Written by: Kadeem Clarke
Compiled by: 0x11, Foresight News
The relationship between cryptocurrencies and taxes
Whether you are an experienced cryptocurrency trader or just received a small amount of cryptocurrency as a gift, it is important to understand its tax implications. Cryptocurrency taxation is a topic that’s rarely discussed and it’s not so exciting that many people don’t know what’s going on in this space.
People often refer to cryptocurrencies as digital currencies, but in the eyes of most governments, they are not real currencies. In Notice 2014-21, the IRS labeled cryptocurrencies as property and market participants were required to report related capital gains and losses.
According to Baker Botts tax partner Jon D. Feldhammer, cryptocurrencies are considered property and should be taxed. If you sell, buy, or trade cryptocurrency for another investment, you will have to pay taxes. If you buy a Bitcoin for $30,000 and then sell it a few months later for $50,000, you will have a short-term taxable gain of $20,000. Even so, Feldhammer mentioned that things start to get complicated from here, as people often trade frequently for various reasons.
Let’s say someone owns $50,000 in BTC and wants to buy an NFT. In this case, he may be asked to use ETH to purchase a specific NFT, so he must first exchange BTC for ETH to complete the transaction. Feldhammer claims that you still have $20,000 in taxable income in this scenario because you exchanged one property (BTC) for another (ETH), which is a taxable transaction.
How are cryptocurrencies taxed?
If you buy, sell or exchange cryptocurrency in a non-retirement account, you will face capital gain or loss. As with IRS taxes on other investments, your profits or losses may be short-term or long-term depending on how long you held the cryptocurrency before selling or trading it.
Assuming you hold the cryptocurrency for a year or less before selling it, any profits are generally considered short-term capital gains and taxed at ordinary income rates. If you hold cryptocurrencies for more than a year, the profits are generally considered long-term capital gains and taxed at long-term capital gains rates.
For short-term capital gains or ordinary income earned from crypto activities, you should use the following table to calculate your capital gains tax:
2022 Short-Term Capital Gains Tax Rates
If you held cryptocurrency for more than a year, use the table below to calculate your long-term capital gains:
2022 Long-Term Capital Gains Tax Rates IRS Guidance on Taxing Virtual Currencies
Virtual currency is broadly defined as a digital representation of value that can serve as a medium of exchange, unit of account, and store of value. Convertible virtual currency is a virtual currency that has an equivalent value to real currency or serves as a substitute for real currency.
As the cryptocurrency landscape evolves, the IRS has released "Rev. Rul. 2019-24" and a list of frequently asked questions about virtual currency transactions. "Rev. Rul.2019-24" is designed to address two unique situations: one is a soft fork, where taxpayers do not receive new cryptocurrency; and the other is a hard fork, where taxpayers receive as a result of an airdrop new cryptocurrency.
When is your cryptocurrency taxable?
To determine whether you need to pay taxes, first consider how you use cryptocurrency.
Examples of non-taxation
Buy cryptocurrency with cash and store it – buying and holding cryptocurrencies is not taxed. Taxes are usually paid when the property is sold, and the proceeds are realized. Donate cryptocurrency to a tax-exempt charity or non-profit organization - You donate cryptocurrency directly to a charitable organization like GiveCrypto.org. Getting a gift – If your cryptocurrency is received as a gift, you don’t have to pay taxes on it until you sell it or engage in other taxable activity (such as staking). Gifts – You can make tax-free gifts worth up to $15,000 per year to a single person (or more to a spouse). If the value of your gift exceeds this amount, you must file a gift tax return. If you transfer cryptocurrency to someone else without purchasing goods or services, it may be considered a gift, even if you did not intend to do so. Transfer Cryptocurrency to Yourself – There is no tax on transferring cryptocurrencies between wallets or accounts. You can use your original cost and purchase date to track your potential tax impact when you sell.
taxed as capital gains
Selling Cryptocurrency for Cash – If you sell an asset for more than it cost, you will need to pay taxes. If you sell at a loss, you can deduct the loss from your taxes. Convert one cryptocurrency to another - for example, if you use Bitcoin to buy Ethereum, you technically have to sell your Bitcoin before purchasing the new asset. The IRS considers this taxable because it is a sale. If you sell your Bitcoins for more than they cost, you'll pay taxes. Use cryptocurrencies to purchase goods and services – for example, if you use Bitcoin to buy pizza, you’ll pay transaction tax. To the IRS, paying in cryptocurrency is no different than selling cryptocurrency.
