Cryptocurrency (crypto) has been steadily gaining traction worldwide for several years.
It started with Bitcoin in 2009, as the world’s first decentralized currency built on blockchain public ledger technology (the underlying technology of crypto). Now, more than 10 years later crypto is expanding and beginning to disrupt a wide variety of industries and transaction types beyond traditional payment systems. With crypto, people can buy, sell, exchange/trade, invest and give out loans through a secure, anonymous and decentralized system.
With crypto beginning to skyrocket among key market participants such as consumers and merchants, software developers, investors and financial institutions, topics on regulations and taxation are beginning to surface. Awareness of current and potential tax laws regarding crypto is essential for the success of anyone involved or interested in crypto.
Current tax treatment
As with any investment, income or asset, tax and accurate bookkeeping of transactions is essential — crypto is no different. It’s even more important to keep track of crypto due to developing regulations that are trying to keep up with the technology.
Crypto (tokens, coins, NFTs, etc.) is taxed and treated as personal property, which typically means gains and losses are capital in nature. To determine capital gains or losses (reported on IRS Form 8949), calculate the difference in price (in USD) of the crypto when it is obtained (cost basis) and the price at the time of disposal.
If you aren’t a high-volume trader and are buying and selling the same number of units each time, this math is relatively easy to track. However, it can become a time-consuming process if you’re a high-volume trader or buying and selling different numbers of units. That’s why it is recommended to record and reconcile transactions throughout the year.
As with most capital investments, gains might be subject to different tax rates; one for short-term holdings (held for one year or less) and another for long-term holdings (held longer than one year). Short-term gains are effectively taxed at ordinary income tax rates, ranging between 10-37%, while long term gains are typically taxed at a more preferential rate ranging from 0-20%. State taxes and net investment income taxes might add tax to these transactions.
Some common transactions that trigger capital gains (or losses) that the IRS would require reported on form 8949 include:
• Exchange of one virtual currency for another (no like-kind exchange deferral allowed).
• Sales of crypto for cash (USD).
• Using crypto to pay for goods or services.
Crypto received outside of a trade or purchase might be treated as ordinary income upon receipt. It also could be subject to self-employment tax depending on whether you are considered to be in the trade or business for which you received the crypto payment.
Examples of earned income might include crypto received from the mining of crypto, providing professional services or selling goods.
Finally, interest received from staking crypto (whether fiat currency or crypto) as well as receipt of airdropped coins is generally considered investment income subject to ordinary rates.
It also is important to understand that certain transactions do not trigger taxable income.
Examples include:
• Buying crypto and holding.
• Transferring crypto positions between personal exchanges or wallets.
• Donating crypto (might be tax deductible).
• Gifting crypto to another individual (if not a disguised payment for goods or services).
Unique tax opportunities
Amidst the challenges related to taxation of crypto transactions, there is at least one major potential advantage in trading crypto versus securities.
A common tax savings strategy that can be used for crypto and securities is known as tax loss harvesting. With tax loss harvesting, an investor sells losing positions to generate capital losses which, in turn, offset capital gains. These losses also can reduce ordinary income up to $3,000 beyond what is used to offset capital gains.
The difference however, under the current regulations, is that securities are subject to wash sale rules, while crypto is not because it’s considered personal property. This means you could sell a particular crypto position at a fair-market value lower than what you purchased (or lower than your cost basis) to create a capital loss.
You can then immediately repurchase that same crypto at approximately the same price you sold it and hold the same amount as before the transaction but with the benefit of recognizing the capital loss to reduce taxable income. This is not possible with stocks and securities which require you to wait 30 days after the sale for repurchase or the loss on the sale of the stock or security is disregarded.
Changes on the horizon
Be on the lookout for potentially significant crypto regulation. Pending legislation of the infrastructure bill includes substantial changes to reporting requirements for crypto buyers and miners. These measures are in effort to better track and tax crypto transactions.
The bill requires crypto brokers to report gross proceeds to the IRS along with the names and addresses associated with transactions. The reasoning behind including these measures in the bill is to help pay for infrastructure related costs of the bill. Congressional accounts estimate that during the span of 10 years, these crypto reporting changes could raise up to $28 billion.
Avoid tax mistakes
Do not neglect reporting crypto activity to the IRS. Some crypto traders assume that since the transactions are made under a special PIN their identity is secure and the IRS can’t track these transactions.
However, this information is relatively easy for the IRS to find and trace. If the infrastructure bill is passed in its current form, this information also will be significantly easier to monitor. If the IRS finds proof of unreported gains, it might be considered tax evasion and a serious criminal offense. The IRS is committing significant resources to initiatives to help uncover unreported income related to crypto to recover related lost tax revenue.
Crypto as a form of investment is a monumental step toward a less-centralized form of currency and can be a great opportunity for some investors. Like most forms of investments, due diligence is a key step toward a successful financial investment. Due diligence is essential before investing to ensure you are making smart investments.