One of the cypherpunks’ original goals when developing digital money was to operate outside of government control, but the Internal Revenue Service has put a big damper on that possibility as we will discuss below. People who hold crypto largely for ideological reasons can still take a chance on evading taxes, and they may succeed. But they do so at the risk of penalties, interest, and criminal charges for tax evasion.
Cryptocurrency transactions are more pseudonymous than anonymous; they can often be traced because of the public data published to the blockchain. And while law enforcement and tax agencies don’t always know how to trace the transactions themselves, they do know how to hire people who can.
The IRS Continues to Struggle with How to Tax Cryptocurrency Transactions
Since the emergence of cryptocurrencies, the IRS has struggled with how to treat crypto for tax purposes. Overall, cryptocurrency is still an emerging asset class with a largely undefined tax framework.
In 2014, a full five years after bitcoin came into being, the IRS finally issued what they referred to as “preliminary guidance” for cryptocurrency taxation by way of Notice 2014-21, (the “Notice”) in the form of “Frequently Asked Questions” (FAQs) which contained a set of sixteen questions and answers focused mainly on cryptocurrency transactions.
On the one hand having cryptocurrencies taxed as property can be considered a favorable ruling as long-term gains and losses will be taxed at your applicable capital gains rate, which ranges from 0 – 20% in 2018 based on your income, versus ordinary income tax rates which can go as high as 37%. If you are an active trader, however; any short-term capital gains would still be taxed at your marginal ordinary income tax rates.
On the other hand, for those who may have substantial realized losses due to poor investment choices compounded by the crypto bear market, a/k/a the “crypto winter” of 2018, the fact that cryptocurrency is taxed as property and not currency makes those losses much more difficult to write off.
The IRS only allows $3,000 net capital (or property) losses per year for married and single filers on personal tax returns. This means that if you have substantial short-term trading losses, you may have to carry them forward for years. This places those who have suffered trading losses in a disadvantageous position compared to what they would have been able to write off if crypto was considered a “foreign currency” with more favorable capital loss treatment against ordinary income.
Classifying cryptocurrencies as property rather than currency also left many unanswered tax-related questions and created potentially complicated, and daunting reporting requirements as crypto related transactions have nuances that typically don’t exist with other more traditional forms of property.
Here are some of the key takeaways from IRS Notice 2014-21:
- The IRS refers to cryptocurrencies as “virtual currencies,” although oddly enough, as discussed earlier, they will not be treated as “currency” for federal income tax purposes.
- As previously mentioned, for federal tax purposes the IRS treats virtual currencies as property, and as a result, the same general tax principals that apply to stocks and bonds, and other property transactions, including payments for goods or services in property, will also apply to virtual currencies.Of course, nobody is buying a cup of coffee by redeeming some, or all, of a share of common stock they own. But In the cryptocurrency tax world, using bitcoin or another crypto to purchase that cup of coffee, or other products or services requires keeping track of every single transaction to determine whether you have a gain or loss on that $3.75 you just paid for your Carmel Macchiato.
- If you receive cryptocurrency as payment for goods or services you must include the fair market value, in U.S dollars, of the cryptocurrency as of the date of receipt in computing your gross income. The value reported would now serve as the cost basis of your cryptocurrency received.
- The sale or exchange of convertible virtual currency to pay for goods or services would require a taxpayer to report any applicable taxable gain or loss depending on the fair market value of the cryptocurrency and the fair market value of the property received on the day of exchange. The character of the taxable gain or loss is dependent on whether the virtual currency is a capital asset in the hands of the taxpayer, resulting in applying more favorable capital gains/loss tax rules, or less favorable ordinary income tax rules for short term gains/losses. (See #2 above) This would be a burdensome and time-consuming requirement to track every small purchase using your crypto, which is why a $200 De Minimis election is being recommended to the IRS by the American Institute of Certified Public Accountants.
- The fair market value of cryptocurrency resulted from mining is includible in your gross income on the day you receive it. The net earnings from your mining activities are further subject to self-employment tax if your mining activity constitutes as a trade or business, and you’re not acting as an employee nor running the mining business under a corporation.To further complicate matters, you need to consider the appropriate way to treat deductions, depreciation schedules etc. for your mining equipment and also keep track of the tax reporting requirements and treatment after your mined coins are sold or exchanged.
- If you receive cryptocurrency as compensation for services performed it’s treated in the same way fiat (U.S. Dollars or other currency issued by a government body) currency would be for services performed. Meaning, payments of virtual currency with a value of $600 or more (2018) to a U.S. non-exempt recipient is a reportable transaction to the IRS and the payee.If you receive cryptocurrency for payment as an independent contractor, that would, constitute self-employment income and would, as with fiat currency, constitute wages for employment tax purposes. Also, wages paid in cryptocurrency to an independent contractor are subject to information reporting (Form 1099’s) and backup withholding as with fiat currency.
Which Cryptocurrency Transactions Are Taxable versus Non-Taxable?
