The number of Americans that own cryptocurrency nearly doubled from 7.95% to 14.4% in 2019, according to Finder, while Grayscale found that half of U.S. investors were interested in crypto assets. At the same time, Bitcoin prices have more than doubled thus far in 2020, creating significant gains for many consumers and investors.
The IRS has made it clear that the gains from crypto transactions are taxable as property and sought to ensure that taxpayers declare them each year. As interest among the general public has risen, the agency has become increasingly aggressive in ensuring compliance by subpoenaing records from crypto exchanges and even trying to track down privacy coins.
Let's dive right into understanding the basics of crypto tax, the IRS’s evolving stance on cryptocurrencies over the past seven years, and where things may be headed in the future.
The Basics Of Crypto Taxes
Buying and selling crypto is taxable. This is because the IRS identifies crypto as property, not currency. As a result, crypto taxes are no different than the taxes you pay on any other gain realized on the sale or exchange of a capital asset.
Capital Losses Or Gains
When you purchase a stock, bond, house, investment, Dogecoin, Bitcoin, or any other capital asset, you establish a basis equal to your cost to acquire it. When you sell, you compare your sales proceeds to the basis to decide whether you have a capital loss or a capital gain. If your proceeds are more than your basis, you have a capital gain. If not, you have a capital loss.
Another thing you need to consider is the time period for which you held the asset. Depending on how long you hold your cryptocurrency, your gains and losses will be considered as “long-term” or “short-term.” This distinction will play a major role in how much crypto tax you have to pay.
Long-Term Capital Gains And Losses
Suppose you buy an asset and sell it after a year. The difference between the sales price and your basis is called long-term capital gain or loss. The tax on the long-term gain is usually lesser than short-term gains. This is because the rates are low for long-term capital gains- 0%, 15%, and 20%. The rate of long-term capital depends on your income.
Short-Term Capital Gains And Losses
If you buy an asset and sell it within a 365 days period, you recognize a short-term capital gain or loss. Short-term gains are mostly subjected to the same rate that you pay on ordinary income (income tax), for example, wages, salaries, commissions, and other earned income. The IRS has seven tax brackets for ordinary income tax ranging from 10% to 37% in 2021.
A Brief History of Crypto Taxes
The IRS has been actively looking into cryptocurrencies since at least 2014 when it issued its first notice. Since then, the agency has become increasingly persistent in its efforts to encourage taxpayers to report their crypto holdings, as well as increasingly aggressive in prosecuting those that intentionally fail to report crypto gains.
April 2014: Notice 2014-21
The IRS released Notice 2014-21 to clarify how existing tax principles apply to virtual currency transactions. In the frequently asked questions, the agency addresses everything from the cost basis of virtual currencies to taxes on crypto mining activity.
December 2014: TD-9706
Treasury Decision TD-9706 solicits comments on the proper reporting of virtual currency as Specified Foreign Financial Assets on Form 8938. The move sets the stage for ensuring that taxpayers holding virtual currencies in foreign accounts still pay taxes.
March 2018: IRS Reminder
The IRS issued a press release reminding taxpayers that income from virtual currency transactions is reportable on their income tax returns. If someone intentionally avoids paying these taxes, they could face up to five years in prison and a $250,000 fine.
July 2019: Educational Letters
The IRS began sending “educational” letters—6173, 6174, and 6174-A—to more than 10,000 taxpayers. These taxpayers were identified through various IRS compliance efforts as having suspected virtual currency transactions.
October 2019: Revenue Ruling 2019-24
The IRS released Revenue Ruling 2019-24 to provide guidance on the tax treatment of airdrops and hard forks after having been criticized for insufficient guidance. However, the ruling led to more questions from tax experts and legislators.
January 2020: Form 2019 Crypto Questions
The IRS added a new question to 2019’s Form 1040 asking taxpayers if they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency. By asking the question, the IRS could set the stage for penalties for anyone lying on the form.
March-July 2020: Outreach to Crypto Firms
The IRS reached out to crypto companies in March to discuss how to balance taxpayer service with regulatory enforcement. Soon after, the agency sought to hire crypto tax companies to help with audits, uncover privacy coin transactions and assist in investigations.
August 2020: New Form 1040
The IRS released a 2020 Form 1040 draft that moved the virtual currency question from Schedule 1 to the top of Form 1040. The move represented an ongoing prioritization of taxing virtual currency transactions over the coming year.
August 2020: More Educational Letters
The IRS sent additional educational letters to taxpayers that it suspected of inaccurately reporting all of their crypto income. The new letters target individuals with fewer crypto holdings than the original round of letters targeted.
August 2020: IRS Memo on Microtransactions
The IRS issued a memo indicating that cryptocurrency earned from crowdsourced micro-transactions was taxable. The move impacts a new breed of crowdsourcing platforms competing with Amazon’s Mechanical Turk.
September 2020: The IRS Awards Contracts
The IRS awarded a contract to Chainalysis to develop a tool that would crack privacy coins like Monero and/or Lightning. In addition, the agency offered a $625,000 award to anyone that could provide useful results in a variety of investigations of privacy coins.
October 2020: Final Form 1040 Draft
The IRS finalized 2020 Form 1040 that asks if a taxpayer dealt with cryptocurrencies and specifies that it includes airdrops, hard forks, and other types of exchanges in draft instructions sent along with the form to taxpayers.
What’s In Store For Crypto Tax In 2021?
The IRS is likely to continue ramping up its efforts to ensure compliance among taxpayers. With its new question on Form 1040, the agency makes it very difficult for taxpayers to conceal cryptocurrency transactions. The IRS is gathering data in 2020 that it could use to prosecute offenders in 2021 and beyond if they discover concealed transactions.
In hiring contracts, the agency is also looking for ways to reconcile taxpayer-reported capital gains and losses on their tax returns with exchanges, wallets, and other data sources. The move to improve privacy coin tracking capabilities also means that the agency could efficiently crackdown on those trying to avoid taxes using these anonymous coins.
How To Ensure Compliance
The constantly changing nature of crypto regulations can make it challenging to ensure that you’re compliant. Fortunately, crypto tax software can help by automating the process and providing a defensible audit trail in case the IRS requests any details.
ZenLedger aggregates transactions across crypto exchanges and wallets, computes capital gains and losses, and auto-populates the most common IRS forms with defensible figures. You can even integrate with TurboTax to automatically complete your taxes electronically and save hundreds of thousands of dollars in billable accounting hours.
In addition to accurately reporting capital gains, ZenLedger’s tax-loss harvesting tool makes it easy to identify ways to save money on taxes. Harvesting tax losses before year-end enables you to offset capital gains elsewhere in your portfolio, as well as up to $3,000 in ordinary income each year.
The Bottom Line
The growing popularity of cryptocurrencies caught the attention of the IRS in 2014. With ongoing growth and strong performance, the agency has aggressively expanded its efforts to ensure that all taxpayers report their crypto activity each year.