You unlock this door with the key of imagination. Beyond it is another dimension. A dimension where an intangible, continually evolving invention meets a needlessly complicated set of rules that can’t quite contain it. You’ve crossed over into…the Crypto Tax Zone.
What is Cryptocurrency?
An in-depth definition, backstory, and pros/cons of cryptocurrency is outside the scope of this article, but for our purposes here’s what you need to know.
Cryptocurrency a/k/a digital currency a/k/a virtual currency is a digital medium of exchange used to purchase goods and services, similar to a government-issued currency with which we are more historically accustomed. Cryptocurrency transactions are recorded in digital ledgers (“blockchains”) shared and validated by a network of numerous, typically independent computers.
If cryptocurrencies are a viable medium of exchange, it’s not because they’re backed by trust in a particular government institution, but rather that their more decentralized nature means that the concept of trust is simply less important. For example, if I have 100USD in my bank account, I am trusting the bank to hold that money until I withdraw it, as well as trusting that the US government won’t do anything to devalue that money. Depending on your perspective, this could be a lot of trust. On the other hand, if I am holding 100BTC (Bitcoin) or another digital currency, I am potentially less concerned about the system that’s generating the digital currency as its environment will likely be much more decentralized than a government. In other words, there’s no one person or institution that can wipe away my wealth. At least in theory. Other properties of digital currencies, such as potential transaction anonymity and international accessibility, can make cryptocurrencies quite appealing.
Whether you think all this is a fad or the future, it’s here and it gets taxed. Let’s take a look.
The IRS and Cryptocurrency
US tax enforcement isn’t the most technologically savvy aspect of our government. To be fair, the Internal Revenue Service has long been underfunded and is still utilizing equipment, applications, and processes that may have made sense in the 1990s. Watching the IRS grapple with tax aspects of digital currencies is a bit like watching a dog chase after a car – even if he catches up to it, what’s he going to do once he has it? However, when it comes to cryptocurrency, the IRS has surprisingly made its way from clueless to court cases in recent years.
One important pronouncement that the IRS has made is that it considers cryptocurrencies as property1, rather than a currency such as the US Dollar or the Euro. This is an important distinction. Let’s say I used US Dollars to purchase a piece of fine art, specifically a painting for $10,000. Years later the painting’s value has increased. I then barter with a jeweler to swap my painting for a ring which has a market value of $23,000. From my perspective, I used to have a painting, now I have a ring, and I’m out $10,000. From the IRS’ perspective, I used to own property worth $10,000, and now I own property worth $23,000 and, thus, have a potentially taxable gain on the exchange of $13,000. Other than you just learned that tax law likes to pick on bartering, what’s the problem here? The problem is that if you are treating your cryptocurrency like a true currency, but tax law treats it like property, you will likely have a taxable event when you use cryptocurrencies to buy and sell goods and services.2
Buying and selling with cryptocurrencies isn’t the only time these investments can generate a tax consequence. Numerous activities can give rise to ordinary income, capital gains, capital losses, etc. As you can imagine, now that it’s up to speed, the IRS is becoming more and more interested in collecting data on crypto transactions, opining on the tax implications of cryptocurrencies’ various uses, and enforcing related tax law. With the IRS’ increased involvement in this area, taxpayers dealing in digital currencies are wise to educate themselves on the potential tax implications of their activities.
Tax Treatment of Various Transactions
NOTE: This list is not exhaustive!
- Purchasing digital currency with USD
The purchase of digital currency using US dollars is not taxable.
- Holding digital currency
Holding digital currency is not taxable.
- Receiving digital currency as payment for goods or services
This is taxable upon receipt of cryptocurrency, typically taxable as it would be if you had instead been paid via a sovereign currency. For example, if your employer pays you in Bitcoin, you have taxable wages to be reported on your W-2 in the amount of the market value in USD of Bitcoin on the date of payment.
- Exchanging one digital currency for another digital currency (swapping coins)
This is treated as a taxable event. It’s as if you sold the old currency for the value of the new currency. The value of the new currency becomes your new tax basis.
- Exchanging one digital currency for another type of asset (bartering/purchase)
Similar to swapping coins – and as discussed earlier in this article – this is taxable event.
