Taxes and Cryptocurrency: The Basics
As with any disruptive technology, the laws regarding cryptocurrency are evolving but one fact has been certain since at least 2014: Cryptocurrency profits are taxable. The basics of cryptocurrency taxation were outlined by the Internal Revenue Service (IRS) in IRS Notice 2014-21.
This notice defined virtual currencies for tax purposes as property, not foreign currency. Further:
- If used in a transaction, its worth is set at its fair market value in U.S. dollars at the time of the transaction. The difference between its value when purchased and its value when spent is taxable at the capital gains rate.
- If sold or exchanged at a profit, that profit is taxable at the capital gains rate.
- If you sell cryptocurrency at a profit, you owe capital gains on that profit, just as you would on a share of stock.
- If you use cryptocurrency to buy goods or services, you owe taxes on the increased value between the price you paid for the crypto coin and its value at the time you spent it.’
- If you accept cryptocurrency as payment for goods or services, you must report it as business income.
- If you are a cryptocurrency miner, your income gained from mining counts as business income.
- For U.S. tax purposes, a Bitcoin or Ether, or any other cryptocurrency, is valued at its equivalent in U.S. dollars at the time of the transaction.
Understanding Cryptocurrency and Taxes
Back in 2019, the Internal Revenue Service (IRS) mailed 10,000 “educational letters” to taxpayers it suspected owed the government tax payments for virtual currency transactions.
Clearly, the days of anonymous cryptocurrency transactions were at an end. It is possible that the federal agency based its list of recipients on customer data acquired from cryptocurrency exchange Coinbase.
Those who do not report income correctly can face penalties, interest, or even criminal prosecution, the IRS warned.
The Move to Transparency
The first cryptocurrency, Bitcoin, was introduced in 2009 as a peer-to-peer cash system. It was designed to be easy to use, easy to store, and anonymous. Your virtual wallet and the Bitcoins in it were as untraceable as the contents of a numbered Swiss bank account.
It wasn’t long before governments observed a surge in money laundering using cryptocurrency. Tax authorities, too, were bound to take note that invisible wealth is difficult or impossible to tax.
Today, most cryptocurrency transactions are transparent. Cryptocurrency exchanges impose anti-money laundering requirements on Bitcoin traders to avoid drawing the ire of regulators and tax officials.
Regulators, central bankers, and federal judges all continue to have different opinions on whether cryptocurrency should be considered a currency or a commodity. Nevertheless, all seem to agree that the profits acquired through trading and using it should be taxed.
So, what does that mean for traders?
At this point, cryptocurrency exchanges do not send their users a 1099 form to help with their taxes. However, blockchain-based apps are available to help cryptocurrency investors record their transaction data and track taxable events.
The Basics of Cryptocurrency Taxes
Remember those two key points from the IRS Notice published in 2014: If cryptocurrency is used to purchase something, it is considered to be worth its fair market value in U.S. dollars at the time of the transaction. If cryptocurrency is sold or exchanged at a profit, that profit is taxable at the capital gains rate.
Using Cryptocurrency for Purchases
Say you bought one Bitcoin for about $3,700 in early 2019. In late February 2022, that bitcoin was worth $38,500. You use your Bitcoin to buy a 2022 BMW X1.
Yes, these are real prices. Bitcoin is that volatile.
However, there are tax implications for both the buyer and the seller in this transaction.
- The seller must report the transaction as gross income, based on the fair market value in U.S. dollars of a Bitcoin at the time of the transaction.
- The buyer must report the transaction as a capital gain, based on the difference between the price paid for the Bitcoin and its value at the time of the transaction.
This Could Get Tricky
The recordkeeping for the taxes owed on cryptocurrency purchases could get onerous. Fractions of bitcoins can be spent. A fraction of a Bitcoin can be as little as one 100-millionths of a Bitcoin, which is known as a satoshi. Each coin in the Ether virtual currency is equal to one quintillion wei.
For instance, if you buy a cup of coffee using a fraction of a Bitcoin, you owe taxes on the difference between that fraction of a Bitcoin at the time it was purchased and the time it was used.
Taxable Events Using Cryptocurrency
Cryptocurrency brokers aren’t required to issue 1099 forms to their clients, as stockbrokers currently do. However, traders are supposed to disclose everything to the IRS or face tax evasion charges.
Taxable events related to cryptocurrency include:
- Exchanging cryptocurrency for government-issued currency, called fiat money.
- Paying for goods or services, such as using Bitcoin profits to buy a car.
- Exchanging one cryptocurrency for another cryptocurrency.
- Receiving mined or forked cryptocurrencies.
The following are not taxable events according to the IRS:
- Buying cryptocurrency with fiat money
- Donating cryptocurrency to a tax-exempt non-profit or charity
- Making a gift of cryptocurrency to a third party
- Transferring cryptocurrency between wallets
Determining how much profit you’ve made and how much you owe in capital gains taxes is understandably complicated.
Cashing Out of Cryptocurrency
Just like with any asset, your taxable profits (or losses) on cryptocurrency are recorded as capital gains or capital losses.
When exchanging cryptocurrency for fiat money like U.S. dollars, the trader will need to know the cost basis of the virtual coin they’re selling.
For example, if you bought Bitcoin at $6,000 and sold it at $8,000 three months later, you’ll owe taxes on the $2,000 at the short-term capital gains tax. Profits on the sale of assets held for less than one year are taxable at the person’s usual tax rate as if the money was earned income. For the 2021 tax year, that’s between 0% and 37% depending on the taxpayer’s income.
If the same trade took place a year or more after the Bitcoin’s purchase, you’ll owe long-term capital gains taxes. Depending on your overall taxable income that would be 0%, 15%, or 20% for the 2021 tax year.
