Bitcoin’s meteoric increase from $1,000 in at the beginning of 2017 to a high of nearly $20,000 turned many early miners into overnight millionaires. These early successes drew miners into other alt-coins, such as Litecoin and Dogecoin, where mining is more accessible than the now-saturated market for mining Bitcoin.
While it’s possible to mine cryptocurrencies with a personal laptop, most crypto miners rent servers from third-party server farms or operate their own rack servers. Mining pools help even out income and generate a more predictable return for those that are just starting out with little resources.
Cryptocurrency miners should be aware that mining cryptocurrency is a taxable event — although the amount of tax liability depends on several factors.
Let’s take a look at how taxes work with crypto mining and how to minimize your exposure.
Hobby vs. Business
Crypto miners may choose to treat their activities as a hobby or a business. While it may seem simpler to treat it as a hobby, 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 a business is worth the tax savings.
The difference between a hobby and 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 crypto mining on your personal computer, you should treat it as a hobby for tax purposes. 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 costs.
Mining as a Hobby
Hobby income is treated as ordinary income by the IRS, which means that it’s taxed at your marginal tax rate. These tax rates depend on your overall level of taxable income. 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 2019:
Marginal Tax Brackets and Rates - Source: Tax Foundation
Mining as a Business
Business income is treated separate from ordinary income (e.g. income from wages or investments). The biggest advantage of setting up a business is that you can deduct many more expenses, although expenses like computing resources and office space must be used exclusively for crypto mining in order to qualify as 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 revenue for the year.
- Calculate your variable expenses by summing 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 it 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 on Form 1040 Schedule C.
For more information on what qualifies as a business expense, see IRS Publication 334 Chapter 10.
Setting Up a 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 personal income from Form 1040 Schedule C. Since sole proprietorships are unincorporated, there’s no liability protection and your personal 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, which means that 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. 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.
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 opposite is true if someone hires your business as a contractor.
Avoiding IRS Troubles
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 amount of coins mined multiplied by the weighted average price for that day. It’s important to have a detailed record in case of an audit and to help with preparing taxes.
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 space 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 drawn the attention of the IRS. 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.