In the early days of bitcoin and cryptocurrency, crypto transactions took place outside of TradFi, the traditional financial system. As cryptocurrency evolved, more scams, illegal activities, and bad actors entered the space. Stories of fortunes made (and lost) proliferated.
Not surprisingly, governments began to take notice. In 2014, the IRS issued Notice 2014-21, 2014-16 IRB 938PDF, which stipulates that “virtual” currency, as they call it, is treated as property for federal income tax purposes.
The IRS believes longstanding tax principles, such as capital gains, applicable to property transactions are also valid for virtual currency. This view will complicate the tax reporting burden for using cryptocurrency for everyday transactions.
Cryptocurrency users must track and report all crypto transactions on their tax returns, including every time they spend or receive crypto as income or from selling goods or services.
For example, suppose you use cryptocurrency to buy a cup of coffee. In that case, you are subject to capital gains tax on any appreciation in the value of the cryptocurrency between the time you acquired it and the time you used it to buy your cuppa joe.
You need a system for automating recording transaction details to avoid a considerable record-keeping headache at tax time.
Overall, the tax implications of using cryptocurrency are complex and subject to change as countries worldwide begin to regulate digital assets. We encourage you to consult with a tax professional to ensure compliance with applicable tax laws.
Let’s take an in-depth look at tax compliance for cryptocurrency holders.
Understanding Cryptocurrency and Digital Asset Taxation
As with any financial activity, there are tax implications for buying, selling, and holding cryptocurrencies. Individuals and businesses must comply with crypto tax laws to avoid penalties and legal issues. Failure to properly report cryptocurrency transactions can result in fines, interest, and criminal charges.
In 2022, the IRS changed the term “virtual currency” to “digital asset,” with rules that now apply to cryptocurrency and NFTs.
Crypto tax law will evolve as the IRS adapts to the crypto industry’s innovations. The NUMBER ONE tip for compliance is record keeping, which we cover later in this guide.
Definition of Cryptocurrency and Its Tax Treatment
Cryptocurrency is a digital or virtual currency that uses cryptographic techniques to secure and verify transactions and control the creation of new units. Cryptocurrencies are decentralized and operate independently of any central authority or financial institution. Some of the most popular cryptocurrencies include Bitcoin, Ethereum, Litecoin, and Ripple.
The tax treatment of cryptocurrency varies depending on the country and jurisdiction in which you’re using it. For tax purposes, most countries view cryptocurrency as property, which means gains or losses are subject to capital gains tax.
A capital gains tax is a tax on the profit of an asset’s sale after its value increases over time. Capital assets can include stocks, bonds, real estate, other investments, as well as cryptocurrency, and digital assets.
Foreign Accounts held by US Citizens
The tax implications of cryptocurrency holdings in foreign accounts depend on several factors, including the taxpayer’s country of residence, where the account is held, and the type of account.
Newer investors may assume that if their crypto account is in another country, they don’t have to report it on their US tax return. That is not correct. Attempts to shelter assets outside of the US is a strategy that predates cryptocurrency by several decades. Not surprisingly, the IRS has some rules about the practice.
In the United States, the IRS requires taxpayers to report all foreign financial accounts (including cryptocurrency accounts) that meet a certain criteria. If you have a total value of more than $10,000 at any time during the year, you must file a Report of Foreign Bank and Financial Accounts (FBAR) with the Financial Crimes Enforcement Network (FinCEN). Failure to file an FBAR can result in significant penalties.
Additionally, the IRS requires taxpayers to report income earned from foreign accounts on their tax returns. This includes income from crypto holdings, like capital gains or losses on the sale or exchange of cryptocurrencies. Failure to report foreign income can also result in significant penalties.
Other countries may have similar reporting requirements for foreign accounts and income, so it is important to consult with a tax professional or the appropriate government agency in your country to determine the specific requirements. At ZenLedger, we have recently extended our best-in-class crypto tax solutions to our global audience.