Mining Cryptocurrency
The rules are different for those who mine cryptocurrency.
Cryptocurrency miners verify transactions in cryptocurrency and add them to the blockchain. That’s work, and they’re compensated for it.
Their compensation is taxable as business income. They also are eligible to deduct the expenses that went into their mining operations, such as computer hardware and electricity.
Paying for Personal Purchases with Cryptocurrency
Tracking the taxes due on purchases using fractions of a virtual coin is not easy, for those who constantly trade cryptocurrency and also use it frequently to buy goods and services.
They have to determine which coin was used to buy a cup of coffee, and make a record of the coin’s price basis and its value at the time of the transaction.
Moreover, this only works with transactions that involve a coin that has been sold at a profit. If a trader buys a Bitcoin for $8,000 and then uses a fraction of it to purchase a pair of jeans when the Bitcoin is worth $6,000, the transaction can’t be declared as a loss.
The smallest denomination of a Bitcoin is one hundred millionth of a Bitcoin, called a satoshi. A millibitcoin equals 100,000 satoshi. A microbitcoin equals 100 satoshi.
Exchanging Cryptocurrencies
Exchanging one cryptocurrency for another also exposes the investors to taxes.
If you buy Ethereum with Bitcoin, you’re effectively selling Bitcoin, so you’ll owe taxes on the difference in Bitcoin’s price between when you bought it and when you spent it on Ethereum.
Keeping Track of Crypto Taxes
Many exchanges help crypto traders keep all this information organized by offering free exports of all trading data. The trader, or the trader’s tax professional, can use this to determine the trader’s taxes due.
Blockchain solutions platforms also can be used to record this data and highlight relevant points of tax interest. Platforms like TrustVerse have smart-contract-based wealth management services that organize the user’s digital identity and assets on the blockchain to ensure that tax and estate obligations are addressed accurately.
It is always best to go to a certified accountant when attempting to file cryptocurrency taxes, at least for the first time. CPAs and other tax professionals are now learning more about crypto assets.
For now, the IRS is letting people become accustomed to the new way of doing things and has published a guide on amending old tax returns that includes some reference to cryptocurrency. Savvy traders are already ahead of their obligations and are now focusing on the next year’s crypto market without this cloud of uncertainty over their heads.
Cryptocurrency and Government Policy
Cryptocurrency and the US government have an interesting relationship.
It makes sense that the government would be uneasy about mainstream acceptance of a currency. For starters, there are the anxieties that government officials must have about ceding monetary control and fiscal policy to an algorithm. Then, there is the extreme volatility of the cryptocurrency markets, plus their associations with dark money.
However, the relationship is changing over time.
On its side, the government is tolerating a gradual yet substantial induction of cryptocurrency into conventional financial services.
On the cryptocurrency markets side, the exchanges started pairing cryptocurrencies to fiat currencies such as the U.S. dollar.
The increasing presence of Bitcoin in finance is also evidenced in Bitcoin futures contracts, which are traded on major institutional exchanges like the Chicago Mercantile Exchange and the Chicago Board Options Exchange.
How Do I Report Cryptocurrency Earnings on My Taxes?
Any profit you make from trading cryptocurrency or using it to purchase goods or services is taxable as a capital gain.
Any earnings you make from mining cryptocurrency is reported as income.
The value of any cryptocurrency you receive in payment for goods or services must be reported as income.
In all of these cases, the value of the cryptocurrency is based on its value in U.S. dollars at the time of the transaction.
When Do You Have to Pay Taxes on Cryptocurrency?
As with any investment activity, the sale of a cryptocurrency or its exchange for another cryptocurrency triggers a tax on any profit from the transaction. A purchase using cryptocurrency triggers a tax on the profit realized by cashing in a virtual coin, or a fraction of a virtual coin, for more than it cost when you purchased it.
All of these transactions represent capital gains. The capital gains tax is due when you file your taxes for the year in which the transaction takes place.
Similarly, any earned income or business income you make from cryptocurrency is due for the year.
How Do I Avoid Paying Taxes on Cryptocurrency?
You can avoid paying taxes on any cryptocurrency you own as an investment in the same way you avoid taxes on stock gains: Don’t sell. It is cashing in your cryptocurrency that triggers a taxable event.
If you mine cryptocurrency, the income from your mining activities is taxed as regular income. You may be eligible to deduct your business expenses in order to owe less taxes. A tax professional can help you with the details.
Is There a Tax on Crypto Per Transaction?
There is no transaction tax on cryptocurrency trading but there are fees involved.
Some exchanges offer commission-free trading but most charge fees ranging from about 0.1% to 1% per transaction.
There also are fees for online deposits and fees for withdrawals and account liquidations.
According to GoBankingRates, fees on cryptocurrency exchanges can change frequently and with little warning, so keep an eye out on the charges.
Do Different Cryptocurrencies Have Different Tax Rates?
No. The taxes due on any cryptocurrency transaction, payment, or income are always based on its value in U.S. dollars at the time that the taxable event is triggered.
The Bottom Line
It may seem odd that the first and, so far the only, substantial statement from the IRS on cryptocurrency and taxes was published all the way back in 2014.
The statement pretty much summed it up for most people who invest in cryptocurrency, use it to buy and sell stuff, or accept it as payment. That is, if you made a profit trading it or using it, you owe taxes on the capital gain. If you accepted payment in it or made income from it, you owe taxes on the income.
Nevertheless, the cryptocurrency world is increasingly complex and difficult to understand, even for bureaucrats who spend their lives studying it.
Tax policy and financial regulation regarding cryptocurrency are bound to evolve over the next few years. Even the massive infrastructure bill that has been stalled in Congress since its introduction in late 2021 addresses cryptocurrency, with proposed changes in required reporting by cryptocurrency exchanges.