Over the past few years, cryptocurrency has become a hot topic, and Bitcoin's historic rise in the fourth quarter of 2021 has further intensified the conversation. With the rise of cryptocurrencies, tax authorities have had to grapple with how to regulate and tax this new asset class. In the United States, the IRS has been actively issuing guidance on how taxpayers should report their cryptocurrency transactions for tax purposes.
If you're new to the world of cryptocurrency, navigating the tax implications of your transactions can be overwhelming. This comprehensive guide will cover everything you need to know about cryptocurrency tax laws in the United States in 2022, from understanding the tax status of cryptocurrencies to reporting your transactions on your tax return.
So, let's dive in and learn everything there is to know about crypto taxes in the USA
What Is Cryptocurrency?
The shortest and simplest answer to this question is: that a cryptocurrency is a form of digital currency. There are two major differences between cryptocurrencies and traditional fiat currency.
- Crypto does not produce a physical bill; it is completely digital
- Cryptocurrency is a decentralized currency which implies that it does not follow the guidelines of any centralized authority like that of a bank or the government
What Is The Importance of Cryptocurrency and Is It Safe?
Cryptocurrency is a digital currency that operates independently of any central bank and is secured using cryptography techniques. It is a decentralized and transparent system that allows users to transfer funds securely and anonymously across borders without intermediaries.
The rise of cryptocurrency has brought about a new era of digital finance and has sparked a revolution in the way we think about money. The technology underlying cryptocurrencies, known as blockchain, has opened up new possibilities for transparency and accountability in financial transactions. It has the potential to disrupt traditional financial systems and provide more financial freedom to individuals around the world.
However, despite the benefits of cryptocurrency, there are also risks and concerns associated with its use. One of the main concerns is the lack of regulation, which can make it vulnerable to fraud and cyber-attacks. In addition, the value of cryptocurrencies can be highly volatile, making it a risky investment.
That being said, the safety of cryptocurrency largely depends on how it is stored and managed. It is crucial for users to take measures to secure their cryptocurrency wallets and protect their private keys. By following best practices and staying informed about potential risks, users can safely and responsibly participate in the world of cryptocurrency.
How Is Cryptocurrency Taxed?
Now that we have a clear understanding of cryptocurrency and its working principles, let's explore how cryptocurrency is taxed.
IRS Considers Crypto As Property
Cryptocurrency is subjected to taxes overseen by the Internal Revenue Service (IRS). The Internal Revenue Service issued Notice 2014-21 in 2014 that stated cryptocurrency is considered ‘property’ and not currency.
In 2019, the IRS included the question, “at the time during the current fiscal year, did you sell, receive, exchange or dispose of any financial interest in any virtual currency?” in front of the Form 1040.
The IRS placed this question in front and center of the form and thus, taxpayers cannot claim that they aren’t aware of reporting crypto transactions. If a taxpayer checks “Yes,” then the tax authority looks for Form 8949 filled by the taxpayer. If they fail to report crypto on their taxes, the IRS may audit the taxpayer and may impose a penalty.
Simply put, cryptocurrency is treated the same as stocks, bonds, and other assets that qualify for capital gains tax on crypto. There are also instances where crypto is treated as income and thus qualifies for income taxes.
Let’s understand this concept with an example. Kate bought $20,000 of Ethereum in August 2021 and sold it in October 2021 for $25,000, Kate would realize $5,000 ($25,000-$20,000) as a capital gain.
On this capital gain, the amount of tax that must be paid by Kate is dependent on the tax bracket and the holding period (short-term and long-term).
But what if Kate hadn’t bought the crypto (Ethereum, in this case)?
If she had received cryptocurrency through mining, airdrops, or as interest from lending, her income would then be subject to income taxes, the rate of which would depend on the income slab she comes under.
Now, the next question that could come to mind is - how will the tax be calculated? For this calculation, it is crucial to understand three essential concepts:
- Fair market value (FMV)
- Capital gain and loss
- Cost basis
Fair Market Value
The price at which an item can be sold on the open market is called its fair market value. In the case of crypto, the fair market value is the price of crypto in its equivalent fiat currency or U.S. Dollar. It is commonly denoted by its abbreviation, FMV.
Capital Gain & Loss on Crypto
A capital gain or loss is incurred on trading or selling cryptocurrency. Just like traditional assets, capital gains will be incurred when the price of selling is greater than the price it has been acquired for (refer to Kate’s example of $5,000 as capital gains above). On the other hand, a capital loss is incurred when the price of selling is lesser than the price it was acquired for.
