What You Need to Know About Cryptocurrency and Taxes
How the IRS Treats Cryptocurrency
Currently, the IRS classifies cryptocurrency as property for tax purposes, this means:
- It is not treated as a type of currency
- It does not pay dividends or accrue interest
- It may require an appraisal for estate tax purposes
- The value may fluctuate in the same way as real estate
How the IRS Taxes Cryptocurrency
The IRS treats all cryptocurrency as a capital asset. Capital assets are real estate, stocks, bonds, art, cryptocurrency—anything you own and use for personal or investment purposes. After a capital asset is sold (generally for a gain/profit), then taxes are applied to the gains made from that capital asset’s sale. Those taxes are called capital gains. This means, when you sell your cryptocurrency, like Bitcoin or Ethereum, for a profit then the capital gains tax rules apply, and you would have to pay short-term or long-term capital gains.
Short-Term Capital Gains
If you sold a cryptocurrency for profit that you owned for less than 12 months, then this is considered short-term capital gains. The short-term capital gains tax rate ranges from 10% to 37%, depending on income and filing status
Long-Term Capital Gains
If you sold a cryptocurrency for profit that you owned for longer than 12 months, then this is considered long-term capital gains. The long-term capital gains tax rate ranges from 0% to 20%, depending on income and filing status.
Taxable Crypto Activities that Need to Be Report to the IRS
You will need to report to the IRS specific crypto activities that can be considered a taxable event. Crypto activities that will be subject to reporting and capital gains taxes are:
- The purchase of a service or good with crypto
- Trade of your cryptocurrency for another cryptocurrency (e.g., trading BTC for ETH)
- The exchange or sale of your crypto for fiat
- Buying NFTs with crypto
Crypto activities considered earned income that are taxable events and need to be reported to the IRS are:
- Payment in crypto
- Mining crypto
- Receiving airdropped tokens as a result of a hard fork
How To Compute Your Cryptocurrency Tax Manually
When selling or trading crypto you will have to take into account the cost basis (the amount spent to acquire the crypto, purchase price, exchange fees, and other relevant costs) and the price you sold the crypto at to find your capital gains or capital losses. The formula is selling price minus cost basis equals capital gain/loss.
Selling Price – Cost Basis = Capital Gain or Loss
From there you would have to find the percentage of the capital gain based on if you held the crypto for less than or more than 12 months. Less than 12 months is considered short-term capital gains and you’ll pay 10% to 37% of the capital gain in taxes. More than 12 months is considered long-term capital gain and you’ll pay 0% to 20% of the capital gain in taxes.
This is a very simple formula if, for example, you only bought and held one Bitcoin and sold that one Bitcoin. But crypto investors don’t invest in this straightforward manner. Crypto investors will usually buy, sell, trade, and purchase crypto for varying amounts on varying dates when the value of coins fluctuate. Therefore, the best thing an investor can do is document their transaction history to include the amount and currency of the coin sold, fiat value when bought, date of purchase, fiat value when traded/sold, and date of sale. From there, there are multiple accounting methods that can be applied to more complex transactions and investments in order to identify the taxes you are liable for. Some of those accounting methods to identify cost basis are as follows:
- First in First Out (FIFO) - The cost basis for a sale is the cost basis of the earliest crypto that you acquired.
- Last in First Out (LIFO) - The cost basis for a sale is the cost basis of the last crypto that you acquired.
- Highest in First Out (HIFO) - The cost basis for a sale is the cost basis of the most expensive crypto that you acquired.
- Actual Cost Basis - Each cryptocurrency is tracked, and any sale is the sale of a specific coin
Because there is so much data, methodologies, and formulas involved when calculating your crypto taxes, we suggest using our crypto tax calculator free of charge so that you can receive accurate reporting on the taxes you will owe to the IRS.
Yes and no. You will only have to pay taxes on your Bitcoin if there is a taxable event. The IRS considers a taxable event when you purchase a service or good with your Bitcoin, when you trade your Bitcoin for another cryptocurrency, and when you exchange or sell your Bitcoin for fiat. This means, if you purchase a good like an Xbox with your Bitcoin, you will pay taxes on it. Or, if you exchange Bitcoin for another digital currency like ETH, you will pay taxes. However, if you hold your Bitcoin, you will not have or pay taxes on it.
Additionally, for the crypto enthusiasts, if you are getting paid in crypto, mining crypto, or receiving airdropped tokens as a result of a hard fork—these too are considered taxable events by the IRS and you must claim them on your income taxes.
No, but there are some loopholes.
Due to its categorization as property, the IRS expects you to declare your existing crypto on your tax return when you withdraw it from your account, sell it, or trade it. If you choose to file a false return or fail to pay taxes on your crypto, the IRS can fine you with tax evasion penalties or press criminal charges against you.
Note, if you have not withdrawn, sold, or traded your crypto then you do not have to pay capital gains tax on crypto.
This all being said, you can defer your tax payment and, in some instances, avoid paying taxes but it may come at a loss of profits. To defer or avoid tax payment, you could:
- Use your retirement account to purchase cryptocurrency. Using a retirement account to purchase cryptocurrency allows you to defer or fully avoid paying taxes on your crypto. Income and gains generated by your retirement account return back into the account with taxes deferred or eliminated completely.
- Take advantage of qualified opportunity funds (QOFs). Qualified opportunity funds are partnerships and corporations that invest in economically distressed communities. Should you take the capital gains made from your crypto and reinvest it in a QOF then taxes are deferred while held in the QOF. As long as the money is in a QOF, at five years there is a 10% reduction in capital gains taxes. At seven years there is a 15% reduction in capital gains taxes. And at ten years, any appreciation on the investment is tax exempt.
- Donate to charity. You will get a tax deduction if you donate your cryptocurrency assets to a qualified charity.
- Gift your crypto. If you want to reduce your taxes and share your wealth, you can always give your cryptocurrency as a gift. Just know that you won’t be taxed on the crypto gift, but the recipient will have to pay taxes on the crypto if they use, sell, or trade it.
- Become a resident of Puerto Rico. Should you move to Puerto Rico and buy a home there within two years, you will pay 0% on capital gains, which means you keep all of your crypto profits.
- Practice tax loss harvesting. If you experience a loss in your crypto investment, then you can sell those crypto investments that have lost value to “harvest” those losses for tax purposes. These realized or “harvested” losses can be used to offset your taxable capital gains.
The majority of crypto exchanges are required to track and report transactions to the IRS. If you have more than $20,000 proceeds and 200 transactions in crypto exchanges, you will receive Form 1099-K that documents your proceeds each month from your crypto exchange. Your crypto exchange will also send a copy of that Form 1099-K to the IRS. Exchanges can report this information without approval from consumers. This is a tracking system for the IRS to gain insight into the taxes a citizen may owe on their personal cryptocurrency gains.
Once you file a tax return and you neglect to include the amounts from Form 1099-K, the IRS computer system will flag you for not reporting and you could be subject to tax notices and penalties. Additionally, should you receive Form 1099-B and do not report it, the same principles apply.
Crypto sales are not just subject to domestic cryptocurrency exchanges. The IRS can also find out about your international crypto transactions. As of recent, the IRS has become more advanced at globally tracing the transactions of digital currencies with support from other agencies like INTERPOL and Europol.