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:
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:
- 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.
- Calculate your variable expenses by adding up your additional electricity bills, server rental costs, and any other variable costs involved with crypto mining.
- Calculate your fixed expenses by listing your qualifying business expenses, such as server hardware, and depreciating them over time.
- 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
CPU Mining
As the name suggests, CPU mining requires a central processing unit (or CPU) for crypto mining. To mine crypto using this method, a miner just requires a computer and a few mining software. The slow processing speed of CPU mining and decreasing profit led to its decline and it has not been in use for almost 5 years now.
GPU Mining
GPU Mining is the most popular method of crypto mining. Mining crypto requires one or more graphic processing units and is a comparatively cheaper and more efficient way to build a crypto mining rig. Mining rigs consist of the following components:
- Motherboard
- Processor
- Rig frame consisting of graphic cards
ASIC Mining
Application-Specific Integrated Circuits, commonly called ASICs are devices used to specifically carry out crypto mining. Unlike CPU and GPU mining, ASIC mining has more productivity as it has more computational or mining power. As a result, miners earn more.
Cloud Mining
Cloud mining allows miners to mine cryptocurrencies such as Bitcoin by using rented cloud computing power. Here, miners don’t have to install and run hardware and software related to mining. Anyone can start cloud mining by opening an account in a cloud mining firm and participating in mining from a remote location. This makes it accessible to a wider number of people around the world and it doesn’t require much upkeep.
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.
Tips for Minimizing Your Mining Crypto Taxes
We already talked about the crypto mining business tax deductions. But, here are some other ways you can minimize crypto mining taxes:
Lower Your Taxable Income
Contributing to a retirement plan such as a 401(k), an IRA, or a health savings account can reduce your taxable income and in turn save you money.
Gift Cryptocurrency
The IRS allows taxpayers to gift cryptocurrency worth up to $16,000 to your family each year. However, the cost basis of the cryptocurrency will transfer to the recipient of the gift. This means that they have to pay taxes on any gains they made by selling the gifted cryptocurrency.
Sell Older Cryptocurrency First
By now it is common knowledge in the crypto community that selling a token after a year of holding it results in long-term capital gains tax, which can reduce your tax liability. So, you can allow older holdings first and let the new acquisitions age before you sell them.
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!
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.
