Experts weigh in on updated IRS notices and changes for 2021
In the approximately dozen years of cryptocurrency trading, the IRS has been working through how to classify it and obtain its pound of flesh. The IRS has juggled its duty to provide clarity with the need to stay light on its feet with this rapidly-evolving digital asset.
“Without a doubt, the IRS will be tackling 1099 information reporting requirements for cryptocurrency exchanges themselves next. Currently, there is no standard as to which type of 1099 cryptocurrency exchanges need to be giving their customers. Some give customers 1099-Ks, and some give nothing at all. This will change in coming months as the IRS is expected to release stricter guidance within the year.”
– David Kemmerer, CEO of CryptoTrader.Tax, a cryptocurrency tax calculator and software solution
Coinbase, one of the largest crypto exchanges, changed from sending out 1099-Ks to 1099-MISCs in November 2020.
In 2014, the IRS announced that all cryptocurrencies should be considered property and therefore follow tax reporting rules similar to real estate.
Only at the end of 2019, however, did the IRS start issuing more specific warnings for those who may be underreporting their crypto transactions or not even reporting them at all. They went as far as to send letters to all taxpayers who had made cryptocurrency transactions with a note reminding them that they could still pay back taxes and amend their returns.
And it makes sense; while 2018 was a pretty poor year for cryptocurrency traders and investors, 2019 produced windfalls once again. This warning-note system continued throughout 2020 as well.
Bitcoin, the largest and clear leader of virtual currencies, saw its value spike from $7,250 to $29,000 during 2020 – a 300% jump.
Considering the enthusiasm returning to cryptocurrencies in 2020, the IRS is taking a more active role in claiming its share of those profits. Now that we’re in 2021, we need to keep these recent changes in mind and be ready both to adhere to best practices, as well as adapt to whatever changes might still be coming our way.
In this article, we’ll first review the recent actions the IRS has announced and taken on virtual currencies. Then, we’ll discuss what anyone who uses crypto needs to know – whether they be business owners, self-employed workers receiving crypto payments, or traders and investors capitalizing on this past year’s good fortune – regarding tax reporting. Finally, we offer some steps one might take to potentially minimize their IRS bill going forward.
“Crypto is not [always] easy [to figure out from a tax perspective]. Any professional who tells you otherwise may lack the acumen to be able to accurately perform the necessary calculations and of course, provide proper tax advice. As they say, you don’t know what you don’t know, and that is the biggest issue with reporting crypto both for pro’s and taxpayers.”
– Joshua Azran, Founder of Azran Financial
Please remember that, while this information is well-researched, this article is meant for educational purposes only and should not be considered advice, which is best obtained directly from a tax professional as part of their services.
Cryptocurrencies in the Eyes of the IRS
As noted already, the IRS began considering all cryptocurrencies to be property starting in 2014. That definition and what investors ought to do about their own individual transactions in virtual currencies left much open to interpretation.
In short, the only answer the IRS gave regarding that classification was that anyone holding crypto for less than a year would need to consider any profits from them to be taxed as ordinary income. Those who have held for longer should consider them to be capital gains or losses and reported as such.
Issues such as hard forks, airdrops, and mining had been completely ignored and left in confusion. Finally, after some pressure from Congress in 2018, the IRS began considering these situations in more detail.
In October 2019, the agency put out Revenue Ruling 2019-24. In this brief new guidance, the IRS addresses two of the more technical problems it has had with reporting of cryptocurrencies. The two situations in question are:
- Hard Forks – When changes to a blockchain force a split, where the old chain continues but a new chain is created.
- Airdrops – When new coins or tokens are given to addresses of another chain.
- Learn more about hard forks and airdrops here
The IRS ruled that hard forks without any airdropped coins or tokens aren’t taxable events because they don’t result in any gross income. This is a change from the previous stance that all events are taxable.
However, hard forks that include airdrops of the new chain or cryptocurrency do result in gross income—or “an accession to wealth”—as a tradable good with value was created. The fair market value at the time of the airdrop is used as the owner’s basis.
Hard forks and airdrops are somewhat rare. But this ruling does indicate that IRS is looking at cryptos more seriously as potential sources of income to tax, and as such examining all of the situations that might arise for taxpaying holders.
One Notorious Question
If that wasn’t enough, virtual currencies made their way onto an official form starting with the 2019 tax year. At the top of the Schedule 1 for Form 1040, Additional Income and Adjustments to Income, this question appears: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
No doubt, checking the wrong box would look bad in the event of an audit. And that too is another recent subject worth noting.
After a full year of confusion, the IRS attempted to clarify what transactions demand a “yes” answer. In December 2020, the IRS put out a statement declaring that taxpayers need to answer “yes” even if they purchased a cryptocurrency and haven’t yet sold it.
Additionally, trading one crypto for another requires a “yes” check even though that too doesn’t constitute a “taxable event.”
The only time you can own crypto without needing to check “yes” is if you bought it before 2020 and held throughout the whole year without any transactions. Again, hard forks resulting in airdrops would also require a “yes.”
Despite all of this, there is still plenty of confusion about certain aspects of how cryptocurrencies are supposed to be taxed. You can read all of what the IRS has officially noted on the subject here.
Filing and Paying Taxes on Cryptos
Even though the IRS seems to be active in both its classification and enforcement of cryptocurrencies, not much in terms of actual tax rules has changed over the last year. Cryptocurrency is, after all, still considered property.
In general, cryptocurrency is treated the same as any other investment you might own or sell throughout a year. If you bought a stock for $10 in January and sold it for $15 in December, you made $5 in ordinary income. If you bought that stock in the year prior, that income would instead be considered a long-term capital gain and taxed as such. Cryptocurrency is treated the same way for tax purposes.
