Blockchain is one of today’s most exciting emerging technologies. The trustless algorithms that it enables have the potential to change many aspects of the way we live. In fact, Bitcoin and other emerging cryptocurrencies have already begun to radically transform the financial industry.
However, with so much excitement happening in the space, particularly in the area of cryptocurrency trading, it’s easy to forget about taxation. While there are still some grey areas about some of the finer points of cryptocurrency use that need further explanation, the IRS has been crystal clear on one point: cryptocurrency is indeed subject to taxation.
Keep reading to learn about all the key points you need to know about crypto taxes.
Cryptocurrency is a capital asset and treated like “listed property”
This is a good place to start when understanding crypto taxation, since it puts us in familiar territory. From the perspective of the IRS, cryptocurrency belongs in the same category as stocks. When you buy a stock, you aren’t taxed on it until you sell it for a gain. The same general principle applies to cryptocurrency purchases. You can buy as much crypto as you want without incurring any tax obligations. You’re only taxed when you sell it, trade it or use it to make a purchase. One distinct difference between digital assets and stocks, however, is that digital assets are not subject to wash sale rules like stocks are. We’ll cover that more in depth at a later time but it can be a powerful tax strategy for cryptocurrency investors.
How cryptocurrency purchases are taxed
After you’ve completed a crypto purchase, there are three main tax trigger points to consider. Here’s a closer look at each scenario:
- Any time you cash in your crypto for USD or any other fiat currency, you’ll realize either a short term or long term capital loss or a capital gain on that disposition. If you earned a profit through the sale, the amount you made will count toward your yearly capital gains total. Likewise, opting to take a loss will decrease your net capital gains for the year.
- Exchanging your crypto for another cryptocurrency will also trigger taxation. In other words, if you bought some Bitcoin and you used it to purchase some Ether, that transaction would either add to or subtract from your yearly capital gains total. Many beginner crypto traders don’t realize this and as a result they end up owing far more in taxes at the end of the year than they anticipated.
- Since using your crypto to purchase a good or service will also realize a capital gain or a loss, this needs to be accounted for as well. Here’s an example: let’s say you bought a Bitcoin back in 2012 when 1 BTC was worth only $10. If you waited until Bitcoin hit the $30,000 USD mark to buy a car worth $30,000, you would incur a $29,990 capital gain at the time of purchase.
Factors that affect your capital gains tax rate
The amount you’ll pay in capital gains taxes will vary, depending on several factors. You could pay as much as 37% or as little as nothing at all. It all depends on how long you hold onto your crypto, how much income you’ve received from other sources and whether or not you’re married.
If you’re single, held onto your crypto for more than a year and your total income during the year was less than $40,000, your capital gains rate will be zero. Keep in mind, however, that the amount of money you’ve made in crypto markets also counts toward your net income. In other words, if your Bitcoin gains fall between $40,000 and $441,450, those profits will bump you up to the next capital gains tax bracket: 15%. The next and last long term capital gains bracket for single, long-term investors is 20%.
Your capital gains tax picture may look slightly different if you’re married. For example, long term crypto investors that are married and file taxes jointly with their spouse won’t be taxed at all until their combined income exceeds $80,000. The maximum capital gains rate for 2020 is 37%. However, you’ll only be subject to that tax rate if you’re a high-income, short-term crypto investor.
If you want further information about capital gains tax rates for 2020, Investopedia has all the details.
How should crypto investments be priced? Cost basis options
On this surface, this seems like a simple question. The initial price (cost basis) of a crypto asset is usually the same as what you paid for it when you bought it. However, complexity arises when a series of investments are made over a period of time.
There are several ways to price cryptos in relation to tax lots. FIFO (First In First Out), LIFO (Last In First Out) and HIFO (Highest In First Out) are just a few of the cost basis accounting methods that the IRS will accept.
For the purposes of this guide, it’s sufficient to say that each cost basis accounting method has its own set of advantages and disadvantages. If you have a question about which cost basis accounting method is right for you, set up a free consultation with Founder’s CPA and tell us about your situation. We’ll do our best to help you out.
Claiming cryptocurrency losses
Since cryptocurrency belongs to the capital asset category, all crypto losses count as capital losses. This is an important point to consider, because it means that opting to take a loss in crypto markets can sometimes be a smart move.
For example, let’s say that you cashed in some of your Bitcoin this year and earned a $10,000 profit. You’re feeling good about that, but you’re not as thrilled about some of the other coins in your portfolio. Maybe you got caught up in the altcoin craze of 2017. Many half-baked crypto projects launched ICOs (Initial Coin Offerings) that year to take advantage of the resultant hype around the blockchain industry that came with the late-2017 BTC price surge. Perhaps you invested about $10,000 in a few of these projects, but none of them went anywhere and now their coins are worth almost nothing. Here’s the good news: if you sell all your altcoins and take that $10,000 loss, it will cancel out your $10,000 BTC gain.
