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, figuring out the tax on cryptocurrency is complex and ambiguous. The IRS clarified some outstanding questions in the past year, but many questions around cryptocurrency tax remain, and it's important to ensure everything is done correctly.
Apart from that the recent regulations and bills passed by the government make understanding cryptocurrency taxes all the more important.
In this blog, we’ll 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.
1. Short-Term Capital Gains Tax
Ordinary income tax rates apply on short-term capital gains, short-term meaning 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.
2. 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 in crypto:
- Selling crypto for fiat (BTC to USD, ETH to GBP)
- 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 crypto 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 is cryptocurrency 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 tax on cryptocurrency is: (Purchase Price in USD + Fees) / Quantity = Cost Basis
You must record four pieces of information for each transaction:
- The date and time each unit was acquired.
- Your cost 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 cryptocurrency that was worth more when you received it than when you sold it. These are distinct possibilities when it comes to splinter currencies.
Crypto Tax: 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 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 cryptocurrency 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 cryptocurrency 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.
Crypto Regulation and Its Effect on Crypto Taxes
One of the earliest attempts to regulate cryptocurrency has focused on taxation, especially the possibility for crypto to be used for tax avoidance. Earlier this year, President Biden's treasury department mandated that “it would be tightening its oversight of cryptocurrency markets. Crypto transactions of $10,000 or more, for example, would be required to be reported to the IRS.”
Many experts, including Yellen, President Biden’s treasury secretary, are concerned about the "highly volatile" character of cryptocurrency in general, and Bitcoin in particular — considerably more so than traditional stock trading. Yellen has described Bitcoin as a "very speculative asset" and expressed concern about potential losses for investors.
However, it's unclear what rules, if any, would aid in the stabilization of the crypto markets.
At best, digital currencies are a work in progress. Crypto would be in the early phases of human testing if it were a new medicine. That is to say, it still has a long way to go before it can be adopted as a credible solution to the problems plaguing our existing financial system.
Until then, here are a few ways on how you can cut down on your crypto taxes:
1. Turning Short-Term Gains into Long-Term Gains
As previously indicated, various capital gains rates apply based on how long you own bitcoin or other cryptocurrencies. If you want to decrease your cryptocurrency tax burden, then hold your cryptocurrencies long enough to convert short-term earnings into long-term gains. It won't be easy, but if you have the patience and bravery to keep your bitcoin for at least a year before selling, you'll most likely pay a reduced capital gains tax rate.
2. Capital Gains and Capital Losses Should Be Offset
Balancing capital gains and losses is another approach to decrease the amount of money crypto investors have to pay in taxes. This works by subtracting taxable gains on cryptocurrencies or other investments that have appreciated in value from losses on crypto-assets sold over the course of the year.
You should be aware, however, that this method has limits. When you incur investment losses, you must first offset losses of the same kind. For example, short-term losses lower your short-term earnings, but long-term losses reduce your long-term gains.
3. Selling During a Low-Income Year to Diminish Short & Long-Term Gains
If you have short-term earnings that are taxed as regular income, you won't have as much extra money piled on to force you into a higher tax bracket.
If you sell short-term assets when you retire and cease working, the income from your short-term gains may decide your whole tax rate. A lower overall income for the year might mean a lower long-term capital gains tax rate. Because the long-term capital gains rate that applies to you – 0%, 15%, or 20% – is computed using your taxable income, this is the case.
As a result, your longer-term capital gains tax rate is more likely to be lower if you have less taxable income.
If you wish to retire early and have enough money saved to support your living expenses until you can access money from your retirement accounts, you may have little to no income during the year. If that's the case, now is an excellent time to lock in long-term capital gains and save money on taxes.
4. Lower Your Taxable Earnings
Reduced taxable income is another tried-and-true tax reduction strategy. In a low-income year, this is akin to selling valuable investments. This includes looking for tax credits and deductions to see whether they can help you lower your taxable income.
You can use the money to pay for pricey medical treatments, contribute to a traditional IRA or 401(k) plan, establish a health savings account, or donate cash or property to charity, for example. You may also qualify for several other tax advantages and credits. You should also consult a tax specialist to determine if there are any extra tax benefits available to you.