This is most often viewed as the IRS attempting to persuade people into thinking of cryptocurrencies as long-term investments rather than quick trades. The rules do get a tiny bit trickier, though.
If you use cryptocurrencies like bitcoin as actual currency (receiving or giving it as payment for something), that’s considered a taxable event. For business owners who accept crypto as a payment option, as well as those that choose to use it as an actual currency rather than an investment, this can cause a headache since each transaction, no matter how small, needs to be reported on annual taxes. That’s like trying to document every can of soda or bag of chips you bought with cash in your year-end tax forms.
The way this works is all dependent on how long you held the coins or tokens. If you receive them for goods or services rendered, that’s easy—it counts as straight-up ordinary income and falls into that category for taxes. If, on the other hand, you paid someone with bitcoins or the like, you still have work to do. You need to figure out exactly when you obtained or purchased those coins originally. If it was less than a year ago, any change in value is considered ordinary income. If it was more than 12 month ago, that’s the same as cashing out a long-term profit or loss in the eyes of the IRS and therefore gets taxed as capital gains.
This can be a pain, to be sure. But there are ways to prepare for these tax hiccups ahead of time. Signing up for a specialized app, software platform, or website can help. These in additional to or as an alternative to setting up a simple spreadsheet of your own can go a long way.
“Use an automated tool like CoinTracker to keep track of your gains and losses. This not only helps you calculate gains and losses, but also fulfills your substantiation requirements by having all your source data in once place… If you are buying crypto for the first time, make sure you track gains and losses for tax purposes and report them even if you don’t get a 1099 form at the end of the year.”
– Shehan Chandrasekera, Head of Strategy – Tax at CoinTracker.io, cryptocurrency portfolio tracker and tax calculator
In truth, you’ll only need to keep track of purchases or dates you received your cryptocurrency and dates when you sold or spent it, along with amounts of the transactions. The gains or losses accrued in periods of less than 12 months is “other income” come tax time. Those accrued over 12-plus months are “capital gains or losses” on your tax form.
There are other “taxable events” you must be aware of when it comes time to fill out your tax forms. In fact, there are four types of transactions that count as “taxable events” and must be reported each tax year. And then there are two that don’t.
- Cryptocurrency into Fiat — Whenever you sell a virtual currency in exchange for USD or other fiat currencies, this creates a taxable event similar to selling a stock for cash.
- Crypto into Another Crypto — Trading one virtual currency like bitcoin into another like ethereum is considered disposing of the original asset. So be aware that the IRS requires you report any gains from the first crypto. You will then use this price as your cost basis for your new crypto holding.
- Crypto into Goods and Services — As noted, whenever you pay for any item with cryptocurrency, the IRS considers this the same as if you sold it on an exchange. This is an annoying but important distinction that needs to be reflected on your tax forms.
- Earning Crypto — Mining new crypto or receiving an airdrop of new crypto requires reporting come tax season. This is considered an “accession to wealth” as indicated by the IRS in 2019.
There are two types of transactions that don’t require reporting (though they may require you answer “yes” to the question above).
- Buy and Hold Crypto — If you simply purchase and hold cryptocurrencies, you aren’t yet liable for taxes on them. Only when selling or trading out of them do you have to report gains or losses.
- Transfer Between Wallets — As long as you don’t actually sell or trade into a new crypto, the mere transfer of the same crypto between wallets is not a “taxable event.”
David Kemmerer, Co-Founder & CEO of CryptoTrader.Tax has an excellent breakdown of these taxable vs. non-taxable events here.
Caveats To Keep In Mind When Planning For Taxes on Cryptocurrency
The largest and most important caveat to consider is virtual currencies in IRAs, as self-directed IRAs do allow cryptocurrencies as asset options.
Cryptocurrency in an IRA makes a lot of sense, even from a tax perspective. Since the taxes on the gains and losses won’t come until retirement or when the IRA is cashed out, it is said that transactions within the IRA are tax-deferred. Trading cryptocurrencies inside, therefore, doesn’t create immediate taxable events.
The most important aspect to understand here is fees. With this being such a new subsector of the IRA world, making sure you know which fees you’ll need to pay and when is important.
Other caveats you should be aware of with cryptocurrency and taxes are:
- Be Mindful of Holding Periods – While we all know cryptocurrencies can move pretty fast, the tax consequences between holding for 365 days and 364 days is significant. The IRS considers the day after you acquire an asset or property (in this case coins or tokens) to be the first day. That calendar date in the following year marks the difference between short-term and long-term according to the agency. Be aware of your dates as you document your holdings and prepare your taxes.
- Don’t Forget Your Losses – Just like any other property or investment, cryptocurrencies go up and down in value. The IRS acknowledges that. Losses taken on cryptocurrencies can be written off, although the limit on this is $3,000.
- Keep One Eye Always on the IRS – With new rules possible any time, periodically checking in on the IRS’ virtual currency documentation will keep you in the loop. This is the central source of truth for all official IRS rulings on virtual currencies.
- Checking in With Experts – Of course, it never hurts to consult an expert. With cryptocurrency regulation and tax situations rather nebulous, a five-minute chat from time to time with an accountant won’t hurt you one bit.
Cryptocurrencies are back in investors’ favor. The IRS is realizing it needs to take them seriously. And whether you are a business owner, freelancer, or an investor, you should too.
At BitIRA, your Digital Currency Specialist can help you get your self-directed IRA opened and cryptocurrency purchased for your retirement savings. We work with individuals interested in this tax-deferment solution to help them get started.
Call us today at (800) 299-1567 to get started.