Cryptocurrency has become a popular alternative digital asset class for long-term investors and a volatile asset for short-term traders. Despite its growing popularity, cryptocurrency taxes are complex and ambiguous. The IRS clarified some outstanding questions in the past year indeed, but many questions around cryptocurrency tax remain and it's important to ensure everything is done right.
Let's take a look at how is cryptocurrency taxed and how you can ensure that you're paying the taxes you owe — and nothing more.
Cryptocurrency Taxes in the United States
The IRS treats cryptocurrencies as property, as opposed to currency, for tax purposes. As with stocks, bonds, or real estate, you must report capital gains or losses and pay the appropriate cryptocurrency tax rates. These crypto tax rates depend on how long the position was open (e.g. time between buying and selling) and your individual tax bracket during a given year.
Short-term capital gains tax:
Ordinary income tax rates apply on short-term capital gain, that is, if you sell a cryptocurrency within one year of buying it. In general, these tax rates are significantly higher than the taxes owed by long-term holders.
Long-term capital gains tax:
Long-term capital gain tax rates, on the other hand, apply if you sell a cryptocurrency more than a year after buying it, which is typically lower than the tax rates for short-term holders.
How to Report Cryptocurrency Taxes In The USA
There are four types of taxable events crypto investors can expect to find themselves in:
- Selling crypto for fiat
- Trading crypto (BTC for ETH, like-kind exchanges are disallowed)
- Using crypto to purchase a good/service
- Receiving crypto as a result of fork, mining, airdrop, or in exchange for goods/services (included as income)
There are also a few notable non-taxable events:
- Purchasing crypto with fiat
- Donating crypto to a tax-exempt organization (carryover basis)
- Gifting crypto (carryover basis, up to $15k)
- Transferring crypto from one wallet that you own to another that you own
The treatment of how cryptocurrency is taxed applies to all types of transactions. Even if you spend crypto on everyday items, such as a cup of coffee, the IRS requires you to record the transaction and calculate the capital gain or loss. There are no exceptions for transactions below a certain threshold or types of transactions — at least for now.
How Is Cryptocurrency Taxed?
The process of calculating a capital gain or loss involves determining the cost basis for each transaction. In other words, you need to know how much it costs you to open the trade in order to calculate the profit or loss when you close the trade, including any fees, commissions, or other acquisition costs expressed in U.S. dollars.
The simple formula to calculate cryptocurrency taxes is: Cost Basis = (Purchase Price in USD + Fees) / Quantity
You must record four pieces of information for each transaction:
- The date and time each unit was acquired.
- Your basis and the fair market value of each unit at the time it was acquired.
- The date and time each unit was sold, exchanged, or otherwise disposed of.
- The fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or value of the property received for each unit.
The capital gain or loss is calculated by subtracting the cost basis from the fair market value of the cryptocurrency. For example, if you acquired Bitcoin for US$500 and sold it for US$600, you have a $100 capital gain on the transaction. If the transaction is subject to a 15% capital gains tax rate, you may owe $15 in tax on that specific transaction.
You may use "first-in, first-out" (FIFO) accounting or specifically identify when the cryptocurrencies being sold were acquired. The optimal choice depends on whether you want to report a capital gain or loss. For example, you may want to report a capital loss to take advantage of tax-loss harvesting and lower your tax bill at the end of the year.
Are Cryptocurrency Airdrops and Forks Taxable?
The tax treatment of airdrops and forks has been ambiguous. While the Internal Revenue Service (IRS) finally issued new cryptocurrency tax guidance last year, the new guidance still left many questions unanswered.
The new guidance said that new cryptocurrency created from a hard fork of an existing blockchain or an airdrop should be treated as ordinary income equal to the fair market value of the new cryptocurrency when it was received. The tax liability exists even if the new cryptocurrency is unwanted by the recipient — if you received it, you owe tax on it.
While most forks don't start out with a high valuation, it's possible for someone to maliciously fork or airdrop tokens and leave you with a large tax liability. Depending on the tokens trade, you could end up paying tax on an asset that was worth more when you received it than when you sold it. These are distinct possibilities when it comes to splinter currencies.