- Selling digital currency
This is a taxable event. Presuming you have an investment intent in holding, you likely have a short or long-term capital gain or loss depending on your holding period, cost basis, and sales price. If you are in the business of buying and selling cryptocurrencies, you may have some type of ordinary income/loss on the sale.
- Donating digital currency
Similar to donating stock, donating digital currency to a 501(c)(3) charitable organization won’t generate taxable income and will generate a charitable contribution deduction equal to the market value on the date of donation (assuming a long-term holding period).
- Hard forks
Hard forks occur when blockchain platforms change the way they do things so significantly that they are no longer backwards compatible. When this happens a new type of cryptocurrency may be created and distributed to holders of the original cryptocurrency. A hard fork that issues a new currency is generally taxable on the date the holder has complete control over the new currency’s disposition, i.e., once the holder can sell or exchange the new currency.3
Mining is one way digital currency is obtained. Miners are provided currency in exchange for their work (their computers’ work) in maintaining a particular blockchain. Digital currency obtained via mining is taxable income upon receipt, specifically ordinary income. If you happen to be in the business of mining, then the income is likely subject to self-employment taxes, and you may be able to deduct related mining expenses.
- Staking Rewards
For digital currencies that operate on a proof of stake platform, “rewards” are typically paid to holders who stake their holdings on the platform. Although not directly addressed by the IRS (yet), staking rewards are likely taxable income, e.g., ordinary income.
- Lost & Stolen Coins
The short answer here is there’s likely not going to be a personal tax deduction available to you for these types of losses.4
There are so many other types of transactions with cryptocurrencies, more of which continue to arise as the technology and platforms develop. Further, the tax treatments listed are subject to change. Before assuming your particular cryptocurrency transaction does or does not have tax implications, consult your tax advisor.
Filing Requirements & Reporting
At a minimum, you may be required to disclose your ownership of digital currencies with the annual filing of your federal income tax return. Indeed, the IRS is so interested that they upgraded from merely asking a question about your digital currency holdings on a schedule within the personal tax return to having that question be one of the very first items on the very first page of the tax return. If you’re in doubt as to whether this question applies to you, ask your tax advisor.
From there, be sure to report any taxable transactions – being paid for your services in digital currency, using digital currency to make a purchase, sales, paying employees in digital currency, etc. If not, expect to receive a “love letter” from the IRS.5
The IRS isn’t the only government agency that wants to know about your crypto dealings. Another branch of the US Treasury – the Financial Crimes Enforcement Network (FinCEN) – is also interested in your holdings and transactions. FinCEN uses its Foreign Bank and Financial Account (FBAR) reporting tool to learn about your offshore assets to make sure you aren’t failing to report taxable income from such assets. FBARs are submitted annually, just like tax returns, and disclose details of your offshore financial assets such as account numbers and USD equivalent balances. Are cryptocurrencies offshore assets? Potentially, if they are held on a non-US platform. FinCEN is currently working on firming up rules around this. Until they do, these are murky waters. Consult your tax advisor if you think you may have an FBAR reporting requirement. Penalties for non-disclosure of non-US financial assets start at $10,000 and can turn criminal, which is not a good look for you.
If you have failed to disclose cryptocurrency transactions on a previously-filed tax return or for a previous year6, your first step should be to speak with a tax attorney who is conversant on this subject. Please do not immediately open up to your CPA about this. Attorneys have attorney-client privilege which generally allows for the contents of discussions with clients to be kept between the two parties. CPAs technically have a similar sort of privilege, but it’s so toothless that it is not helpful here. Assume anything you disclose to your CPA could be turned over to the government. Certainly ask your CPA for a referral, but spill your secrets to the attorney first.
Now that I have made you very afraid of failing to disclose cryptocurrency transactions, you’ll want to know what sort of records you should maintain to be in compliance.
If it doesn’t go without saying, keep impeccable records of your crypto purchases and sales – dates of purchase, dates of sale, amounts paid, etc. There are a growing number of apps/platforms out there to help with this. If you’re a long-time holder (ahem, HODLer), some of your older data may be harder to track down. Work with your tax advisor to determine cost bases of sales, etc.