taxed as income
Get Paid in Cryptocurrency Get Cryptocurrency in Exchange for Goods or Services Cryptocurrency Mining Earn Staking Rewards Earn Other Income Earn Cryptocurrency from Hard Forks Receive Airdrops – You may receive airdrops as part of a marketing campaign Airdrops from cryptocurrency projects. Receiving airdrops is considered income and you must report the amount on your taxes. Earn other rewards – This list is not exhaustive; there are many reasons why you can earn free cryptocurrencies. These include learning tips or incentives such as receiving $5 in Bitcoin for referring a friend to a cryptocurrency exchange. In any case, you must report these as income.
If you make a lot of money from cryptocurrencies, it may affect your tax bracket and you may pay a higher tax rate on all your income. You can visit IRS.gov for the latest guidance on federal income taxes.
The IRS sent more than 10,000 tax notices to potentially non-compliant taxpayers in 2019, it sent another batch of tax notices to questionable taxpayers in mid-2020, and no letters were sent in 2021, which may be As the IRS transitions to remote work and resolves incentive-related issues.
Additionally, IRS audits are expected to increase with the passage of the Inflation Lowering Act in August. The bill allocates $45 billion for enforcement activities, including digital asset surveillance and compliance activities. Over the next decade, the agency will invest those funds in audit and tax tools and personnel.
In light of these developments, cryptocurrency taxpayers may be concerned that they will be audited by the IRS. Knowing the ins and outs of IRS audits and how to avoid them may take away some of the fear.
According to the IRS, only a small percentage of people who buy, sell or trade cryptocurrencies properly report these transactions on their tax returns. In October 2019, the agency issued guidance on how to report and tax cryptocurrencies for the first time since 2014.
Beginning with the 2020 tax year, the IRS changed Form 1040 to include the following question: Did you receive, sell, send, trade, or otherwise obtain any financial interest in any virtual currency at any time in 2022?
If you check "yes," the IRS may want to see income from cryptocurrency trading on your tax return.
Crypto tax software allows you to track all of these transactions, ensuring you have a complete list of activity to report when you file your taxes. The software integrates with multiple virtual currency brokers, digital wallets, and other crypto platforms to import cryptocurrency transactions into your online tax software. This may include cryptocurrency transactions and transactions involving virtual currencies as a form of payment for goods and services.
Based on crypto tax software, transaction reporting may be similar to the tax return you file on Form 8949. The IRS may format it so they can easily import it into tax preparation software.
Can the IRS monitor cryptocurrency activity?
Although cryptocurrencies are anonymous, the IRS may be able to track your crypto activity. For example, if you trade on a cryptocurrency exchange that reports via Form 1099-B, Broker Gains, and Barter Exchange Transactions, they will report your trades to the IRS.
Additionally, the IRS uses blockchain analysis tools to identify cryptographic activity on digital wallets and link them to individuals in cases of suspected tax evasion or money laundering. Therefore, you should make sure to report all cryptocurrency activity on your tax return for the current year.
Are you facing a crypto tax nightmare?
Mark Steber, chief tax information officer at Jackson Hewitt, said if taxpayers are unable to pay by the Tax Day deadline, they can work out a payment plan with the IRS. It’s not enough to tell the IRS you didn’t realize your cryptocurrency transactions were taxed. According to EY tax partner Thomas Shea, if you trigger a taxable transaction but lack fiat currency to pay the tax, you can exchange the additional assets for fiat currency, which is essentially a sell-to-cover.
If you're even a little concerned about messing up your crypto tax bill, you'd better consult a tax professional. Walker asserts that there are several deductions available for capital gains liabilities and that taxpayers can use a variety of tax credits and deductions to reduce the income tax owed.
Finally, here are some practical ways to reduce your crypto taxes:
Hold profitable cryptocurrency investments for at least a year before selling or using them, with long-term gains taxed at lower rates than short-term gains. Take advantage of tax loss compensation. If you make profits and losses on various types of cryptocurrencies, you can sell both cryptocurrencies at the same time and use the losses to offset your gains. Consider setting up a crypto IRA. This type of account, like other IRAs, allows you to make tax-deductible contributions and pay taxes only when you withdraw funds.
Crypto natives who want to play by the rules, or at least abide by the few existing rules, have some options. They can manually calculate their crypto taxes and hope to pay the correct amount, or they can use tax deduction tools that allow them to keep more crypto after tax.