Before selling a capital asset, you must figure out if the investment was short-term or long-term. Long-term gains and losses are incurred when the assets were held for more than a year, whereas short-term capital gains and losses are incurred when the assets have been held for less than one year.
Cost Basis Methods for Tax Calculation
Cost basis can be defined as the amount spent to buy an asset (cost price). It also includes any additional expenses that were incurred at the time of acquiring the crypto, such as transaction or gas fees.
Various methods are followed for the calculation of cost basis:
- Average cost
- Specific identification
- First in, first-out (FIFO)
How To Calculate Your Crypto Taxes?
Now that we know the basic terminologies used for crypto tax calculation, let’s explore taxable events, various tax methods, and the concept of tax-loss harvesting in our crypto tax guide.
Taxable vs. Non-Taxable Crypto Events
Most crypto transactions are taxable - but not all of them.
Taxable crypto transactions include:
- When you sell crypto for fiat currency like the U.S. Dollar, Euro, Canadian Dollar, etc.
- Trade crypto for another crypto, such as Bitcoin for Ethereum, and Ethereum for Cardano
- Buy goods or services using crypto
- Receive crypto because of advanced crypto situations, like a hard fork or crypto mining
Non-taxable crypto transactions include:
- When you buy crypto with fiat currency
- Transfer crypto from one of your wallets to another crypto wallet that you own
- Gifting crypto (non-taxable below a limit, subject to gift tax above that)
- Donate crypto to a tax-exempt organization
Crypto Tax Rates: Long-Term vs. Short-Term Capital Gains
The rates of crypto taxes depends on the holding period of the asset and can be categorized into two groups; long-term and short-term gains.
1. Long-Term Capital Gains
Long-term gains are applied to crypto-assets that have been held for 366 days or more. Investors who opt for long-term investments are at an advantage compared to those holding short-term crypto investments because long-term investors are subject to incentives and lower crypto tax rates.
As of 2021, the long-term capital gains slab ranges from 0% to 20%, depending on a few parameters. Here’s a list of the rates of cryptocurrency taxes for long-term crypto holdings.
2. Short-Term Capital Gains
Short-term gains are applied to crypto-assets that have been held for less than 365 days. Unlike long-term gains, short-term gains do not receive any special treatment. Short-term gains are analogous to income from a job and are thus subjected to taxes according to income slabs.
As of 2021, the short-term capital gains range from 10% to 37% depending on a few parameters and are treated as taxes on ordinary income.
Two Types of Crypto Taxes: Capital Gain vs. Income
As mentioned earlier in our crypto tax guide, cryptocurrencies are taxable and in the United States, and there are two types:
- Capital Gains Tax, is similar to bonds, stocks, and other assets that qualify for capital gains.
- Income Tax includes mining, staking, airdrops, and other related crypto activities from which one can earn income.
In the case of capital gains, the rates depend on the holding period and are classified as:
- Short-term capital gains tax, taxes on assets that are held for less than a year. The rates are usually higher and range from 10% to 37%.
- Long-term capital gains tax, taxes on assets that are held for a period longer than a year. The rates for long-term capital gains range from 0% to 20%.
Here is a list of activities that fall under capital gains tax vs. income tax.
Capital Gains Tax Activities
The gains from the following activities qualify for capital gains tax activities:
- Selling crypto for fiat currency
- Buying goods and services using cryptocurrencies
- Trading one crypto for another
Income Tax Activities
The earnings from the following activities are subject to income tax:
- DeFi lending
- Receiving crypto via airdrop
- Receiving crypto as a reward or bug bounty
- Earning crypto by staking and liquidity pools
- Earning crypto mining income from transaction fees or block rewards
- Minting an NFT as an artist/creator
- Receiving token rewards from play-to-earn games (Such as Axie Infinity)
Crypto Tax Calculation Example
Suppose your annual income is $55,000 and you file your taxes on crypto as single. On August 1st, you purchased $500 of BTC and sold it a year later, on July 1st for $1,500. Your gain of $1,000 will qualify for short-term capital gains at the rate of 25%, resulting in 0.25 (tax rate) *$1,000 (capital gain) = $250 (tax owed)
Sale price of assets - Cost of acquiring assets = Short-term gains
Sale price = $1,500
Cost of acquiring assets = $500
$1,500 (sale price) - $500 (cost of acquiring) = $1,000 (gains)
This gain of $1,000 is a short-term gain as the assets were sold within a period of 11 months.
Annual income = $55,000, and the short-term capital gains tax rate for this income is 25%.
So, tax owed = 25% * Capital gains = 0.25 * $1,000 = $250
Another example is your annual income is $35,000 and you bought $500 of BTC on August 1, 2020. If you sell it at $1,500 on August 2, 2021, you incurred a long-term capital gain of $1,000. According to the rates tabulated above, you’ll have to pay 0% taxes. Thus, no federal taxes on crypto will apply.
