The Treasury Department predicts that the difference between taxes owed and taxes paid could reach a staggering $7 trillion in the next decade. In 2022, the Biden administration planned to boost the IRS budget by a whopping 10.4% to close this gap. A significant part of this effort was aimed at cracking down on tax evasion related to cryptocurrency through new reporting requirements and other enforcement measures.
As the IRS continues to closely monitor the cryptocurrency market, it's crucial for traders to stay informed about the reporting requirements and potential changes in the near future. So, be prepared to stay on top of the latest developments and ensure compliance with cryptocurrency tax laws, or risk facing penalties and fines.
How the IRS Treats Crypto
The IRS treats digital and virtual currencies as property, meaning they're subject to capital gains taxes. In addition to trading and investing, these taxes apply to anyone that uses cryptocurrencies to buy goods and services or exchanges cryptocurrencies. So, for example, using Bitcoin to purchase a coffee is a taxable event in the eyes of the IRS!
Other non-obvious taxable events include-
- Staking rewards
- Interest from DeFi
- DeFi reward tokens
- Airdropped tokens
- Crypto debit cards
The amount of taxes owed depends on the holding period and your marginal tax rate. In particular, cryptocurrencies held for more than one year are subject to long-term capital gains tax rates of up to 20%, whereas those held for less than a year are subject to short-term capital gains tax rates equivalent to your marginal tax rate.
There are also a couple of exceptions to keep in mind:
- Mining income is taxable as ordinary income at the time of receipt. When the mined coins are sold, you also owe capital gains tax on any increase in value. That said, mining businesses may be able to deduct certain mining-related expenses.
- Non-fungible tokens, or NFTs, may be "collectibles" in the eyes of the IRS. If that's the case, you would owe a 28% collectibles tax on them regardless of your marginal tax rate. However, the IRS has not given explicit guidance on the tax treatment of NFTs.
- You can donate crypto to avoid paying capital gains tax on any unrealized profits, as well as secure a tax write-off for the value at the time of donation. It's a great way to support a charity that you care about while reducing your tax burden.
U.S. cryptocurrency tax laws are constantly changing, and investors should work with their accountants to ensure they're keeping up. In addition, crypto tax software, like ZenLedger, can help automatically keep up with the latest regulations and ensure you're not overpaying or underpaying your taxes each year.
Reporting Crypto Taxes in 2023
The IRS added a question on Form 1040 asking about the sale, trade, exchange, or receipt of financial interest on cryptocurrencies during 2020. The IRS added a question on Schedule 1 to Form 1040, "At any time during 2022, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?". The question is located on line 7 and is aimed to help the IRS identify taxpayers who may have had transactions involving virtual currency and ensure that they are reporting it correctly on their tax returns.
If you answer "yes" to the question, you must report any capital gains or losses from cryptocurrency transactions on Form 8949. You may also need to file other forms for foreign transactions and other events.
If you received a CP2000 letter based on Form 1099-Ks from certain exchanges, you should reply to the letter on time to avoid a default judgement against you. Form 1099-K reports your aggregate transaction volume without factoring in the cost basis, meaning that you may not owe the amount that the IRS assumes.
If you didn't receive any forms, that doesn't mean that you don't have to pay any crypto taxes. If you have past crypto gains that you didn't report, you should file an amended return for those years and pay any taxes due. This year, the new question on Form 1040 will make it harder to argue ignorance in the future and make prosecution easier for the IRS.
You should always accurately report your crypto taxes to avoid any problems in the future. For example, in March 2021, the IRS announced a new initiative called "Operation Hidden Treasure," where agents trained in cryptocurrencies will focus on taxpayers that omit crypto income from their tax returns. New reporting requirements could also come soon.
ZenLedger makes it easy to aggregate transactions across wallets and exchanges to simplify the preparation of Form 8949 and other tax forms. If you use TurboTax, you can automatically import these transactions to automate the entire process. If not, you can print off pre-filled tax forms and provide them to your accountant to reduce billable hours.
Potential Upcoming Changes in Crypto Tax Laws
Cryptocurrency tax laws are constantly changing. For example, the Senate passed a $1 trillion infrastructure bill in mid-2021 that could have significant implications for cryptocurrencies.
