With all of the excitement about cryptocurrency, it might be easy to forget about the very real tax implications of buying and selling cryptocurrency. There is also still a lot of grey areas when it comes to certain types of transactions. As of 2018, all of the guidance on how to treat cryptocurrency for taxation purposes comes from a bulletin that the IRS issued in 2014, in which the IRS has opted to treat cryptocurrency as property, so there are capital gain (and loss) implications.
That means that if you make profits from the sale of your crypto, those profits are taxed. On the other hand if you incur losses, you may be able to deduct the losses and reduce your tax bill. Given that there are a myriad of ways in which you can transact in crypto, here is a quick rundown of how these different transactions need to be reported on your taxes.
Crypto miners use special software to solve math problems and are issued a certain number or fractions of a coin in exchange. Cryptocurrency mining is the process of adding transaction records to a coin’s public ledger of past transactions or blockchain. While not all cryptocurrencies can be mined, some of the most popular ones such as Bitcoin and Ethereum, can be mined.
Some users of cryptocurrency may opt to mine coins for larger rewards instead of purchasing them directly. If you mine coins by using cloud-mining services or your own mining rig, the value of the coins that you mined will be considered as taxable income. Mined coins are considered ordinary income that is equal to the fair market value of the coin on the day that it was mined.
Some people like to trade between cryptocurrencies. If you trade Bitcoin for “altcoins,” such as Ethereum (ETH), in order to take advantage of better pricing or to have the ability to purchase certain altcoins that can only be bought with Bitcoin or Ethereum, each of your trades will generate a capital gain or loss.
Exchanging Cryptocurrency for Fiat Currency
Under currently applicable law, virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes. If you exchange your crypto for fiat currency (e.g. Bitcoin for USD), this transaction will generate a taxable event subject to a capital gain or loss.
Depending on how long you held the crypto before spending it, you may be subject to either a short- or long-term capital gain. If you choose to spend your crypto to pay wages to your employees these payments must be reported by an employer on a Form W-2. These payments are also subject to federal income tax withholding and payroll taxes.
If you use crypto to pay for your other business expenses by making a payment to a U.S. individual or business with a value of $600 or more in a tax year, you will also be required to report the payment to the IRS and the payee via Form 1099 and Form 1096.
An airdrop is when the developer of a crypto project gives away free coins. As a part of the new project, the developer will issue a new coin or token. This is typically done as a marketing tool to get people interested in the developer’s new project.
When people sign up for the airdrop with their Ethereum or Bitcoin addresses, they receive a set amount of the token or coin being offered by the company on a specific date. They may also receive additional free coins or tokens for sharing news about the airdrop with others by recruiting referrals.
When it comes to taxes, airdrops are considered ordinary income on the day of the air drop. That means that the sale of the coins or tokens will trigger a capital gain when they are sold.
How to Prepare Your Taxes
Given that there is still little guidance from the IRS on how transactions via exchanges should be reported, taxpayers are required to self-report. As a result, we strongly recommend that you maintain detailed records of all of your crypto transactions at exchanges. Make sure to also speak to your tax professional about classifying exchanges correctly.
Most exchanges, except for Coinbase, do not issue 1099-K forms nor do they calculate the capital gains or cost basis for the trader. For U.S. tax purposes, transactions using crypto must be reported in U.S. dollars. Therefore, taxpayers will be required to determine the fair market value of crypto in U.S. dollars as of the date of payment or receipt.
Gains that are made from crypto assets that are bought and sold within a year or less are considered as short term capital gains. If you made gains from assets that were bought and sold after a year, these gains are considered as long term capital gains. Long term capital gains have different rates depending on your income tax rate of 0%, 15% or 20% (if you fall into the top income tax-bracket). However, as a result of the passage of the tax law, the thresholds have changed for 2018.
Here is an example of how to calculate a short term capital gain:
James earns $60,000 per year. He purchase 1 Bitcoin (BTC) for $10 on January 1, 2017 and sells it on November 7th, 2017 for $1,000. The cost basis of his purchase was 410 with a fee of 0.5%, $10.05. The sale income also included a transaction fee of 0.5%, so it was in total $995. Therefore, his capital gain was $995 – $10.05 = $984.95. Since he held his Bitcoin for less than one year, he is required to report short term capital gains on his tax return. The gain is added to any other income he earned from other sources and is taxed at his ordinary tax rate of 28%. James would pay $984.95 * 0.28 = $275.79 in additional taxes.
In some cases, the IRS bulletin can be somewhat ambiguous when it comes to certain types of transactions. As a result, it is probably best to consult a CPA for further assistance before preparing your taxes if you have performed any transactions involving cryptocurrency.
Best Ways to Minimize Taxes from Owning Cryptocurrency
Most of the concerns about the taxation of cryptocurrency stem from the taxes that are owed as a result of buying and selling. If you still want to deal in cryptocurrency and you wish to minimize your tax bill, the best solution is to simply buy and hold for more than 1 year.
By doing so you’ll avoid having to pay any taxes at the short term capital gain rate. Keep in mind that any transactions that you make regardless of whether they are on an exchange or not can impact your tax bill.
If you would like some more information on Cryptocurrency, check out some other articles here.