Cryptocurrency Mining Taxes
Cryptocurrency mining has become less common as professional operators have displaced individuals, especially for large cryptocurrencies like Bitcoin. That said, there are still many individuals that mine lesser-known cryptocurrencies in the hopes of becoming rich. These individuals may be subject to double taxation when mining new coins.
There are two different taxes that must be paid:
- The income from the cryptocurrency as it was mined with a $0 cost basis. For example, if you mined one cryptocurrency with a value of $100, you owe tax on the $100 in income.
- The capital gain or loss incurred when selling or trading your mined cryptocurrency. For example, if the cryptocurrency above was sold for $200, you would owe capital gains tax on $100 in additional income from the transaction.
The good news is that you can deduct qualified business expenses related to the mining operations to reduce your overall tax burden. For instance, you may be able to deduct the cost of computing hardware that’s used to mine cryptocurrency.
Mistakes To Avoid When Calculating Your Cryptocurrency Taxes
1. Not Including Crypto Activities from Previous Years
It may seem like common sense to include only your recent crypto activity when filing annual taxes. After all, why are previous years relevant, especially if you have already reported them?
Unfortunately, the inclusion of your entire trading history is mandatory when filing cryptocurrency taxes. This is due to the financial concept known as basis value. The cost basis is the initial value of an asset when it was acquired by its current owner. Since cryptocurrencies can vary significantly in value over relatively short periods of time, the only way to accurately determine the value basis of a coin is to incorporate your past trading activity. Without this, your reports will be invalid.
If you have not kept records, you can use tax encryption software to correct your calculations. The good news is that revising your previous years can actually help you save a lot on your taxes if the records show that you had losses.
2. Ignoring Crypto Losses
While crypto gains are taxed, crypto losses can be used to decrease your tax bill. Many cryptocurrency investors and traders do not know that filing incurred losses on crypto can really save them a fortune. This is a rather common mistake that can cost taxpayers a lot if they do not use a reliable method of reducing taxable profit from capital gains.
It is important to remember that crypto losses work just like other property losses. This means that if you incur any losses as a result of any crypto transactions throughout the year, you can use these losses to compensate for capital gains and pay lower taxes in general.
In fact, you can not only compensate for all capital gains, you can also use these losses to offset up to $3,000 in regular income. Another good thing is that at the time of this writing, the Wash Sale Rule doesn’t apply to crypto, which means you can sell your coin at a loss on December 31st and buy it back on January 1st, then use that cash however you want.
3. Inconsistent Cost-Based Methodology
The most widely-used cost basis method is first-in-first-out (FIFO): when the coin that was bought first is also sold first. This method is the most recommended; in fact, it is the default calculation mode. Some people, however, calculate the cost basis of their coins using the last-in-first-out method: the last coin bought will be the first coin sold. Though any of these methods are suitable for use when completing your cryptocurrency taxes, it is worth noting that they can lead to different outcomes in terms of capital gains.
Ultimately, the choice of method is left to each trader, but as soon as you start using one method, you are stuck. The IRS does not allow you to change the method used between applications (or at least not easily). If you decide to use a method that does not work for you, you will have to physically send a request to the IRS asking for permission to switch to another method, and there is no guarantee that they’ll answer your request in a reasonable amount of time.
So, nothing is impossible when it comes to successfully collecting all the data and recording it yourself, but it can be a tedious process. At the same time, it has many potential points of failure. For traders who simply do not have the time or opportunity to calculate and file their own taxes, there are accounting professionals who specialize in taxes related to cryptocurrency. It would be wise not to exclude professional accountants or tax firms, especially those who specialize in cryptocurrency.
The Bottom Line
Cryptocurrencies have become a popular asset class, but cryptocurrency taxes remain a complex and ambiguous topic. While the IRS provided some new guidance, traders and investors should ensure they're using the right software to automate the calculation of capital gains and losses, as well as consult with an experienced accountant to ensure everything is done right.
For more, make sure to read How to Report Crypto Taxes: A Step by Step Guide.