Cryptocurrency is slowly but surely redefining and helping expand the world of finance, with companies like Mastercard and Venmo jumping into the fray to support the growth of cryptocurrencies.
See more: How i know my crypto is activity taxable
At the same time, the Internal Revenue Service is taking note of the growth in digital currencies and closely scrutinizing tax returns for any discrepancies involving cryptocurrency.If you own or have transacted in digital currencies, you must follow and comply with the IRS’s guidance on tax reporting involving cryptocurrency.Understanding cryptocurrency terms, tax laws, and reporting will not only help you stay IRS-compliant, but will also help you more easily recognize crypto tax savings opportunities.
IRS guidance on cryptocurrency tax laws and tax liability
Some important provisions in the 2014 IRS guidance on digital and virtual currencies, commonly known as cryptocurrencies, are:
- Treatment of cryptocurrencies as personal property makes them liable for taxation as capital assets
- The capital gains tax applies when cryptocurrency is used to buy goods and services, or cryptocurrency is sold for fiat, or other cryptocurrencies
- Any virtual currency retrieved from mining is taxable as income at the time of receipt, which equals its fair market value
- Expenses on mining equipment can be deducted as a legitimate business expenditure
Cryptocurrency activities that constitute a taxable event
The IRS now includes a question on Form 1040 asking about the sale, trade, exchange, or receipt of financial interest on cryptocurrency during 2020. Essentially, this means if you’ve transacted with cryptocurrency, you must report it on your cryptocurrency tax forms. If you answer yes to this question, you will also need to file an 8949 tax form, used for reporting gains and losses from stocks and equity, as well as cryptocurrency gains and losses.But what cryptocurrency events do you need to report? Below we’ll break down what events you need to report, and how they’re taxed.
Taxable crypto activity
Cryptocurrency reporting can be tricky, especially since some transactions trigger capital gains while others count as ordinary income. Let’s cover the capital gains transactions first.Cryptocurrencies are capital assets, which means that they receive similar tax treatment to stocks. Any realized income from appreciation in the value of the crypto asset is taxable as a capital gain, though you can offset them against capital losses.Here are some common crypto transactions that trigger capital gains, which the IRS requires you to report on the 8949 tax form:
- Sale of cryptocurrency for cash
- Exchange of one virtual currency for another
- Using cryptocurrency or crypto debit cards to pay a merchant
In addition to gains and losses, you will need to report all receipts of cryptocurrency earned as income on your income tax forms, such as:
- Mining or staking cryptocurrency
- Receipt of airdropped tokens
- Payments received in the form of cryptocurrency
Depending upon your use, you may have both capital gains and ordinary income cryptocurrency tax events to report.To give you an example, if a gig worker getting paid in crypto uses their crypto income to make a purchase at a merchant, they must file the IRS 8949 form for the capital gain or loss resulting from the purchase in addition to reporting the cryptocurrency income on Form 1040.All cryptocurrency traders need to report each trade, or sale as a taxable event, even in the case of a capital loss. A capital loss can reduce the tax rate burden, and may sometimes earn you a bigger refund. We’ll discuss this strategy, called tax-loss harvesting, in more detail below.
Non-taxable crypto transactions
Not all crypto activity is taxable! Let’s look at some of the non-taxable cryptocurrency events that you don’t need to include while filing the IRS 8949 form:
- Buying cryptocurrency and holding
- Transferring cryptocurrencies between exchanges or wallets
- Gifting cryptocurrency, not including large gifts that could result in other tax liabilities
- Donating cryptocurrency, which in fact, is tax-deductible
Long-term capital gains
Long-term capital gains for a cryptocurrency transaction occur when you sell the asset after holding it for more than a year. In this case, the long-term capital gains rate applies, which varies from 0% to 20% depending on your ordinary income tax rate.
Short-term capital gains
Short-term capital gains for a cryptocurrency transaction occur when you sell the asset after holding it for one year or less. In this case, the capital gains from your crypto or Bitcoin transactions are added to your income and taxed at your ordinary income tax rate, which are typically higher than the long-term capital gains tax rateCheck out our article on the cryptocurrency tax rate for more information.
Have you received a CP2000 letter based on Form 1099-K?
The IRS has issued CP2000 letters based on the receipt of Form 1099-K, from certain exchanges for several users for the tax year 2018.The Form 1099-K is a report that aggregates a user’s total volume of transactions without taking the cost basis into account. It is not conducive to the transactions of digital currency assets and does not accurately portray your tax obligations.