Overview of Tax Implications of Different Types of Cryptocurrency Transactions
The tax implications of cryptocurrency transactions vary depending on the jurisdiction and any specific circumstances. Here are some general guidelines:
- Trading or exchanging cryptocurrencies: This type of transaction occurs when a person buys or sells cryptocurrencies intending to make a profit. For tax purposes, these transactions are similar to traditional stock trading and are subject to capital gains taxes. Capital gains tax is calculated based on the difference between the sale price and the purchase price of the cryptocurrency.
- Payments for goods or services: It is a taxable event when you use cryptocurrency to purchase goods or services. The transaction is a sale, and any gains or losses are subject to capital gains tax. You will use the value at the time of the transaction to determine the amount of taxable gain or loss.
- Staking: Staking involves holding cryptocurrency in a wallet and using it to help validate transactions on a blockchain network. Some jurisdictions treat staking rewards as income, while others consider them a form of interest. The tax treatment will depend on the specific laws in your jurisdiction.
- Mining cryptocurrency: Mining cryptocurrency involves using specialized software to solve complex mathematical problems and verify transactions on a blockchain network. When a miner successfully validates a block of transactions, they receive a certain amount of cryptocurrency. In most jurisdictions, this is considered a taxable event, and the newly mined coins are income for tax purposes. The value of the coins at the time of mining will determine the amount of income you report.
- Airdrops: Airdrops are typically free cryptocurrency distributions to holders of a particular token or users of a specific platform. The tax implications of airdrops can be complex and will depend on the specific circumstances. Generally, the value of the airdropped coins at the time of distribution will be considered income for tax purposes.
Crypto Tax Compliance and Planning Strategies
Record keeping is the first step for compliance. Secondly, it is essential to note that different strategies for tax compliance can help investors save money on their crypto tax bill.
Here is an overview of some strategies to keep in mind. We encourage you to consult a tax accountant for more information.
Tax-loss harvesting is a strategy that involves selling investments that have decreased in value to offset capital gains from other investments. This strategy can benefit crypto investors because cryptocurrencies are known for their volatility, which means they can experience large price swings quickly.
It’s important to note that tax-loss harvesting can only be done in a taxable investment account, not in a tax-advantaged retirement account like an IRA.
Additionally, the IRS has rules about “wash sales,” which prevent investors from buying the same or substantially identical security within 30 days before or after selling it at a loss.
A self-directed IRA is a type of IRA that allows investors to invest in a broader range of assets, including cryptocurrencies. Using a self-directed IRA, investors can defer taxes on any gains from their cryptocurrency investments until they withdraw funds from the account.
Using a self-directed IRA for crypto investments has some unique advantages. For example, since the IRA owns the cryptocurrency, any gains or losses from the investment are tax-deferred until the investor withdraws funds from the account. Additionally, if the investor uses a Roth IRA, any gains from the investment will be tax-free when withdrawn.
However, there are also some disadvantages to using a self-directed IRA for crypto investments. The IRS has strict rules about how self-directed IRAs can be structured and managed, and failure to comply with these rules can result in penalties and taxes.
Donating cryptocurrency to a qualified charity can be a tax-efficient way to reduce your tax liabilities. You may be able to deduct the cryptocurrency’s fair market value on your tax return, which can help reduce your tax bill.
Timing of Transactions
The length of time that you hold your cryptocurrency can have a significant impact on your tax liabilities. For example, if the “holding period” of your cryptocurrency is more than one year, you will be subject to long-term capital gains tax rates, generally lower than short-term capital gains tax rates.
If you sell your cryptocurrency at the end of the year, you could delay paying taxes on the gains until the following year. Selling your cryptocurrency when your income is lower may allow you to reduce your tax liabilities.
If you mine cryptocurrency, you may be subject to self-employment taxes on the value of the cryptocurrency you receive. However, you may be able to delay paying taxes on the value by mining cryptocurrency at the end of the year.
It is important to note that cryptocurrency taxation is a complex and evolving area of law. Consult with a tax professional before making any decisions regarding your cryptocurrency transactions.
