Cryptocurrencies are becoming increasingly popular among traders, investors, and the general public. Despite its popularity, the IRS has become increasingly frustrated by the underreporting of capital gains—particularly given the steep rise in crypto asset prices. In fact, the IRS testified in 2015 that only 802 Americans reported Bitcoin transactions!
Let’s take a closer look at how crypto taxes work via our cryptocurrency bitcoin tax guide, how to lower your tax liability and reduce audit risk in 2021.
Is Cryptocurrency Taxed? Bitcoin Tax Guide 101
The IRS's stance on cryptocurrencies has been clear since 2014. But we do understand there have been some ambiguities surrounding issues like cost basis, hard forks, and airdrops. However, it’s no secret that taxpayers must pay capital gains tax on any transactions that result in a capital gain, as well as ordinary income tax on any mining activity that generates cryptocurrency.
So, yes. Cryptocurrency is taxed by most jurisdictions around the world including UK, Canada, Australia, and our very own United States.
Crypto Tax Reporting: How Is Crypto Taxed?
Bitcoin or any other cryptocurrency is typically (or at least in the US) taxed and treated like property. This means that if your digital asset (cryptocurrency) appreciates in value and you sell/trade/use it for profit, your gain will be taxed like capital gains tax. Likewise, if the asset depreciates in value and you sell/trade/use it at a loss, you are permitted to deduct the losses against other capital gains and reduce your owed taxes. The tax bracket is determined on the basis of how long the crypto was held. If you sell your crypto at least one year within the year of acquisition, you will owe a short-term capital gains tax, whereas, if sold any time after the first year of acquisition, you will owe a long-term capital gains tax.
It must be noted that the amount of total tax owed varies from case to case and is dependent on the total capital gains and losses earned on the said asset along with other factors like how long you have held the asset, and other specific regulations in one's country. Each crypto taxable event can potentially create a capital gain and hence, it is advised to record the date, cost basis, sale value, and any fees associated with each crypto transaction.
When it comes to cryptocurrency, the following are the typical taxable events:
- Sale of cryptocurrency for fiat currency (i.e. USD, CAD, EUR, JPY, etc.)
- Trading cryptocurrency for other cryptocurrencies
- Usage of cryptocurrency to buy a good/ service
- Cryptocurrency gains as a result of a fork or from mining
However, you will not have to pay taxes on crypto in the following events:
- Purchase of cryptocurrency with fiat currency (provided the purchase price is lower than the fair market value of the purchased coin)
- Donation of crypto in a tax-exempt organization
- Gifting cryptocurrency to anyone
- Transferral of cryptocurrency from one wallet that you own to another wallet that you own
Can You Avoid Paying Taxes On Cryptocurrency?
With this Bitcoin tax guide or crypto tax guide, we advised to not commit a crypto tax fraud provided that over the past couple of years, the IRS has become increasingly aggressive in its enforcement of cryptocurrency taxes. The agency sent out warning letters to taxpayers suspected of owning cryptocurrencies warning them to fix discrepancies in their tax filings before it escalates the situation into a full inquiry or even a costly and time-consuming audit.
In mid-2020, the IRS began soliciting expert contractors to help audit cryptocurrency-related tax returns. The agency appears to be interested in analyzing blockchain transactions in order to identify taxpayers and prove that they have generated taxable capital gains. These efforts could be a prelude to greater levels of enforcement in 2021 and beyond.
These escalations have come despite concerns by the agency’s own internal watchdog group. The Taxpayer Advocate Service alleged that one of the agency’s warning letters undermined taxpayer rights by demanding a statement of facts and a detailed trading history accounting for years outside of the statute of limitations while using a “disturbing” tone.
Cryptocurrency Tax: Does the IRS Track Cryptocurrency?
The IRS introduced a cryptocurrency question on Schedule 1 of Form 1040 in 2019. The simple YES or NO question asked whether you received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency during the year. That said, Schedule 1 is an easy-to-miss addendum for declaring additional income that most Americans never fill out.
In 2020, the IRS moved the cryptocurrency question to the top of Form 1040. The move effectively requires every American to answer the question, which eliminates any chance of accidentally forgetting to answer the question or feigning ignorance. If answered incorrectly, taxpayers could be subject to fines and penalties beyond any accidental underpayment.
Taxpayers must answer YES if they received any cryptocurrency for free, including via airdrops or hard forks, as well as if they used cryptocurrency to purchase physical goods, like coffee. Those that are merely holding cryptocurrencies, or transferring them between wallets they own, may be able to answer NO as long as they didn’t transact in any way.
Many crypto experts see the move as a trap for crypto traders and investors that have thus far feigned ignorance to avoid paying taxes. When filing their 2021 tax return, taxpayers should ensure that they answer the question truthfully in order to avoid a host of future repercussions, particularly as the agency gears up to prosecute more crypto-related cases.
Additionally, the US government has even proposed a new rule allowing them to track anyone's fishy cryptocurrency transactions without the need for a warrant. So basically, yes, the IRS can track your crypto if they should want to.
How to Prepare Your Bitcoin Taxes for 2021
There are two very important things to keep in mind heading into the new year regarding crypto taxes.
- First, the IRS is stepping up enforcement, so you should ensure that your taxes are accurate and up to date.
- And second, tax-loss harvesting can help you lower your tax burden over the course of the year by realizing losses.
Use A Crypto Tax Calculation Software
The best way to prepare is to use crypto tax software. By aggregating transactions across wallets and exchanges, tax software can correlate transactions and ensure that you accurately report crypto taxes and avoid overpaying each year. Tax-loss harvesting tools can help identify opportunities throughout the year to offset your capital gains exposure.
ZenLedger is a comprehensive crypto tax software solution that makes it easy to realize these benefits by aggregating transactions and providing tax-loss harvesting advice throughout the year. In addition to automatically generating tax forms, you can integrate with TurboTax to make tax prep a breeze each year. Try ZenLedger today!
How To Amend For Previously Missed Crypto Tax Filing On Capital Gains and Losses?
The IRS can go back up to three years to prosecute cases of tax evasion. If they find a substantial error, they can go back up to six more years to uncover wider instances of fraud. Taxpayers that have unreported or underreported crypto gains should be proactive and amend previous tax returns in order to avoid much more severe problems.
There are several steps to the process:
- Determine how much you owe using a bitcoin tax calculator or other methods.
- Amend your previous tax returns using IRS Form 1040X.
- Mail in your amended return along with any payment.
If you cannot afford to pay backed taxes, the IRS offers payment plans that enable you to make payments over an extended timeframe. Some taxpayers may also be eligible to enter into a settlement whereby they would pay a portion of the total amount due as a one-time settlement, although there is no guarantee that this is an option for everyone.
The Bottom Line
The IRS has become increasingly aggressive with its enforcement of cryptocurrencies in 2021. Using crypto tax software, you can ensure accuracy through the automatic aggregation of transactions across exchanges and wallets while identifying tax-loss harvesting opportunities. It also helps to have a CPA go over your tax returns and ensure they’re accurate. Above all, we hope that our bitcoin tax guide or the cryptocurrency tax guide has helped you gain a better understanding of the whole taxation process!