Cryptocurrency has become a popular alternative asset class for long-term investors and a volatile asset for short-term traders. Despite its growing popularity, the tax treatment of cryptocurrencies is complex and ambiguous. The IRS clarified some outstanding questions last year, but many questions remain and it's important to ensure everything is done right.
Let's take a look at how cryptocurrencies are taxed and how you can ensure that you're paying the taxes you owe — and nothing more.
The IRS clarified some tax questions surrounding cryptocurrencies last year, but many questions remain and it's important to ensure you're on the right side of the law.
Cryptocurrency is Property
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 tax rates. These 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.
Ordinary income tax rates apply 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.
Capital gains tax rates 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.
There are four types of taxable events:
- Converting a cryptocurrency to a fiat currency.
- Exchanging one cryptocurrency for another cryptocurrency.
- Using cryptocurrency to purchase goods or services.
- Earnings cryptocurrency as income.
There are also a few notable non-taxable events:
- Gifting cryptocurrency.
- Transferring cryptocurrency between exchanges or wallets.
- Buying cryptocurrency with U.S. dollars.
The tax treatment of cryptocurrency 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.
Every Transaction Matters
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 cost 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 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 you tax bill at the end of the year.
Airdrops and Forks Are Taxable
The tax treatment of airdrops and forks have been ambiguous. While the IRS finally issued new 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 is Double Taxed
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.
The Bottom Line
Cryptocurrencies have become a popular asset class, but 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.
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