When you purchase Bitcoin and profitably sell it, you will be subject to capital gains taxes. This is true regardless of whether you purchase Bitcoin and then sell it for dollars or exchange it for another cryptocurrency at a profit. This is also true if you purchase Bitcoin, it appreciates in value, and you then exchange it for goods or services.
IRS Revenue Rulings 2014-21 and 2019-24 provide guidance on cryptocurrency tax issues. In 2014, the IRS made the critical determination that cryptocurrency is property, not currency, for federal tax purposes. This critical determination means that profits earned from crypto trading will be treated similarly to profits earned from stock trading, as both stocks and crypto are considered property for tax purposes. While treating cryptocurrency profits as if they were stocks may seem straightforward, the rules are less clear for Bitcoin and other cryptocurrencies, as they can be purchased with dollars, fluctuate in value, and then be exchanged for a Tesla, pizza, or even cash at a Bitcoin ATM. Because these exchange outcomes are uncommon in stock trading, the rules governing crypto taxation are perplexing.
Cryptocurrency trading and short-term vs. long-term gains
As with a personal stock portfolio, you’ll need to track the value of the crypto you purchase and then the value of the crypto when it’s sold or exchanged. For instance, if you purchased Bitcoin for $30,000 and then sold it for $50,000, you will earn a profit of $20,000. This gain is taxed at either the short-term capital gains rate or the long-term capital gains rate, depending on how long you held the Bitcoin. If you hold Bitcoin for more than a year, you qualify for preferential long-term capital gains rates ranging from 0 to 20%. In general, the long-term capital gains tax rate is 0% for low- to middle-income earners (generally less than $40,000 for singles and $81,000 for married couples), 15% for middle- to high-income earners (generally income up to $445,000 for singles and $510,000 for married couples), and 20% for high-income earners (generally income in excess of $445,000 for singles and $510,000 for married couples).
If you held Bitcoin or another cryptocurrency for less than a year, you are subject to short-term capital gains tax rates ranging from 0% to 37%, depending on your modified adjusted gross income.
Converting one cryptocurrency to another
The conversion of one cryptocurrency to another generates taxable income. For instance, if you purchased $50,000 in Bitcoin one month and later exchanged it for $70,000 in Ethereum, you will have a taxable gain of $20,000. This is true regardless of whether you held the Bitcoin for a minute and then traded it for another cryptocurrency, or if you held it for years.
Using cryptocurrency to pay for goods or services
When you exchange cryptocurrency for goods or services, you are taxed on the appreciation in value of the cryptocurrency from the time of purchase to the time of exchange. For instance, if you purchased a Tesla with $100,000 in Bitcoin, you would need to keep track of when the $100,000 was purchased and then pay tax on the increase. If the Bitcoin is purchased for $40,000, the gain is $60,000 when it is exchanged for the Tesla. If held for more than a year, it will result in a long-term capital gain at preferential rates. If the Bitcoin was held for less than a year, the $60,000 gain is subject to short-term capital gains taxation.
When you purchase Bitcoin or another cryptocurrency at a loss and then sell it at a profit, you are entitled to a tax loss. Losses can occur when crypto is sold at a loss or when crypto is exchanged for another cryptocurrency, goods, or services at a loss. Losses from one cryptocurrency trade or exchange can be used to offset gains from other cryptocurrency trades or exchanges. Cryptocurrency losses can be used to offset short-term gains, and long-term losses can be used to offset long-term gains. Cryptocurrency losses may also be used to offset gains on stocks or mutual funds. If cryptocurrency losses exceed cryptocurrency gains, as well as stock, ETF, and mutual fund gains, up to $3,000 of the loss may be used to offset other income such as wages or self-employment. Any losses that cannot be fully offset by income in the current year can be carried forward and offset by future crypto or stock trading gains.
Cryptocurrency hard forks and airdrops
IRS guidance issued in 2019 clarified two rare occurrences on a crypto blockchain. A fork is the first. There are various types of forks that may occur, and what crypto owners should know for tax purposes is that if a new coin is created as a result of a hard fork, those new coins are taxable to the recipient as ordinary income. Additionally, the IRS clarified in 2019 that an airdrop of new coins to existing cryptocurrency holders is taxable to the recipient as ordinary income at regular income tax rates. Airdrops are promotional distributions of free coins or tokens to existing cryptocurrency holders.
Cryptocurrency mining is treated as ordinary income and is taxed at regular rates.
For tax purposes, cryptocurrency mining is considered ordinary income. Cryptocurrency mining is a service that computers provide to the blockchain network of a cryptocurrency. Typically, the network compensates the owners of these computers with cryptocurrency in exchange for their services. Thus, if I owned computers or other hardware devices that enabled cryptocurrency mining, I would typically receive cryptocurrency in exchange for these services and would owe the IRS tax on the cryptocurrency. Payment in cryptocurrency is taxable income in the same way that payment in dollars is taxable income if I perform these same services for the network. Not only are you subject to ordinary income tax on this income, but crypto miners will also be subject to self-employment tax on it because it is considered a trade or business. As a result of this tax outcome, many crypto miners use an S-corporation, which allows them to minimise their self-employment tax liability.