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There is a standard two-year lag with IRS audits, which means that the 2018 tax year is under review currently. Presumably, exchanges will desist from issuing this incorrect form in the future, as announced by Coinbase and many others.In any case, it is critical that you do not ignore or disregard the deadlines on a CP2000 letter. Your failure to respond can lead to a default judgment against you, without giving you a chance to resolve the dispute.TaxBit has seen and assisted many taxpayers caught in a flurry of cryptocurrency audits that began in November 2020 based on Form 1099-Ks issued during the 2018 tax year. For our Pro customers, we are willing and able to assist in resolving these audits.
Conversion to Ethereum 2.0 and its tax implications
Ethereum began updating to Ethereum 2.0 at the beginning of December 2020. This new update plans to help augment efficiency and lessen system congestion as the network switches from a proof of work to a proof of stake algorithm.As in mining, the accession to wealth in staking is like a receipt of interest on the property, making it logical to interpret that staking leads to ordinary income on receipt of the asset at fair market value.Exchanges provide a 1099-MISC to the users for incomes over $600, making it easier for the users to know the income generated through staking on an exchange.While the original chain will continue to maintain data continuity, users can shift to Ethereum 2.0 at a one-to-one ratio. The transaction is more like a protocol update rather than an accession of wealth through the creation of a new currency.An upgrade from Ethereum to Ethereum 2.0 does not conform to the description of a hard fork, thus making it a non-taxable event. The taxpayer maintains the original cost basis before the conversion.
Tax implications of cryptocurrency mining
Mining digital currency creates numerous tax implications that a user must report on multiple forms. Whether you are a business with a custom mining rig or you mine on a computer as a personal investment; you must report the mined cryptocurrency as ordinary income in your tax forms.In both cases, your cost basis shall be the fair market value when you receive the currency. Below are some of the tax implications you need to be aware of, depending upon whether you are a self-employed full-time miner, or indulge in mining as a personal investment.
Tax considerations when mining crypto as a business
Taxpayers who treat their cryptocurrency activities as a business will generally have more paperwork than those who treat them as a personal investment. They must:
- File as a sole proprietorship, corporation, or limited liability company (LLC)
- Report and deduct ordinary and necessary expenses incurred as part of the business
- If filing as a sole proprietorship, you will pay an additional 15.3% self-employment tax and will report income and expenses on Schedule C of Form 1040
Tax considerations when mining crypto as a personal investment
Taxpayers who treat their cryptocurrency activities as a personal investment have fewer paperwork responsibilities, but they won’t be able to net any of their expenses against their income. They must:
- Report their income on Line 8 of Form 1040 (other income)
- Pay taxes on their entire crypto income at their ordinary income rate
Investors who mine crypto in their free time will usually be better off treating the activities as a personal investment. It’s difficult to incur enough deductible expenses to make taking on the extra self-employment taxes worthwhile.
Tax implications of staking rewards
Mining requires specialized equipment and huge amounts of energy. Proof of Stake (PoS) is a popular alternative that only requires investment in certain virtual currencies as they are staked (locked up) for the security of the blockchains.There is no specific IRS guidance on the taxation of staking yet. The best we have currently is Notice 2014-21, which is the tax guidance on mining income.The notice states that you should report crypto income at the time of receipt for rewards, and a taxable event also occurs when you sell the mined currency. The current interpretation of the notice is that staking rewards are taxable as ordinary income upon receipt.However, this 2014 notice fails to consider the inflationary effect of newly staked tokens and the ordeal of initiating a taxable event each time there are new tokens, which could be multiple times every day.It’s been theorized that the IRS may issue guidance stating that taxpayers should consider staking rewards to be the creation of new property. In that case, there would be no taxable event until the sale of the property.That would do away with the need to regard their dilutive and inflationary effects on the wealth of a user. For now, though, staking rewards remain taxable as ordinary income, just like earnings from mining activities.
The tax implications of Non-Fungible Tokens
Non-Fungible Tokens (NFTs) have been drawing a lot of attention recently. With NFTs, an investor buys a digital form of an asset.NFTs are usually capital assets, just like digital currencies. You can either create NFTs to sell in a marketplace, or you can invest in them to buy and sell as a trader.Investors should generally treat them as property and follow the typical rules for capital gains and losses. It is possible, however, that NFTs could be viewed as collectibles. The IRS defines collectibles as:
- Any work of art,
- Any rug or antique,
- Any metal or gem (with exceptions),
- Any stamp or coin (with exceptions),
- Any alcoholic beverage, or
- Any other tangible personal property that the IRS determines is a “collectible” under IRC Section 408(m).
