Cryptocurrency Taxes

Many early investors in cryptocurrencies, like Bitcoin and Ethereum, did so because they believed the virtual currencies allowed them to accumulate assets without government knowledge. However, the Internal Revenue Service (IRS) and other government agencies soon realized that taxpayers could potentially use cryptocurrencies to avoid paying taxes. These agencies have made great strides in tracking and taxing income from trading digital assets.

In the following sections, we will explain how the IRS defines cryptocurrencies and how they are taxed.

What Is a Cryptocurrency?

A cryptocurrency is a digital or virtual currency stored in an encrypted format on decentralized networks using what is known as blockchain technology. These currencies are held in a digital wallet, like Coinbase. This system makes it almost impossible to counterfeit the currency. Unlike other currencies, cryptocurrencies are not issued by a government. Some crypto transactions are designed to be difficult for governments to track.

Cryptocurrencies are bought and sold on crypto exchanges. These exchanges are accessed via the internet, using either real-world currencies or other virtual currencies. For example, if you wanted to purchase Bitcoin, you could do so on an exchange with either U.S. currency or Ethereum virtual currency.

What Cryptocurrencies Do the IRS Tax?

People use "cryptocurrency" to describe a range of digital currencies. However, the IRS uses the term "virtual currency" for tax purposes. According to the IRS, virtual currency describes the various types of digital currencies with an equivalent value in real currency and which can be used as a medium of exchange. These are known as "convertible currencies," as they are easily converted into U.S. dollars or other real-world currencies. Bitcoin, Ethereum, and other commonly used cryptocurrencies are convertible digital currencies.

The IRS also taxes the profits you earn from the sale of nonfungible tokens (NFTs), even though most people don't consider them to be cryptocurrencies. NFTs are taxed as collectibles. This means they are subject to a higher capital gains tax than most other asset sales.

How Does the IRS Tax Cryptocurrencies?

The IRS does not have a designated "crypto tax." The agency treats cryptocurrency as property for tax purposes. That means the IRS applies the same general principles to taxing cryptocurrencies as it does to any other property you own. That means you are taxed on the profits from the sale of your cryptocurrencies. How you are taxed depends on how long you owned it.

If you sell cryptocurrency you owned for less than one year, the profits from its sale are short-term capital gains that receive the same tax treatment as ordinary income. However, if you held the cryptocurrency for more than one year, it is considered a capital asset. It is subject to the long-term capital gains tax.

The advantage of treating the profits from the sale of cryptocurrency as a capital gain is that they will be taxed at a lower rate. The highest federal income tax rate for ordinary income is 37%, while the highest capital gains rate is only 20%.

What Transactions Are Taxed?

If you sell, trade, or use cryptocurrency to buy something, the IRS may find that you were involved in a taxable event. Common cryptocurrency transactions include:

• Selling cryptocurrency for cash
• Trading one virtual currency for another
• Using cryptocurrency to pay for an item or service
• Receiving payment in cryptocurrency
• Cryptocurrency received in an airdrop
• Credit cards that offer cryptocurrency as a reward

When cryptocurrency is received as payment in return for work, as a reward, or through an airdrop, it is included in your gross income by the IRS and subject to the income tax. If you receive cryptocurrency in exchange for a financial interest in an asset, you will pay the capital gains tax on the difference between the value of the asset when it was acquired and the value that was received when you sold it.

The IRS may also find that you must pay taxes if you are involved in mining or staking cryptocurrency. If you are engaged in cryptocurrency mining, the IRS will consider you to have earned taxable income. It may consider you to be self-employed and subject to the self-employment tax. Staking is when you pledge your cryptocurrency to help validate blockchain transactions. In return for allowing the use of your currency, you will be paid a reward, which is treated as income.

Cryptocurrency as an Investment

If you acquire cryptocurrency that you hold as an investment, you will not be taxed on the value of the cryptocurrency while you hold it. The taxable event occurs when you sell, trade, or exchange a cryptocurrency investment. You will be subject to tax if the amount you realize from your cryptocurrency transaction is greater than what you gave up to acquire the currency (generally, the amount you paid). The initial value of the currency when you acquired it is known as your “cost basis" in the currency. This is usually the purchase price or the fair market value at the time it was received.

The difference between the cost basis and the selling price is your capital gain. If you sell for less than the amount paid, you may be able to take advantage of tax loss harvesting and claim a tax deduction for a capital loss.

Do I Need To Report My Cryptocurrency?

The current Form 1040 individual income tax return asks filers whether they were involved in any virtual currency transactions during the tax year. While you may think the IRS doesn't know about your crypto activities, the agency has implemented new tax reporting requirements for crypto exchanges and brokers to report to the IRS each time a customer receives or disposes of cryptocurrencies. So, it's generally a good idea to answer the virtual currency question on your return honestly. This will help you avoid being penalized by the IRS when it discovers your unpaid tax liability. Generally, if not reported as income, it is reported on Schedule D, which is used to report capital gains and losses.

Have More Questions? Speak With a Lawyer

If you own cryptocurrencies or are considering conducting financial transactions with them, you may want to speak to a local tax attorney about possible tax implications. The tax consequences of engaging in crypto transactions can be complex, and the tax rules are constantly changing. A tax professional can ensure that you comply with all tax laws and represent you if the IRS has questions about your income from cryptocurrency transactions.