The value of the cryptocurrency at the time it is received is the value that will be used for tax purposes. If the value of the cryptocurrency increases after you receive it, you will be subject to capital gains tax on the increase in value when you sell or exchange the cryptocurrency. As an example, suppose you received $1,000 in Bitcoin in exchange for crypto-mining services. This cryptocurrency then increased in value and was sold and traded for $1,500 three months later. The first $1,000 is subject to ordinary income taxation. This income will be taxed at regular income tax rates, which range between 0% and 37%. The $500 increase in the value of the Bitcoin following its acquisition will be considered capital gain income.
The IRS has not addressed the taxation of crypto staking income specifically. While staking is similar to mining, it is significantly different in numerous ways. If you are staking crypto and own or control a node, your income is almost certainly ordinary income and will be taxed at ordinary income rates, plus self-employment tax. This is analogous to the taxation of cryptocurrency mining profits.
If, on the other hand, you are merely staking crypto and another party owns and controls the node, the income will almost certainly be taxed at regular rates. However, you are not required to pay self-employment tax because you are not engaged in the trade or business of crypto staking and are only providing crypto to be staked, not hardware or services. Although the IRS has not addressed staking specifically, there are pending tax court cases on crypto staking that we hope will provide additional guidance and clarity on crypto staking income.
Maintaining records and reporting is required.
Cryptocurrency taxation is complicated and necessitates meticulous recordkeeping when purchasing, selling, or exchanging. The cryptocurrency owner is responsible for properly reporting this. Numerous cryptocurrency tracking applications have been developed to assist cryptocurrency investors, users, and traders in tracking and reporting their taxes properly. Taxbit has established themselves as the crypto tax leader and has the most robust offering among crypto tax providers, but there are approximately ten other companies that offer an application to assist you in tracking your cryptocurrency for tax purposes.
The IRS requires cryptocurrency gains and losses to be reported on form 8949. Form 8949 is filed in conjunction with your individual 1040 tax return. Beginning next year, all providers of cryptocurrency in the United States will be required to report crypto transactions and trading to the IRS. Coinbase, Gemini, Kraken, Cash App, Voyager, FTX US, PayPal, and Binance.us are all included. Whether or not the exchange you used currently reports to the IRS, you still have a reporting obligation.
However, do not believe that by using a company located outside the United States, you can avoid paying taxes. You must exercise caution, as this may impose additional foreign asset reporting requirements on you by the IRS. For example, the foreign bank account reporting rules, commonly referred to as FBAR, are currently undergoing revisions that would include crypto holdings under the definition of a bank account, resulting in foreign bank account reporting of crypto assets. Additionally, if the value of crypto held with a provider outside the United States exceeds $50,000, a Statement of Specified Foreign Financial Assets, or Form 8938, may be required. To summarise, do not assume that trading and holding crypto outside of the United States will exempt you from tax reporting requirements. Indeed, it complicates matters and has no effect on your tax obligations.
Utilizing an IRA to postpone or obtain tax-free gains on cryptocurrency
A Roth IRA can be used to invest in cryptocurrency and will grow tax-deferred until retirement. When trading cryptocurrency through a Roth IRA or other retirement account, you can avoid the tracking and annual tax reporting requirements, as crypto profits held in a Roth IRA or other retirement account are tax-free and do not appear on your 1040 personal tax return.
Many early cryptocurrency adopters with whom my company worked found the tax rules and reporting requirements for cryptocurrency gains to be onerous and costly. These early adopters saw dramatic increases in the value of their cryptocurrency, which resulted in significant tax bills when they sold or exchanged it. The Roth IRA quickly became a favourite of those anticipating large gains, as it enabled them to invest in and own cryptocurrency, where their gains can grow tax-free until they reach retirement age of 59 12.
A self-directed Roth IRA is a more tax-efficient vehicle for long-term cryptocurrency investment or trading. For those unfamiliar, a Roth IRA’s income and gains are not taxable, and they grow and mature tax-free in retirement. This is true for stocks that you trade in your Roth IRA, as well as for cryptocurrency that you trade in your Roth IRA. When you use a retirement account, you can also avoid filing an annual tax return on your 1040, as retirement account income is tax-free.
Along with Roth IRAs, you can invest in bitcoin and other cryptocurrencies using traditional IRAs, HSAs, solo 401(k)s, and other retirement accounts. Bear in mind that traditional IRAs and 401(k) accounts are taxed on distributions at retirement, but are not taxed year to year and grow tax-deferred until distributions are taken.
It is critical to understand that funds in a Roth IRA or other type of retirement account cannot be withdrawn until the account owner attains the age of 59 12. If an account owner distributes investment gains from a Roth IRA before reaching the age of 59 12, the account owner will be subject to early withdrawal penalties and taxes on the investment gains distributed.
The traditional broker dealers that offer retirement accounts do not permit cryptocurrency investment and trading in their IRAs and Roth IRAs. Rather than that, you must use a retirement account custodian that offers self-directed accounts. This is what my company, along with approximately twenty other firms in the so-called self-directed IRA industry, provides. These companies enable you to invest in real estate, private companies, and cryptocurrency, among other things. When selecting a provider for a crypto IRA or crypto Roth IRA, keep an eye out for excessive trading fees, ensure the provider is licenced, and ensure you are comfortable with the management team and services chosen.
The landscape surrounding cryptocurrency and the legal liability of its holders will continue to shift, necessitating due diligence. With less than a week until tax day in 2022, the time to conduct yours is now.