Crypto Taxes and Accounting

Crypto Mining & Taxes: What You Need to Know

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February 28, 2022
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    Bitcoin's meteoric increase from $1,000 at the beginning of 2017 to a high of more than $60,000 turned many early miners into overnight millionaires. These early successes drew miners into other altcoins, such as Litecoin and Dogecoin, where mining is more accessible and less saturated than the mature Bitcoin market.

    While it's possible to mine cryptocurrencies with a personal computer or laptop, most crypto miners rent servers from third-party server farms or operate their own rack servers. The most popular and easy-to-use options are mining pools that help even out income and generate a more predictable return for those just starting with limited resources.

    Of course, the growing popularity of cryptocurrencies has caught the attention of the IRS and other government regulators to levy crypto mining taxes on miners. The Biden administration has made the “tax gap” a priority issue for the Treasury, and cryptocurrencies are a key area of focus with new rules that are making miners pay taxes on crypto mining. 

    Let's take a look at how to pay taxes on crypto mining and how to minimize your exposure. But first, the foundation of mining.

    Proof-of-Work

    Think of crypto mining as mining precious metals where miners unearth diamonds, silver, and gold. Similarly, crypto miners help release new coins into circulation. Miners use specialized mining rigs that are capable of solving complex mathematical puzzles appearing as cryptographic hashes—chunks of compact digital signature data—that are created to securely transfer data on the blockchain. Miners on the network compete to solve the mathematical puzzles and the first one to solve it gets to add a block on the blockchain and earn a reward. 

    Every block leverages a hash function that is connected to the previous block, building a perfect chain of blocks that cannot be changed or deleted also leading back to the first block. This is why peers on the blockchain can easily verify the authenticity of blocks and whether the miners received their rewards for validating the blocks.

    Is Crypto Mining Taxed?

    The IRS is cracking down on crypto tax evasion and dedicating more resources toward enforcement, so it's essential to stay on the right side of the law and pay what you owe. While the agency's guidance is hardly clear-cut, its guidance on crypto mining has been unambiguous since its original input in 2014.

    According to IRS Notice 2014-21:

    If a taxpayer's "mining" of virtual currency constitutes a trade or business, and the "mining" activity isn't undertaken by the taxpayer as an employee, the net earnings from self-employment (generally, gross income derived from carrying on a trade or business less allowable deductions) resulting from those activities constitute self-employment income and are subject to self-employment tax.

    The IRS also provided subsequent guidance to answer questions related to hard forks, airdrops, and other events that may occur when miners continue to hold cryptocurrencies in its Frequently Asked Questions on Virtual Currency Transactions. The more uncertain areas of the law apply to things like decentralized finance (DeFi) and non-fungible tokens (NFTs).

    Crypto Mining: Hobby vs. Business

    Crypto miners may choose to treat their activities as a hobby or a business. While treating it as a hobby may seem simpler on the surface, mining as a business has more deductions and benefits, and may reduce your overall tax liability. The key is determining if the added complexity of owning a company is worth the tax savings.

    The legal difference between a hobby and a business depends on subjective factors like:

    • The time and effort spent.
    • Your intent to make a profit.
    • Your dependence on mining income.
    • Your mining profitability.

    In short: If you're trying out small-scale crypto mining on your personal computer, you should treat it as a hobby for tax purposes. On the other hand, if you own your own rack server and rely on the income, you should treat it as a business and write off some of your crypto mining taxes. If you have any questions, it’s best to ask a tax professional for specific advice.

    Mining as a Hobby

    Hobby income is treated as ordinary income by the IRS, which means that it's taxed at your personal marginal tax rate. These tax rates depend on your overall level of taxable income from your job, investments, and other sources. There are only a handful of deductions that you may be able to take for a hobby business, so most of that income is directly taxable.

    Here are the marginal tax rates for 2021:

    Marginal Tax Brackets and Rates - Source: Tax Foundation

    Mining as a Business

    Business income is treated separately from ordinary income (e.g., income from wages or investments). The most significant advantage of setting up a business is that you can deduct many business-related expenses (see below). However, fees like computing resources and office space must be used exclusively for crypto mining to qualify for a deduction.

    The high-level process for calculating business income is:

    1. Calculate your revenue by taking the amount mined each day, multiplying it by the trading price on a reputable exchange, and summing up income for the year.
    2. Calculate your variable expenses by adding up your additional electricity bills, server rental costs, and any other variable costs involved with crypto mining.
    3. Calculate your fixed expenses by listing your qualifying business expenses, such as server hardware, and depreciating them over time.
    4. Subtract the revenue from the expenses to come up with the net income. This figure is reported on your corporate tax return or Form 1040 Schedule C.

    For more information on what qualifies as a business expense, see IRS Publication 334 Chapter 10. And again, it’s worth speaking to a tax professional that can help give you a definitive answer that’s defensible in the event of an audit.

    Different Crypto Mining Methods

    There are mainly four types of mining methods

    • CPU Mining
    • GPU Mining
    • ASICs Mining
    • Cloud Mining

    When crypto-mining first began, CPU mining was the preferred option of most miners. Eventually, miners figured out that CPU mining is a tool slow as it took several months to earn even a small amount of profit considering the high utility cost and increased complexity across the board.

    Later, miners moved to the GPU mining method, which optimized the computational power by combining a set of GPUs in one mining rig requiring a motherboard and cooling system. The GPU miners are still used along with the ASIC miners that are specifically designed for mining cryptocurrencies. These miners are expensive and as mining difficulty increases day by day, they become obsolete quite quickly. 

    Considering the constantly increasing costs of ASICs and GPU mining, cloud mining is quickly gaining traction. In cloud mining, miners can leverage dedicated mining facilities and mine cryptocurrencies.