Sale price of assets - Cost of acquiring assets = Long-term gains
The sale price = $1,500
The cost of acquiring assets = $500
$1,500 (sale price) - $500 (cost of acquiring) = $1,000 (gains)
This gain of $1,000 is a long-term gain as the assets are sold after a period of 1 year.
Annual income = $35,000, and the long-term capital gains tax rate for this income is 0%.
Understanding Tax Calculation Accounting Methods: FIFO, LIFO, HIFO
Now let’s move on to one of the most important parts of our crypto tax guide: tax calculation accounting methods. When you sell your crypto, you have to pay taxes (capital gains or income) which can be calculated using the formula:
Value at the time of selling - Cost Basis = Capital Gain
However, if the value at the time of selling is higher than the value at the time of purchase (purchase price), you’ll incur a capital loss. This loss can be used to offset your capital gains in a particular year with a method known as tax-loss harvesting. (More on this later)
Now, the accounting method you choose to calculate your taxes decides how much tax you have to pay and can also significantly reduce your taxes. The most popular tax calculation accounting methods are:
- FIFO (First-In-First-Out)
- LIFO (Last-In-First-Out)
- HIFO (Highest-In-First-Out)
In order to understand each of these accounting methods, let’s look at a simple example. Suppose, on April 1st, Jake purchased $3000 of ETH. In May, he purchased another $3500 of ETH, and on July 1st he sold ETH for $4000.
Now, what will be the capital tax that he pays on his gains? Let’s explore method by method.
According to the FIFO accounting method, the assets that are bought first are counted first. Let’s calculate the tax in the above example.
Selling price= $4000
Cost price (April) = $3000
Capital gain= $1000
According to the LIFO accounting method, the assets that are bought last are counted first. Let’s calculate the tax in the same example.
Selling price= $4000
Cost price (May) = $3500
Capital gain= $500
Now we can see that using the LIFO method, instead of the FIFO method will save you $500 on your crypto capital gains.
According to the HIFO accounting method, the assets that are priced the highest are considered first. In the given example, it would lead to the same gains as the LIFO method, but in the case of hundreds of transactions, the gains would significantly vary.
Which Crypto Tax Accounting Method Is Best For You?
Even though LIFO and HIFO can help you shield yourself from paying hefty taxes, FIFO is the most common method among taxpayers.
It must also be noted that if you intend to use the LIFO or the HIFO method for gains calculations, you have to keep a detailed record of all your transactions. Only then you can calculate the gains in a hassle-free manner.
This was all about calculating your crypto capital gains, but what if you incur losses? Let’s explore tax losses and how harvesting those losses can help you minimize your tax obligations.
Crypto Tax-Loss Harvesting
We know that whenever we sell real estate, stocks, or virtual currency for a profit, we have to pay capital gains tax on the earnings. But a number of investors opt to sell a part of their assets at a loss, in order to reduce the capital gains and hence, the tax liability in a particular year, which is known as tax-loss harvesting.
Crypto Tax-Loss Harvesting Example
Let’s consider that Tim gained $10,000 on Ethereum this year, but he also owns a few Ripple that he bought a couple of years ago at $8,000, which is now priced at only $2,000.
Tim can now “harvest” his Ripple losses by selling it or exchanging it for another crypto. This results in a taxable event and $6,000 in capital losses ($8,000 - $2,000).
Tim's $6,000 loss brings his total capital gains to $4,000. ($10,000 - $6,000).
Advanced Crypto Tax Situations With Examples
Whether you’re new to crypto or not, it is essential to understand advanced crypto tax situations such as airdrops, mining, staking, and their specific tax implications.
If you have free coins sent to your wallet, it is termed an “airdrop.” In this scenario, the way you utilize the coins will have an impact on how they’ll be taxed. Since airdrops are similar to free money received as part of a giveaway or a lottery victory, they will be taxed as ordinary income at the fair market value on the date of receipt.
Suppose Alan received 300 UNI tokens in the Uniswap airdrop of September 2020, when the tokens were priced at $3.50. On claiming the tokens, he earned $1050 (300*$3.50). Thus his cost base is equivalent to his income, i.e., $1050.
Two months later he sold his 300 UNI for $2500. As mentioned earlier, this is a taxable event and he incurred a gain of $1,450 ($2500-$1050).
In the crypto world, when a blockchain experiences a diversion into two paths forward, it is called a fork and the crypto you receive as a result of this fork is taxed as income. Forks can also be understood as a protocol change resulting in a permanent diversion from the legacy distributed ledger.