Investors who buy and hold crypto don’t owe any taxes. It’s only when selling, exchanging, or transferring it that a taxable event occurs. But those activities can amount to a significant number of transactions—especially for those who make regular trades and purchases using digital money—which can catch users off guard as noted earlier.
Crypto Taxation Cheat-Sheet
- Selling cryptocurrency for fiat currency (USD, EUR, YEN, etc.)
- Trading cryptocurrency for another cryptocurrency
- Using cryptocurrency to buy a good or service
- Being paid in cryptocurrency for goods or services provided
- Receiving cryptocurrency as a result of a fork, mining, or airdrop
Non -Taxable Events
- Buying cryptocurrency with Fiat currency
- Donating cryptocurrency to a tax-exempt organization
- Gifting cryptocurrency (larger gifts may trigger a gift tax)
- Transferring cryptocurrency from one wallet that you own to another wallet that you own
Calculating and Paying Taxes on Your Crypto
Gather Transaction Information for the Tax Year
Here is the information that will be needed:
- When you bought your crypto
- How much you paid for it
- When you sold it
- What you received for it
This information can be gathered from exchange records (downloadable preferably), spreadsheets, crypto portfolio exchange aggregation tracking software like Blockfolio, or gain/loss records provided by an exchange directly like Coinbase.
Determine Your Cost Basis
- Identify the cost basis method to be utilizedAlthough there is no specific guidance from the IRS as to which to use, the most conservative approach is to use FIFO. The key is to be consistent with whatever method you choose.
- Option 1. First-in-First-Out (FIFO) – FIFO means that the first “coin” that you purchase (chronologically) is the first coin you use in a sales transaction.
- Option 2. Specific Identification (SI) – You identify exactly (SI requires “adequate identification”) which “coin” is being spent at the time of a transaction. This approach can be quite challenging with cryptocurrency however.
- Identify the cost basis for each crypto purchase.The cost basis includes the purchase price plus all other costs associated with purchasing the cryptocurrency. Other costs typically include things like transaction fees and brokerage commissions from the exchanges you purchase crypto from.
The cost basis for coins received in Hard Forks, Individually and Pooled Mining, Airdrops, Giveaways etc. must also be determined using a consistent method. Refer to existing IRS guidance in Notice 2014-21, the suggested tax treatment in the AICPA letter to the IRS on 5/30/2018, or your tax professional for specific guidance.
Determine the Fair Market Value of Your Crypto at the Time of Each Sale / Exchange / Use in Commerce
Fair Market Value (FMV) is the value of your cryptocurrency at the time you sold/traded it. Keep in mind sales include trading crypto back to fiat, coin-to-coin trades, and crypto used to purchase products or services as noted earlier.
Record Cost Basis and Gains/Losses of all Crypto Sales on IRS Form 8949
This is the form you will need to list the detail of each of your crypto-transactions for the taxable year. For each trade made during the year, you will need to report, the date the crypto was acquired, the cost basis (“Fair Market Value”), the amount of crypto traded, the date sold or utilized in commerce, the sale price (FMV) and the short, or long-term capital gain or loss that occurred as a result of each transaction.
IRS Form 8949 Example
Image from Cryptotaxtrader.com
Record Cost Basis and Gains/Losses from Form 8949 on IRS Form 1040 Schedule D
The IRS Form 1040 Schedule D is the form that you use to report capital gains and losses from all personal property. This includes artwork, collectibles, stocks, bonds, and cryptocurrency. Once you have completed your form 8949, simply transfer the sum of your capital gains/losses, both short and long-term, onto the Schedule D form.
If you use TurboTax, you can simply upload your Form 8949 information, or provide it to your tax professional.
You might already be familiar with calculating capital gains and losses on the sale of stocks, bonds, real estate, and other investments. But unless you’re a day trader, you probably don’t generate dozens or even hundreds of taxable transactions per year. And even if you do, the brokerage you trade through usually makes your life easy by generating a record of all your transactions that you can use when filing your taxes—a form 1099. One copy goes to you, and the other goes to the IRS.
Most cryptocurrency exchanges don’t send out tax forms, though. One exception is Coinbase, which sends a Form 1099-K to certain customers. Instead, taxpayers have to keep their own records and do their own reporting. That might be good news for people who intend to evade taxes, but it’s bad news for those who intend to pay their taxes because so many digital currency transactions are taxable—more than you might realize.
Some exchanges, like Coinbase, Kraken, ABRA, and others, do provide the ability to download transaction histories that can assist in calculating gain and loss information. The challenge of course in keeping track of your crypto portfolios cost basis and gain and loss information, is when you send coins from one exchange to another to access trading pairs not available on your current exchange.
Example: If you own Bitcoin (BTC) on Coinbase but want to purchase BNB – Binance Coin, which is not currently available on Coinbase, you may choose to send some BTC to an exchange that offers a BTC/BNB trading pair. When you sell BTC and buy BNB, it would then be your responsibility to track the cost basis and gain/loss of the BTC you used to purchase BNB. Imagine doing this a dozen or more times throughout the year, on multiple exchanges, to access different cryptocurrency trading pairs, as many traders often do. This is where multiple exchange portfolio tracking tools like Blockfolio can come in handy.
