can do the calculations for you. Using crypto to buy your morning coffee every day could result in many transactions; you might not be keen on doing that all by hand.
It is also important to understand that making many trades chasing crypto prices also generates potentially taxable transactions.
Active traders of crypto can create a sizable volume of transactions, each with potential tax consequences. Taxes, as always, should not be the reason to make or not make a trade, but they are a factor and should be given consideration when dealing with this virtual currency.
The Bottom Line
The markets giveth and the IRS taketh, and that holds true for crypto as well. As with other assets, there is no free lunch: If you make profitable gains with crypto, the government will be there for its share, just like any other time you make a gain.
The key for individual taxpayers is to know the rules, so as to avoid unnecessary taxation. Sometimes it might be better to use another form of payment for a latte, and not create a taxable event where you don’t need to make one.
And be real careful to understand the tax implications of making large purchases with appreciated crypto assets. Big gains can mean big taxes. If you're unsure of the tax implications, consult a financial advisor who is conversant with cryptocurrency taxes.
The world of cryptocurrency continues to evolve. The IRS taxation of crypto is by no means onerous or more complex than other property. Many people may not know that each crypto transaction is a potentially taxable event. This isn’t a reason to not use crypto, but it is a reason to use it in a knowledgeable and responsible manner.
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Sources
https://www.cnbc.com/select/how-is-crypto-taxed/
https://www.bankrate.com/investing/crypto-taxes-guide-bitcoin-ethereum/