In July 2021, Eric owned 3.5 ETH and as a result of the Bitcoin Cash hard fork he received 3.5 Bitcoin Cash.
He would earn $1,575 ($450*3.5) if Bitcoin Cash was trading at $450 per BCH on the day he received it. Therefore, Eric’s cost basis on Bitcoin Cash will be $1,575.
If you earn cryptocurrency from a job, staking, or mining, your earnings will be considered as ordinary income and will be reported accordingly.
Crypto mining taxes are analogous to regular income taxes. When you successfully mine virtual currency, you create a taxable event, and you must declare the fair market value of the mined coins as gross income at the time of reporting crypto taxes.
The process of reporting crypto mining taxes depends on whether the miners are hobby miners or professional miners.
- Income to be reported in line 21 (other income) of your Form 1040 Schedule 1 (Additional Income and Adjustments to Income)
- Direct expenses of mining to be reported on a Schedule A (Itemized Deductions) and miscellaneous expenses are subject to 2% of AGI limitation (applies only to 2017 and prior years)
- Both income and expenses to be reported on a Schedule C (Profit or Loss from Business) or on applicable business returns (Form 1065, Form 1120, and Form 1120S)
- Income can be subject to the 15.3% self-employment tax
- Offset mining income by deducting business expenses
Crypto Mining Taxes
The formula for calculating your gains and losses is:
Sale Price - Cost Basis = Capital Gains/Loss
The value of the coin at the moment it was mined is your cost basis (the amount included as ordinary income). To calculate your capital gain or loss, you have to subtract this amount from the price you sold the mined coins for.
You get a capital gain if the value of the coin is higher than your cost basis at the moment of selling. If the value is less than the market value, the taxpayer will suffer a capital loss. An IRS 8949 cryptocurrency tax form must be filled out for every sale or transfer of mined cryptocurrency.
Suppose John earned 0.20 BTC from mining on a day when Bitcoin was worth $34,000 ($.20 * $34,000 = $6,800). The price of BTC grew to $38,000 at the end of the tax year (.20 * $38,000 = $7,600). However, because the taxable event occurs when bitcoin is deposited, even though the asset's current value is $7,600, you would still be taxed on $6,800 of income.
Proof of Stake is a consensus technique that allows blockchain networks to use less energy while retaining a reasonable level of decentralization. If you’ve earned $600 or more in a single tax year, you’ll have to report your earned income using the Form-1099-MISC (Miscellaneous Income).
If you’re earning income in the form of interest from any crypto lending operation or liquidity pool, your income is taxable. This income has to be reported on your taxes similar to mining and other staking incomes.
NFT, short for Non-Fungible Taxes, refers to a special kind of digital asset that uses blockchain technology to verify its authenticity. It can include JPEG, MP4, and also GIF. Each of these NFTs has a unique ID that can be verified to identify the one who minted, produced, and initially held it.
Taxable NFT Activities
- In exchange for bitcoin, you sell an NFT
- Using a fungible coin to buy an NFT
- An NFT is exchanged for another NFT
Buying and selling NFTs will incur capital gains or losses depending on how the fair market value of the tokens you used for the transaction has changed since you got them. Also, if you are the creator of NFTs, the revenue that you get is considered regular income and will be taxed appropriately.
Thus, there are two types of NFT tax rates:
The majority of people that deal with NFTs are investors. These are the individuals that are active in the open market purchase and sale of NFTs. Investor taxes occur when people buy and sell NFTs.
Creators are the people who mint or manufacture NFTs and then sell them on websites like SuperRare and OpenSea. NFTs are not taxable for creators. The Internal Revenue Service, on the other hand, considers any crypto transactions using NFTs to be taxable (IRS).
Donations & Gifts
Donations to a tax-exempt charitable organization are considered tax-free. If you are donating $500 or more, it must be recorded on Form 8283. The amount of your tax-deductible donation is calculated by how long you have owned the assets:
- If you have held your crypto assets for more than a year, 30% of your gross annual income is deducted
- If you have held your crypto assets for less than a year, 50% of your gross annual income is deducted
In the case of gifting crypto assets, you can give up to $15,000 per friend or family member and are tax-free for the recipient.
The Internal Revenue Service has not specified any guidelines pertaining to margin trading, but we may deduce the likely approach based on prior guidelines. The most common strategy would be to treat borrowed funds as your own investment and pay capital gains tax on margin trading profits and losses.
Governance & Incentive Tokens
Governance and incentive tokens are issued by DeFi networks for being active on their platform. These tokens are taxable as income depending on the market value of those tokens. On selling these tokens, you’ll qualify for capital gains or losses.