5. Using a Self-Directed Individual Retirement Account
Another method to decrease your crypto tax burden is to invest in a tax-deferred or tax-free Self-Directed Individual Retirement Account (SDIRA). As a consequence, you have the option of paying taxes later, when your taxable income in retirement may be lower, or paying taxes now, when you contribute to your Roth SDIRA, if you expect to pay higher taxes in retirement.
Giving your bitcoin to family members is another way to lower your cryptocurrency tax burden, depending on your spending intentions. Each year, the IRS allows you to make tax-free gifts of up to $15,000 per person. While the foundation of the cryptocurrency goes to the new owner, the recipient may have a low enough income to avoid paying taxes on the appreciated property when it is sold. At the absolute least, you'll save money on taxes compared to selling bitcoin yourself.
This technique is ideal for achieving your overall estate planning objectives and distributing your money. As a result, it's something you should discuss with an estate planner beforehand to ensure it'll work for you.
Cryptocurrency to a good cause. You may consider donating your bitcoin to charity, similar to how you might donate appreciated cryptocurrency to a family member. Not only will you avoid paying capital gains tax, but you may also be able to claim a large tax credit on your tax return.
You can deduct the appreciated fair market value at the time of donation from your taxable income when you give an asset. For example, if you possess $50,000 in Bitcoin and contribute it to a charity you frequently support, you may be eligible to deduct it from your taxes as a charitable donation.
8. Relocate to a State with No Crypto Tax Rules
State-level income taxes have been overlooked in this article until now. Your state, understandably, has a strong interest in your investing profits.
A handful of tax-friendly states, fortunately, have minimal or no income taxes. That means you'll have to pay federal taxes, but you won't have much to give to your state's coffers.
Consider moving to a low or no-income-tax state if you can, as this will decrease or even eliminate taxes on all forms of income. These little sums can mount up, allowing you to keep more of your cryptocurrency profits.
9. Leave It to Your Heirs
Bequeathing your crypto assets as part of your estate is the last cryptocurrency tax reduction method on our list. When you die, the investment's basis will be "stepped up" (i.e., increased) to its fair market value at the time of your death. When your heirs sell the bitcoin they inherited, they won't have to pay taxes based on your initial basis.
However, because cryptocurrencies are very volatile, they might rocket up (or down) at any time, depending on the virtual currency you possess. If this occurs, and virtual currencies soar to new heights, your heirs' tax burden will be reduced, since they will have gotten more money.
Cryptocurrency Tax News: From ‘Buying’ Citizenship to IRS’ VDP and Crypto as Taxes in Illinois
St. Kitts and Nevis, a Caribbean two-island country, offers a citizenship by investment program in which you can receive a passport for 3.89 BTC. The good news doesn't stop there, either! Nothing, including cryptocurrency, is subject to a capital gains tax in the country.
Combining Citizenship by Investment Programs with cryptocurrencies, according to Savory & Partners, an accredited agent for several nations, increases the degree of mobility, allowing a person to wander the globe with their riches.
The other news involves the IRS’ VDP: a Voluntary Disclosure Program (VDP) permits taxpayers to withhold information from their tax returns on purpose. Cryptography was recently incorporated into the IRS's program. Is this, however, a good thing or a negative thing? Possibly both!
Increasing IRS audits in this sector are almost expected, and taxpayers who willfully refuse to adhere to their crypto holdings and gains will likely face little sympathy. While the VDP isn't fun, it may be the best way for many taxpayers to "come in from the cold" and avoid more significant penalties and criminal culpability.
Moving over to Illinois, House Bill 5287 has been sent to the state Senate which will allow the Illinois Department of Revenue (IDR) to receive cryptocurrency payments in the same way that it accepts credit card transactions. However, its status as a legal tender is yet to be confirmed and requires clearer regulatory guidelines.
The Bottom Line
Cryptocurrencies have become a popular asset class, but tax on cryptocurrency remains 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.
Disclaimer: This material has been prepared for informational purposes only and is not intended to provide, tax, legal or financial advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.