Best Practices for Crypto Tax Compliance
For experienced investors, staying compliant with tax laws as a crypto investor will be a relatively familiar process.
For newer investors, the initial process may seem daunting. Try not to get discouraged. Look at this as an essential step to becoming a sophisticated investor. While staying compliant with tax laws, you are learning valuable information about TradFi tax strategies. Check out our 2023 US Crypto Tax Guide for more specifics.
The Devil in the Details, Keeping Accurate Records
The first step is to set up a system. Some investors use spreadsheets, and others benefit from crypto compliance services like ZenLedger.
For tax reporting purposes, here is an overview of the information to record for each cryptocurrency transaction.
- Date of the transaction
- Type of transaction: Buy, sell, exchange, or transfer
- Amount of cryptocurrency: In units or a fiat currency value
- Value of cryptocurrency: The cryptocurrency’s fair market value at the time of the transaction, either in units or in a fiat currency value.
- Cost basis: When calculating your gains or losses, you need to know the cost basis of your cryptocurrency, which is the original price you paid for it. If you bought the cryptocurrency with fiat currency, the cost basis is the amount you used to purchase it. If you received the cryptocurrency as payment for goods or services, the cost basis is the cryptocurrency’s fair market value when you received it.
- Capital gains or losses: You’ll calculate the transaction results by subtracting the cost basis from the sale price or fair market value. Selling cryptocurrency for more than you bought it for results in a capital gain, which may be subject to tax. Selling at a loss results in a capital loss, which may be deductible against other capital gains.
- Holding period: How long you held the cryptocurrency before the transaction occurred. This period determines whether the transaction qualifies as a short-term or long-term capital gain or loss.
- Any fees or commissions associated with the trade.
Record-keeping Methods for Crypto Tax Compliance
Several record-keeping methods exist for cryptocurrency tax reporting, each with its own benefits. Your chosen method will depend on your tax situation and investment strategy. It is critical to consult a tax professional to determine the best method for your needs.
FIFO (First In, First Out): This method assumes that the first cryptocurrency that is acquired is the first one that is sold or exchanged. This method is the default method for most tax authorities and is easy to understand and implement.
LIFO (Last In, First Out): This method assumes that the last cryptocurrency acquired is the first one sold or exchanged. This method can be helpful if you want to minimize your tax liability because it usually results in a higher cost basis.
HIFO (Highest Cost, First Out): This method assumes that the cryptocurrency with the highest cost basis is the first one that is sold or exchanged.
Specific Identification: This method involves tracking the cost basis of each cryptocurrency asset and determining which one is being sold or exchanged at the time of the transaction.
Crypto Tax Forms
In the United States, if you bought, sold, or exchanged cryptocurrency during the tax year, you may need to file certain tax forms to report your cryptocurrency transactions to the IRS. Here are some tax forms that may need filing:
- Form 8949: You’ll use this form to report capital gains and losses from the sale or exchange of cryptocurrency and other property types.
- Schedule D: This form reports capital gains and losses from all investment transactions, including cryptocurrency transactions.
- Form 1040: This is the standard individual income tax return form that most taxpayers use to report their income and deductions. You may need to include information from Form 8949 and Schedule D on your Form 1040.
- Form 1099-K: If you received over $20,000 in gross payments and had more than 200 transactions in a calendar year, cryptocurrency exchanges and payment processors must issue a Form 1099-K to you and the IRS.
Crypto tax compliance can be difficult for two reasons. First, the US tax code is notoriously complex. In designating crypto as property, the IRS transfers existing complexity onto a new asset class, and many other countries follow suit.
Secondly, the digital assets category continues to evolve ahead of the federal regulation that guides the IRS, so current guidelines and regulations aren’t always consistent.
ZenLedger can help you aggregate transactions across exchanges, compute your capital gain or loss, and auto-fill the IRS forms you need yearly. You can even use our tax loss harvesting tool to identify ways to save throughout the year.
The above is for general info purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.