Other capital losses can reduce your crypto tax exposure, as well. If you took a loss when you sold your home, for example, this will also reduce your total capital gains for the year. Or, perhaps you took a gamble in the stock market and took a loss there. That loss would also count against your net capital gains.
Capital losses can even be used to reduce ordinary income, like the salary income you earned at your day job. The IRS allows you to write off up to $3,000 worth of capital losses against your ordinary income. In addition, if your losses exceed $3,000, you can even carry those losses over to future tax years.
What about crypto theft?
Prior to 2018, crypto losses resulting from hacks and other forms of theft could be written off. However, the Tax Cuts and Jobs Act (TCJA), which went into effect that year, changed that. Now, you can only deduct theft losses if they take place within a federally declared disaster area.
Other crypto taxation scenarios
As mentioned above, you don’t have to worry about crypto taxation if you simply purchase crypto with fiat currency and hold onto your investment without selling it. However, the situation is different when you receive crypto for some other reason. Let’s look at a few common scenarios.
Crypto gifts
If you receive crypto as a gift, you won’t incur any tax obligations until you sell. In this way, receiving a crypto gift is similar to making a purchase when it comes to taxation. The person who gave you the crypto doesn’t incur tax obligations either, unless the amount given exceeds $15,000 during the tax year. If the crypto gift exceeds that amount, the giver will have to pay a gift tax.
Crypto mining
Cryptocurrency miners help cryptocurrency networks validate and process transactions. They contribute their own computing power to the system, so that people all over the world can send and receive crypto to each other. However, crypto miners don’t do all this for free. To pay crypto miners for their contributions, cryptocurrency networks give out mining rewards. The more computing power miners contribute, the greater their potential reward becomes. The money miners receive is derived from the small fees that crypto users pay when they send money to each other.
The IRS categorizes crypto mining income as self-employment income. That means that even if you hold on to the crypto you make from mining, you’ll still owe taxes on it. The price of the crypto at the time you received it becomes your cost basis. However, you can deduct all your mining expenses (like electricity costs, for example) from your net mining income. If you sell your mining rewards for a profit, this income is considered to be a capital gain.
DeFi yield farming
DeFi yield farming is currently one of the hottest trends in cryptocurrency today. Various cryptocurrency projects are using liquidity pools to provide all kinds of financial services, ranging from insurance to loans to derivatives and more. Smart contracts– computer algorithms that initiate actions automatically when certain verifiable events take place– control the movement of money inside these liquidity pools. To attract investors, many DeFi platforms are offering high interest yields. These yields give crypto investors a way to earn passive income on their crypto holdings.
Any income you earn from DeFi yield farming is taxable. The IRS is clear on this. The question then becomes: how should DeFi yield income be categorized? The answer to that depends on the nature of the DeFi project in question. Sometimes, DeFi yield farming income is treated as capital gains, while other times it’s treated as ordinary income.
Forks and airdrops
Crypto airdrops are marketing tools that crypto projects use to give their coins exposure. Often these airdrops are distributed automatically. You could wake up tomorrow to find out that you’ve suddenly become the owner of a new altcoin. One such example of this will occur when the Flare network distributes its Spark token. Forks are similar to airdrops, but with a few key differences to note. Forks occur when a coin’s development team splits up. After the split occurs, a new coin is generated and everyone who owns the old coin receives a free deposit of the new one. The emergence of Bitcoin Cash from Bitcoin is perhaps the most well-known example of a crypto fork.
The IRS recently published a statement about forks, specifying that all cryptos gained as a result of a fork should be treated as ordinary income. The guidance goes on to say that the cost basis must be set to the price of the forked coin at the time that the wallet owner gained control of the newly received funds.
What are the relevant forms I need to fill out to file crypto taxes?
Form 8949, the same form used to file capital gains, is the main form that you’ll need to submit at tax time. You’ll need to file multiple 8949 forms if you have other types of capital gains to report, like property sales or stock trading.
If you pass a certain threshold while using a crypto exchange, you may receive another form: the 1099K. Exchanges are legally required to send their customers 1099Ks once they exceed $20,000 worth of transactions or use the exchange to make 200 or more transactions.
Common crypto tax mistakes
One of the most common mistakes beginner crypto traders make is failing to recognize that crypto-crypto trades are also taxable.
Advanced crypto traders that use bots to place trades automatically may fail to consider the complexity involved in accounting for thousands– or sometimes even millions– of transactions.
A third mistake that traders make is that they don’t reconcile their deposits and withdrawals before submitting their taxes. If there is a mistake or missing information, it usually shows up during the reconciliation process.
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