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Collectibles are subject to a 28% long-term capital gain tax rate, regardless of income levels. The IRS has yet to confirm which NFTs are subject to collectible rules. However, it’s important to note that the difference only comes into question when assets are held for over one year.With that being said, any NFTs sold after a holding period of less than one year will be subject to short-term capital gains tax rates (which equals ordinary income tax rates), regardless of whether they’re viewed as property or collectibles.Additionally, purchasing an NFT is a taxable event if the investor buys the NFT with virtual currency. The transaction counts as the disposal of the cryptocurrency and will trigger a capital gain or loss.
The tax implications of Decentralized Finance
Decentralized Finance (DeFi) takes banks out of the equation and allows individual investors to lend, trade, and borrow from each other directly. There is a wide range of taxable activities that fall under the bucket of DeFi, and they receive different treatments.Here are some of the most common types of activities:
- Lending: Lending out your cryptocurrency generates interest, which can be taxable as ordinary income or capital gains depending on the DeFi platform.
- Receipt of incentive tokens: Some platforms issue tokens to reward their users, which are generally taxable as ordinary income at their fair market value upon receipt.
- Transfers into tokens and liquidity pools: In general, it’s safest to assume that these transactions trigger capital gains and losses.
DeFi is one of the most rapidly evolving areas of the cryptocurrency industry. Again, the IRS has yet to issue any specific guidance, but it’s generally safest to assume similar rules apply to those that govern other crypto transactions. When in doubt, always consult a tax professional.
Tax implications of AirDrops and hard forks
The latest IRS guidance states that taxpayers must recognize ordinary income based on the fair market value of new tokens received in both airdrops and hard forks. Airdrops are taxable in the same way whether they’re the result of a previous hard fork or marketing efforts.You must report this income on Form 1040 as other income. The transactions don’t need to go on Form 8949, where you report your short-term and long-term capital gain from cryptocurrency investments.Taxbit can help you tag tokens as airdrops and hard forks to make it easier to report these as ordinary income instead of capital gains.
Tax-loss harvesting is an indirect way to minimize taxes on capital gains that crypto traders may owe. This strategy takes advantage of market dips and can help lower tax liability or increase tax refunds, especially at the beginning stages of a portfolio for crypto investors.Two important things to keep in mind while using tax-loss harvesting to maximize wealth accumulation are:
- You should only off-set long-term capital losses against long-term capital gains
- You can use either long-term or short-term capital losses against short-term capital gains
Note: TaxBit’s Tax Optimizer (available in the Plus and Pro plans) gives real-time, proactive recommendations on when to engage in tax-loss harvesting, based on your trading activity. Many crypto investors leave money on the table by not taking advantage of these tax considerations!
Tax treatment for donations and gifts of cryptocurrency
There is a clear distinction between gifting and donating your cryptocurrency. If you’re looking for a tax break, you’ll want to make sure that your transaction qualifies for treatment as a donation.Let’s take a look at the rules.
To get a tax deduction for giving up your cryptocurrency, the recipient must qualify as a charitable organization. If they do, you can take a deduction for charitable donations on your taxes.How much you can deduct depends on how long you’ve held the cryptocurrency. If you’ve held it for more than a year, you can deduct the fair market value. If you’ve held it for less than a year, you can deduct the lesser of the fair market value and the cost basis.Donating your cryptocurrency directly is most beneficial if it has appreciated. You won’t owe any taxes on the disposition of the asset like you would if you sold it and donated the proceeds.
If you give your cryptocurrency to a party that is not an eligible charity, you will not receive any tax deduction. That means that giving cryptocurrency to a friend, family member, or individual in need will not provide you with any tax benefit.However, giving cryptocurrency is not a taxable event either. You won’t have to pay capital gains on the transfer if the fair market value exceeds the cost basis.To continue learning about Cryptocurrency Tax Basics, see the additional articles in the series:
- Cryptocurrency Taxes
- Cryptocurrency Tax Forms
- Cryptocurrency Tax Reporting
- Cryptocurrency Tax Rate
- Taxes on Cryptocurrency Gains
- How to Report Cryptocurrency on Taxes
TaxBit makes reporting crypto taxes easy
Cryptocurrency tax laws can be confusing. That’s why we created TaxBit: to make tax reporting easy for the average crypto investor. Our product connects to all the major cryptocurrency exchanges and integrates with other tax platforms.Learn more about plans and pricing today!
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