For purchases made with cryptocurrency, your records should include:
- The date you purchased or otherwise received the currency.
- Its market value on the date you received it. If you purchased it, this would be the amount you paid for it.
- Its market value on the date you “used” it. If you bought a car with cryptocurrency, this would be the date you bought the car. If you paid an employee with cryptocurrency, this would be the date they were paid. And so on.
What can you do to minimize your digital currency tax burden and avoid IRS love letters? Here are just a few ideas:
- Educate yourself about the tax implications of digital currency transactions. If you’re a casual investor and your holdings translate to a small dollar amount and/or a small amount of your portfolio, perhaps you’re not overly concerned about tax consequences. As long as you’re disclosing and reporting as required to the IRS, this approach is probably fine. However, as your holdings significantly increase, you’ll want to stay on top of changing tax rules for optimal results.
- If you have some old, unreported transactions that you’re concerned about, talk to a knowledgeable tax attorney. Like, right now.
- Develop your risk tolerance for transactions where tax treatment is unknown or unclear. This goes back to the previous point about education and will likely involve discussions with your tax advisor and possibly legal counsel.
- When selling or otherwise using only a portion of your holdings, you’ll need to determine which cost basis to associate with the transaction. For example, you have two Bitcoins and sell one of them. Which one did you sell? The one you purchased for $10,900 on October 1, 2020, or the one you purchased for $41,300 on June 14, 2021? By default, you would select the older coin as the sold coin. This is the first in, first out method (FIFO). Alternatively, you could utilize the specific identification method to select the newer coin. The second approach might allow for a more optimal tax answer.
- Consider timing of realizing digital currency taxable gains/losses. For example, you may wish to harvest tax losses before the year is out to offset gains. Also, you will likely want to sell coins that you’ve held for over a year to obtain more favorable long-term capital gains.
- In general, consider tax moves available to capital assets. On the lighter side, donating highly appreciated coins for charitable contribution deduction. On a heavier note, paying an exiting member of a partnership in cryptocurrency for possible taxable gain deferral.
- On the more extreme side, some crypto holders are opting to renounce their US citizenship. To avoid taxation on cryptocurrency activity, simply leaving the US isn’t sufficient for US citizens. The US remains one of just two countries in the world to tax citizens on their worldwide income regardless of where their citizens live or where/how their income is earned. Well beyond the scope of this article, the pros, cons, and costs of such an extreme move should be explored with experienced professionals.
Ronald Reagan said this about how the government views the economy: “If it moves, tax it. If it keeps moving, regulate it. If it stops moving, subsidize it.” Right now, we’re in Step 2 – regulation. Auspicious court rulings7 combined with on-point tax reporting forms and platforms allow the IRS and other government agencies to easily obtain the details of your digital currency transactions. The cowboy days of underreporting crypto activity and getting away with it have passed us. Report thy cryptocurrency transactions lest they become transgressions.
Be aware that the IRS could change its mind about treating cryptocurrency as property. As other countries adopt Bitcoin and other digital currencies as legal tender8, this could lay the groundwork for the IRS to also treat digital currency as fiat currency with relating tax rules subject to change.
In short, the world of digital currencies and taxation is still in flux. Stay educated, stay compliant.
2 Further, depending on your intent with owning/holding cryptocurrency, you could have situation where you have a non-deductible loss when making a purchase if your cryptocurrency is a personal asset rather than an investment asset. An example of this would be trading in your personal-use vehicle and the dealer offers you significantly less than what you paid for it. This situation doesn’t result in a tax-deductible loss, nor would using cryptocurrency you hold as a personal-use asset to make a purchase when the cryptocurrency’s value has decreased from when you acquired it.
6 Possibly known as tax fraud.
7 ZIETZKE v. U.S., Cite as 125 AFTR 2d 2020-537, Code Sec(s) 7609; 7602, (DC CA), 01/17/2020; U.S. v. COINBASE, INC., Cite as 120 AFTR 2d 2017-5239, Code Sec(s) 7609; 7402, (DC CA), 07/18/2017
Links of Interest:
- Crypto Tax Guide
- Managing your crypto inventory for tax purposes:
- IRS Digital Currency FAQ
- IRS Reporting Tool
- Wash Sales