In the first five years of Bitcoin’s existence, the IRS did not offer any guidance about how cryptocurrency would be taxed. In 2014, though, the bureau finally started to weigh in on the subject, starting with their declaration that cryptocurrency would be classified as a property for tax purposes, not as a currency.
There are many significant ramifications of this decision, especially for cryptocurrency investors. This cryptocurrency tax guide will:
- Break down the current laws and how cryptocurrency owners are responding to them.
- Present an overview of considerations for individuals when paying taxes on cryptocurrency.
- Suggest some options to minimize cryptocurrency taxes owed.
Cryptocurrency Taxes in the Current Regulatory Climate
By classifying Bitcoin and other cryptocurrencies as property, the IRS requires owners to pay tax each time they sell their digital currency. Depending on how involved you are in buying and selling crypto, keeping track of every single sale sounds implausible at best (especially since prices fluctuate on an hourly basis). Perhaps Neeraj Agrawal, a virtual currency advocacy leader, summarized it best when he said, “currently, a user needs to calculate capital gains on every stick of gum they buy with cryptocurrency.”
With stringent reporting requirements for even minor crypto transactions, the IRS has motivated investors to take more of a long-term view on holding cryptocurrency. Tax rate policy reinforces this trend, too. If you hold a crypto asset for less than a year before selling, the IRS will tax it at the ordinary income tax rate. If you hold the cryptocurrency for more than a year before selling, though, you can pay a reduced tax rate for long-term capital gains and save money.
Disincentivizing the use of digital currency for everyday transactions may be a lost opportunity for the IRS. Encouraging more widespread use of cryptocurrency would likely incentivize the creation of infrastructure to make reporting of crypto transactions for tax purposes easier.
The pressure to pay heavy tax rates has even motivated some crypto investors to use foreign exchanges or to move their funds to privacy coins — those that offer a higher degree of anonymity. But such measures don’t absolve crypto investors. Laura Walter, a CPA and educator known online as Crypto Tax Girl, put it in black-and-white terms to BitIRA: “You are required to report all crypto regardless of where it was purchased if you are a US citizen/resident.”
Just because cryptocurrency is the new kid on the block doesn’t mean the IRS is using kid gloves when it deals with it. Starting in 2017, the IRS began analyzing crypto exchanges to check for tax fraud. That November, a federal judge in San Francisco ordered Coinbase to honor a summons to identify more than 14,000 accounts totaling nearly 9 million transactions between 2013-2015. The IRS was specifically targeting accounts that sent or received coins in excess of $20,000.
How to Pay Taxes on Cryptocurrency
The IRS refers to trades of Bitcoin and the like as virtual currency transactions. These trades are treated the same as transactions involving property. Taxpayers not reporting these transactions on their income tax can be liable for both interest and penalties. In fact, the IRS has recently been sending out letters to anyone holding virtual currencies, nudging them to pay their taxes on these holdings, even if that means paying back taxes.
Despite how cryptocurrency is defined as property, cryptocurrency transactions take different forms and are taxed in slightly different ways. Here’s a primer on what each kind of cryptocurrency event qualifies as, according to the IRS:
- Trading cryptocurrencies: Produces capital gains or losses, which must be reported as such on a tax return.
- Paying with cryptocurrency: Constitutes a taxable event that can cause capital gains or capital losses (either short- or long-term capital gains based on the holding period).
- Receiving payment in crypto: In exchange for goods, services, or as a salary, considered ordinary income and does not need capital gains taxes.
If those were the only uses of cryptocurrency, the case would be cut and dried, but traders know better. Cryptocurrency extends far beyond into processes such as Bitcoin mining and ICOs. Of these cases, Walter notes, “There is no specific guidance on these… So we are forced to make our best guess as to how it is to be treated based on similar assets and hope the IRS agrees. In the end, consistency is key.” In September 2018, congressional leaders even criticized the IRS for its lack of clarity about cryptocurrency for taxpayers.
Though specific guidance from the bureau is lacking, the IRS has offered some general clues about how these special cases are to be taxed. Bitcoin mining (using computers to create new digital coins) has generally been defined by the IRS as self-employment income, as the taxpayer is using his or her own hardware and processing power. Initial coin offerings (ICOs) are viewed as ordinary income and taxed as such, CNBC reports.
Air drops (free giveaways of new virtual coins) and hard forks (splitting of one cryptocurrency into two) have befuddled even the most seasoned IRS employees since, essentially, investors are getting something out of nothing. The IRS’s general stance has been that this “new” currency must start with a price of $0, meaning that whenever you sell it, you will pay a capital tax based on the final price. In 2019, the IRS released some further clarity on air drops and hard forks, specifically noting that if new currency is created via a hard fork and delivered by an air drop, it is considered gross income.
The best way for investors to prepare for paying taxes on cryptocurrency is to track all cryptocurrency purchases and sales. This can be time-consuming depending on how frequent of a trader you are but can go a long way to combat IRS auditors. Walter recommends cointracking.info as the best tool for tracking and reporting cryptocurrency trades. Even keeping a basic spreadsheet will go a long way toward being ready for tax season.
Strategies to Minimize Crypto Taxes
Just like with any other income you make over the course of a tax year, you may look for ways to lessen the amount of your cryptocurrency profits that you owe to the IRS. There are a few ways to reduce taxes, such as writing off any capital losses you’ve had from cryptocurrency (although you can’t write off a net loss of more than $3,000).
Another tax-reduction strategy is to roll over to or open a new Digital IRA that invests in crypto assets. With such a retirement account, taxes on your cryptocurrency are delayed for as long as you hold the funds within your account.
Research suggests that less than 1% of investors are reporting their crypto earnings to the IRS. The government isn’t a fan of missing out on potential revenue, meaning it’s likely only a matter of time before the IRS begins doling out punishment for underreporting and conducting audits of traders to get its share. The letters they’ve been mailing out to cryptocurrency holders only further reinforce this.
The IRS might have been slow to get the ball rolling when it comes to classifying cryptocurrency for tax purposes, but now investors can no longer ignore how much they are spending and making in cryptocurrency. The technology exists to make tracking your crypto trades a relatively simple process. Just as importantly, investors should keep up-to-date on shifts in current tax policy (as well as ways to minimize costs and connect deductions to your taxable income).
Note: The information presented in the article above is intended for educational purposes only. It is in no way meant to offer financial advice, and specific guidance about how to properly pay taxes should be sought from a certified accounting professional.