    How to Set-up a Crypto Mining Business

    The simplest type of crypto mining business is a sole proprietorship. Any income earned by the business is passed through and added to your income from Form 1040 Schedule C. The only downside is, since sole proprietorships are unincorporated, there's no liability protection, and your assets could be at risk to repay business liability.

    There are a few different ways to structure a business (although this list is not all-inclusive):

    • Limited Liability Company (LLC) - The LLC designation creates a separate entity for your business assets. You can add an LLC to a sole proprietorship or partnership.
    • S-Corporation - S-Corps are corporations with pass-through tax status, which means that your crypto mining income is only taxed once at your personal level.
    • C-Corporation - C-Corps are traditional corporations that are separately taxable entities. They must pay taxes at a corporate level, and any dividends or wages may be taxed at a personal level.

    If you're paid in cryptocurrency from these entities, you must treat the cryptocurrency as wages. Thus, you must take the fair market value of the coins to get your income and then compute your tax liability using the ordinary income marginal tax bracket above. However, you may also take dividends or distributions in some cases at a lower tax rate.

    If you pay others more than $600 as part of business, you are also required to report the payment to the IRS and send the recipient a 1099-MISC form. The reverse is true if someone hires your business as a contractor. These forms are designed to ensure that you or your contracts pay tax on any significant income.

    What Mining Deductions Are Available?

    Many crypto miners incorporate as a business to deduct their expenses and lower their overall taxes on crypto mining. Fortunately, there are many different ordinary and necessary expenses that you can deduct as a crypto miner.

    Some of the most common deductions include:

    • Equipment: Crypto miners may deduct the cost of their mining equipment. If the equipment cost exceeds $1 million, you need to use the modified accelerated cost recovery system (MACRS) to determine how to depreciate the equipment over time for tax purposes, although accelerated depreciation may apply.
    • Electricity: Crypto miners may deduct the cost of electricity, but you must track only the amount used to mine. For example, you may need a separate meter to ensure proper allocations. Oftentimes, electricity is one of the largest expenses associated with crypto mining operations.
    • Repairs: Crypto miners may deduct the cost of repairs to their mining equipment. When making repairs, keep any receipts to provide evidence in the event of an audit.
    • Space: Crypto miners may deduct the area that holds mining equipment. While rented rooms are straightforward, home offices can be a lot more challenging to deduct.

    There may be other deductions available as well depending on your business. Speak with your accountant or tax professional to discuss these deductions and balance the benefit of a deduction with the risk of an audit.

    How To Pay Crypto Mining Taxes

    The best way to avoid trouble with the IRS is keeping detailed records and paying what you owe.

    The easiest way to keep detailed records is using an online exchange that automatically tracks prices. Alternatively, you can use your own wallet and maintain a daily spreadsheet that includes the number of coins mined multiplied by the weighted average price for that day. It's essential to have a detailed record in case of an audit and to help with filing taxes on crypto mining.

    Paying what you owe means avoiding many potential shortcuts that could trigger an audit. For example, you may not want to take a home office deduction for crypto mining operations taking place with a shared room (e.g., a bedroom or living room). The lack of a dedicated space makes it difficult to prove that you only used the area for mining.

    ZenLedger makes it easy to calculate your crypto tax liability by aggregating transactions in wallets and across many popular crypto exchanges. In addition, the software helps auto-populate many popular tax forms, such as Form 8949 and Form 1040 Schedule D, as well as FBAR and other regulatory forms.

    The Bottom Line

    Crypto mining has become a big industry, which has made the IRS more attentive toward crypto mining taxes. If you're mining cryptocurrencies, you should carefully consider how to structure your business, keep detailed records of all transactions and ensure that you're following the rules to the "T." That way, you can rest assured that the IRS won't come knocking on your door.

    ZenLedger can help you easily calculate your crypto taxes, and also find opportunities for you to save money and trade smarter. Get started for free now or learn more about our tax professional prepared plans!

    Crypto Mining Taxes FAQs

    1. Is crypto mining taxable?

    Yes. If you mine cryptocurrency, receive it as a promotion or as remittance for goods or services, it is considered as taxable income. The taxes will be levied upon you on the entire fair market value of the coins that you received on that day at a regular income tax rate.

    2. Do you pay tax on mining?

    Yes. When you earn crypto from mining, it is subjected to capital gains tax, which is levied upon you if you’re seen making an income from mining or receiving crypto as a promotion or as remittance for goods or services.

    3. What happens if you don't report cryptocurrency on taxes?

    The IRS already knows about your crypto transactions so you should track your transactions and pay taxes on time otherwise you might face an IRS audit resulting in penalties or even criminal charges as it is considered tax evasion or fraud.

    4. How do I report cryptocurrency on my taxes?

    The IRS considers cryptocurrency as property as per the IRS Notice 2014-21 and like any property, the capital gains and losses have to be reported on Schedule D and Form 8949 if required.

    5. Do I have to report crypto on taxes if I don't sell?

    To report taxes, there has to be a taxable event first. Buying cryptocurrency is not a taxable event itself but if you buy, sell, or exchange the virtual currency then it is a taxable transaction and that’s what the IRS is looking for. Therefore, buying and holding crypto for a long time is not taxable even if the price of the tokens held rises significantly.

    6. How does the IRS know if you have cryptocurrency?

    The IRS always knows about your crypto transactions. For one, crypto exchanges send Form 1099 to the IRS to alert the agency that a taxpayer has been trading cryptocurrency and therefore, the said taxpayer has to report crypto on their tax returns.

    Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, tax, legal or financial advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.

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