IRC Section 1091 – The Wash Sale Rule
The wash sales rules prohibit a taxpayer from claiming an Internal Revenue Code (IRC) Section 165 loss on the sale or exchange of a security when the taxpayer sells or trades a security at a loss and then buys a “substantially identical” security either 30 days before or after the original trade date of the loss.
Although the IRS has remained silent on the issue of whether wash sales rules apply to crypto, the predominant view among practitioners is that Section 1091’s strict statutory prohibition on wash sales of stocks or securities does not apply to bitcoin or other cryptocurrencies as they are classified as property and therefore outside the scope of the current statute as written although the IRS has the right to expand the rule to include cryptocurrencies in the future.
IRC Section 1031 – Like-Kind Exchanges
The like-kind exchange exception allows a taxpayer, when it sells a business or investment property for a similar piece of property, to avoid immediate recognition of gain and to defer any such gain until the subsequent property is sold.
1031-like-kind exchanges do not apply to crypto to crypto exchanges. In 2018 The IRS clarified its position as part of The Tax Cuts and Jobs Act, that 1031-like-kind exchanges only apply to real estate. However, it is unclear whether exchanges in 2017 and prior qualify. The conservative approach is to assume they do not.
Avoiding and Evading Cryptocurrency Taxes
There is one way to legally avoid paying taxes on appreciated cryptocurrency: donate it. Fidelity is one institution that accepts bitcoin donations. If you avoid turning your appreciated cryptocurrency into cash before donating it, you don’t have to pay taxes on the gains because you aren’t benefiting from them: the charity is. And the charity doesn’t have to pay taxes on your donation because of its tax-exempt status.
Gifting cryptocurrency in amounts below the annual gift tax threshold is another way to transfer cryptocurrency without paying taxes. Gifted cryptocurrency does not receive a step-up in basis, however. If Michael purchased two bitcoins in mid-2016 for $500 each and gave them to his son in mid-2018 when they were valued at $6,000 each, his son’s basis in those coins will be $1,000, not $12,000.
Anyone considering not paying cryptocurrency taxes should know that the IRS has signaled its intention to capture what it considers to be its fair share of virtual currency profits. It has contracted with Chainalysis to trace who is involved in crypto transactions. It has been investigating tax compliance risks relating to virtual currencies since at least 2013. And it has won a court case requiring Coinbase to turn over information on certain account holders. In mid-2018, the IRS formed a coalition with four other countries to investigate tax fraud and other crimes involving cryptocurrencies.
Tax Resources for Cryptocurrency Holders
Bitcoin.tax – An online tool where you can pay to import your trading history and have the tool calculate your potential gains and losses and estimate your tax liability. Depending on your level of trading, they offer a $30 and $100 annual package.
Blox.io – An online tool that allows you to auto-sync all your wallets and exchange accounts in one place making it easier to calculate your tax liability and streamline communications with your tax preparer.
Cointracker.io – CoinTracker has partnered with TurboTax and Coinbase to create a cryptocurrency tax calculator that saves hours of work. Generate your tax forms (including IRS Form 8949) in minutes. CoinTracker supports taxes in the US, UK, Canada, Australia, and more and syncs your transactions across Bitcoin, Ethereum, and 2500+ coins from your wallets and exchanges including Binance, Bitstamp, Bittrex, Huobi, and others.
Cointracking.info – An online tool that will analyze your trading history and calculate your tax liability. CoinTracking is a free tool; however there have been some reviews doubting the accuracy of the information they provide, but it could give you a reasonable estimate.
Cryptotrader.tax – An online tool that allows you to import your transaction data from Coinbase, CoinbasePro, Bittrex, Gemini, Binance and Poloniex and calculates your crypto tax liability using FIFO.
CryptoTaxCalculator.io – An online automated crypto tax calculator that imports data from over 65 exchanges and supports ICO’s, OTC, pools, airdrops, mining rewards, lost or stolen funds, and crypto payments.
While the taxation of cryptocurrencies once fell into a legal gray area, that hasn’t been the case since 2014. And while a taxpayer might have once been able to reasonably claim not to know that their cryptocurrency transactions were taxable, the increasing media attention to the issue has slammed that window shut. Ignoring or failing to understand the tax laws won’t keep you out of trouble with the IRS if you get caught not paying your crypto taxes.
If you’re overwhelmed by the recordkeeping and reporting requirements or have better things to do, a crypto-savvy tax advisor or financial planning firm like Finivi can help. If you’re the DIY type, tools such as those listed above can help with tracking cost basis, gains, and losses.
Note: The author is not a CPA, and the information contained in this article is NOT tax advice and is provided for informational purposes only and is subject to change without notice. All information is provided “as is,” and the author disclaims any responsibility for the accuracy and adequacy of the information contained herein. For financial, tax, or legal advice, please consult your own professional.