The most significant change thus far requires "brokers" to report crypto gains to the IRS via Form 1099. Currently, the word "broker" is defined as "any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person," which crypto advocates think is overly broad.
The U.S. Treasury Department plans to clearly define "broker" without amending the bill to avoid delays. However, many crypto advocates worry that the definition wouldn't be binding and could hurt miners, developers, stakers, and other parties that don't have customers. If that's the case, the law could trigger new and onerous reporting requirements.
In addition to federal actions, some states have modified their tax code in ways that impact cryptocurrencies. For example, Washington's HB 1406 and SB 5426 established a 1% wealth tax on more than $1 billion intangible financial assets, including virtual currency. Meanwhile, Nevada AB 324 exempted virtual currencies from taxation.
The Biden administration is also targeting additional changes in its Fiscal Year 2022 Revenue Proposals:
- Expanded 1099-K Reporting: Crypto exchanges with users that transact $20,000 in gross volume and 200 transactions in a given year are given Form 1099-K. The Biden administration wants to change that threshold to $600 to subject more users to oversight.
- Reporting for $10,000+ Transactions: The Biden administration wants businesses to report receiving crypto transactions worth over $10,000, such as buying a car or house.
- Improved Global Communication: The Biden administration wants to automate information sharing with foreign jurisdictions to catch crypto users attempting to evade taxes, including U.S. individuals holding cryptocurrencies in offshore accounts.
For its part, the IRS continues to provide updated guidance on cryptocurrency tax laws and concerns. Many accounting experts anticipate further guidance on DeFi, NFTs, and other cutting-edge crypto use cases that currently have unclear tax obligations. Until then, most accountants recommend taking a conservative approach.
Take Advantage of Tax-loss Harvesting
In 2022, the value of many cryptocurrencies dropped significantly, leading to losses for many investors. It's important to take advantage of tax-loss harvesting by reporting these losses on your tax return to potentially lower your tax liability. The process for deducting losses on digital assets like Bitcoin is similar to the one used for losses from traditional investments like stocks or bonds. Keep in mind, you can only write off a maximum of $3,000 in losses per year.
Here's an example of how tax-loss harvesting works:
Let's say an investor bought Bitcoin for $10,000 in January 2022 and the value of Bitcoin dropped to $7,000 in December 2022. The investor would have a capital loss of $3,000 ($10,000 - $7,000) from the sale of the Bitcoin.
If the investor also had other capital gains from other investments, they could use the $3,000 capital loss from the Bitcoin sale to offset those gains and reduce their overall tax liability. For example, if the investor had $5,000 in capital gains from stocks, they would only be taxed on $2,000 ($5,000 - $3,000) in capital gains.
Alternatively, if the investor did not have any capital gains to offset, they could use the $3,000 loss to offset up to $3,000 of their ordinary income.
It's important to note that there are different regulations and laws in different countries, so it's always a good idea to consult a tax professional for your specific case.
Don’t Underestimate the IRS
While some cryptocurrencies prioritize privacy, it does not mean that cryptocurrency traders are completely anonymous. The IRS uses various methods to monitor the industry, including issuing subpoenas to popular cryptocurrency exchanges to gain information on thousands of users.
It's important to remember that not reporting or underreporting gains from cryptocurrency trades can result in fines and penalties, in addition to the taxes owed. Furthermore, non-compliance with tax rules and regulations can increase the likelihood of an audit.
It is important to report cryptocurrency transactions for taxes, even if you think the IRS may not find out about it. If you are unable to pay the taxes owed, you can apply for a repayment plan with the IRS and avoid penalties for underreporting income, filing taxes late or not filing taxes at all.
The Bottom Line
U.S. cryptocurrency tax laws are constantly changing, making it hard for crypto investors to keep up. In general, crypto is subject to capital gains taxes, ordinary income taxes, or collectible taxes, depending on the situation. Any gains are reported on Form 8949, while you can write off losses to offset other capital gains or up to $3,000 in ordinary income.
When preparing your taxes, it's always a good idea to seek out the guidance of a professional tax preparer, such as a CPA. In addition to ensuring everything is properly prepared, these professionals can help identify ways to reduce your tax liability using other parts of your portfolio or financial situation.
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