The revenue that is generated from liquidity pools is taxed as capital gains and income in the following ways:
- Capital gains: You are subjected to capital gains if the liquidity pool token balance remains constant but rises in value owing to demand or fee collection.
- Ordinary income: You are subjected to ordinary income if you are getting direct interest in the underlying asset.
Losses From Hacks & Thefts
Losses on cryptocurrency investments due to scams, hacks, or other thefts are not treated as casualty losses, but instead, as investment losses.
According to tax code 165 (c)(ii), even though the investment is not linked to any business, your investments have been put in for profit. This is why any loss that has occurred as a result of scams, theft, or fraud is tax losses. But how can you claim such losses when filing taxes?
Crypto losses as a result of hacks and theft can be claimed as $0 proceeds transactions on Form 8949. This implies that if you paid $15,000 for 1 ETH and it was taken as a result of an exchange breach, you might claim a loss of $15,000.
How To Prepare For Crypto Tax Season?
We now know the basics of crypto taxes, their calculations, and the various taxable vs. non-taxable events. It's time to move on to one of the most important sections of the tax guide—How best to prepare for crypto tax season?
All crypto activities such as airdrops, earning interest as other crypto events mentioned above are considered taxable events under crypto capital gains or income tax events; and according to the Internal Revenue Service, “you must keep a record of all your crypto purchases and sales.”
The most popular crypto exchanges and software have a built-in feature of reporting tools that can automatically help you create crypto transaction reports.
Gather Your Information
The Form 1099-K and other related 1099 forms of the Internal Revenue Service are provided by most of the crypto exchanges like Kraken, Coinbase, etc. All the 1099 forms serve the same purpose, which is to report non-employment income to the Internal Revenue Service.
Apart from the 1099s, there are many other crypto tax forms that you will need to file as per your requirement and the crypto activities that you have undergone.
Calculate Gains And Losses With Crypto Tax Software
The easiest way to calculate your capital gains and losses is using crypto tax software. Crypto tax software is integrated with major crypto exchanges, blockchains, and wallets, and can help you with reporting and filing your crypto taxes.
At ZenLedger, you can use our crypto tax calculation software to simplify tax reporting and financial analysis in compliance with the crypto tax laws by the IRS and the SEC rules and regulations.
Reporting Cryptocurrency On Your Taxes
Let’s get to the final step of understanding crypto taxes in the USA by learning how to report cryptocurrency taxes.
It is easy to get confused as to which IRS tax form is required for what purpose. As we already know crypto investing leads to the generation of capital gains tax on crypto, and activities like mining, staking, and rewards collection will lead to income taxes.
Most important tax forms in the United States:
Other Forms Issued by the Exchanges
A crypto exchange could issue Forms such as 1099-B, 1099-MISC, and 1099-K.
Forms 1099-B report cost basis when available. It is used to report capital gains and losses incurred by the taxpayer after selling certain assets via exchanges and barter exchanges. The IRS and the investor both receive a copy of this form for crypto transactions from the crypto exchange.
This form covers a wide range of payments such as referral bonuses, crypto earnings, and other incomes. If you’ve earned more than $600 in crypto or bonuses this year, this form will be sent to you by your crypto exchange that issued the payments.
Some crypto exchanges issue Form 1099-K. This form sums up the number of electronic payments a taxpayer has received throughout the year made by credit card, debit card, or online payments system such as PayPal.
The Form 1009-K is for taxpayers that accept payments via electronic means instead of people who sell their properties such as crypto tokens.
When some exchanges issue Forms 1099-K, they only include the total value exchanges and not the proper adjustments for cost basis. For instance, if an investor bought Bitcoin for $100,000 and sold it for $90,000, the taxpayer and the IRS will receive Form 1009-K with $90,000 as income received.
Due to this miscalculation, many exchanges have stopped issuing this form and many have exchanged this form for 1099-B because it is an accurate tax form and provides the user experience, and eliminates the possibility of an IRS audit as per crypto tax laws.
The Financial Takeaway
The IRS published guidelines on cryptocurrencies back in 2014 and hasn’t updated them much since then. However, it pretty much summed up for many crypto investors. If you earned a profit from trading it or using it, you have to pay taxes. If you accepted it as a payment or earned income from it, you have to pay taxes. Even though it sounds easy, the crypto tax space is pretty complex and we hope our crypto tax guide has helped.
ZenLedger easily calculates your crypto taxes and also finds opportunities for you to save money and trade smarter with our portfolio tracker. Get started for free now or learn more about our tax professional-prepared plans!
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.