Written by: Kadeem Clarke
Compile: 0x11, Foresight News
The relationship between cryptocurrencies and taxes
Whether you’re an experienced cryptocurrency trader or just received a small amount of cryptocurrency as a gift, it’s crucial to understand its tax implications. Cryptocurrency taxation is a less-discussed topic, and it’s not so exciting that many people don’t know what’s going on in this space.
People often refer to cryptocurrencies as cryptocurrencies, but they are not real money in the eyes of most governments. In Notice 2014-21, the IRS marked cryptocurrencies as property and market participants were required to report related capital gains and losses.
According to Baker Botts tax partner Jon D. Feldhammer, cryptocurrencies are considered property and should be taxed. If you sell, buy or trade cryptocurrency for another investment, you will have to pay taxes. If you buy one bitcoin for $30,000 and then sell it for $50,000 a few months later, you will have a short-term taxable gain of $20,000. Even so, Feldhammer mentioned that things get complicated from here, as people often trade frequently for various reasons.
Let’s say someone has $50,000 in BTC and wants to buy an NFT. In this case, he may be asked to use ETH to buy a specific NFT, so he must first exchange BTC for ETH to complete the transaction. Feldhammer claims that you still have $20,000 in taxable income in this scenario because you exchanged one property (BTC) for another property (ETH), which is a taxable transaction.
How are cryptocurrencies taxed?
If you buy, sell or exchange cryptocurrencies in a non-retirement account, you will face capital gains or losses. As with the IRS taxation of other investments, your profit or loss may be short-term or long-term depending on how long you held the cryptocurrency before selling or trading it.
Assuming you held the cryptocurrency for a year or less before selling it, any profits are generally considered short-term capital gains and taxed at ordinary income rates. If you hold cryptocurrencies for more than a year, profits are generally considered long-term capital gains and taxed at the long-term capital gains tax rate.
For short-term capital gains or ordinary income earned through crypto activities, you should use the following table to calculate your capital gains tax:
Short-term capital gains tax rates for 2022
If you hold cryptocurrencies for more than a year, use the table below to calculate your long-term capital gains:
Long-term capital gains tax rates for 2022
IRS Guidance on Taxation of Virtual Currencies
A virtual currency is broadly defined as a Crypto representation of value that can serve as a medium of exchange, unit of account, and store of value. Convertible virtual currency is a virtual currency that has an equivalent value to or acts as a substitute for real currency.
With the development of the cryptocurrency landscape, the US Internal Revenue Service released “Rev. Rul. 2019-24” and a list of frequently asked questions about virtual currency transactions. “Rev. Rul.2019-24” aims to address two unique situations: one is a soft fork, where taxpayers do not receive the new cryptocurrency; and the other is a hard fork, where taxpayers receive new coins due to an airdrop cryptocurrency.
When is your cryptocurrency taxed?
To determine whether you need to pay taxes, first consider how you use cryptocurrency.
Example of no taxation
Buy cryptocurrencies with cash and store it – there are no taxes on buying and holding cryptocurrencies. Taxes are usually payable at the time of sale, and the proceeds are realized.
Donate cryptocurrency to tax-exempt charities or nonprofits – You donate cryptocurrency directly to charities like GiveCrypto.org.
Acquired as a gift – If your cryptocurrency is acquired as a gift, you will not be taxed on it until you sell it or engage in other taxable activities such as staking.
Gifts – You can give gifts of up to $15,000 to a single person (and even more to a spouse) tax-free each year. If your gift is worth more than this amount, you must file a gift tax return. If you transfer cryptocurrency to someone else without purchasing a good or service, it could be considered a gift, even if you didn’t mean it.
Transfer cryptocurrencies to yourself – There are no taxes on transferring cryptocurrencies between wallets or accounts. You can carry over your original cost and purchase date to track your potential tax impact when you sell.
taxed as capital gains
Selling cryptocurrencies for cash – If you sell an asset for more than it cost, you will have to pay taxes. If you sell at a loss, you can deduct the loss from your taxes.
Converting one cryptocurrency to another — for example, if you use bitcoin to buy ether, you technically have to sell your bitcoin before buying the new asset. The IRS considers it taxable because it is a sale. If you sell bitcoins for more than you cost, you pay taxes.
Buying goods and services using cryptocurrencies – for example, if you pay for a pizza using Bitcoin, you will be subject to transaction taxes. For the IRS, paying for cryptocurrency is no different than selling it.
taxed as income
Get paid in cryptocurrency
Acquire cryptocurrency in exchange for goods or services
Earn staking rewards
earn other income
Get cryptocurrency from Hard Fork
Receive Airdrops – As part of your marketing campaign, you may receive airdrops from cryptocurrency projects. Receiving an airdrop is considered income and you must report the amount on your taxes.
Earn other rewards – this list is not exhaustive; there are many reasons why you can earn free cryptocurrency. These include learning tips or incentives such as $5 in bitcoin for referring a friend to a cryptocurrency exchange. In any case, you must report these as income.
If you make a lot of money from cryptocurrencies, it may affect your tax bracket and you may pay a higher tax rate on all income. You can visit IRS.gov for the latest guidance on federal income taxes.
The IRS sent more than 10,000 tax notices to potentially non-compliant taxpayers in 2019, it sent another batch of tax notices to dubious taxpayers in mid-2020, and sent no letters in 2021, which may is due to the IRS transitioning to remote work and addressing incentive-related issues.
In addition, with the passage of the Inflation Reduction Act in August, IRS audit work is expected to increase. The bill allocates $45 billion for enforcement activities, including Crypto asset monitoring and compliance activities. Over the next decade, the agency will invest those funds in audit and tax tools and personnel.
Given these developments, cryptocurrency taxpayers may be concerned that they will be audited by the IRS. Knowing the ins and outs of IRS audits and how to avoid them may take some of the fear away.
According to the IRS, only a small percentage of people who buy, sell or trade cryptocurrencies report those transactions correctly on their tax returns. For the first time since 2014, the agency issued guidance in October 2019 on how to report and tax cryptocurrencies.
Beginning with the 2020 tax year, the IRS changed Form 1040 to include the following question: Did you receive, sell, send, trade, or otherwise acquire any financial interest in any virtual currency at any time during 2022?
If you ticked “yes,” the IRS may want to see income from cryptocurrency transactions on your tax return.
Crypto tax software lets you keep track of all these transactions, ensuring you have a full list of activities to report when you file your taxes. The software integrates with multiple virtual currency brokers, Crypto wallets, and other crypto platforms to import cryptocurrency transactions into your online tax software. This may include cryptocurrency transactions and transactions involving cryptocurrencies as a form of payment for goods and services.
Based on crypto tax software, the transaction report could be similar to the tax return you file on Form 8949. The IRS may format it so they can easily import it into tax preparation software.
Can the IRS Monitor Cryptocurrency Activity?
Although cryptocurrencies are anonymous, the IRS may be able to track your crypto activity. For example, if you trade on a cryptocurrency exchange that reports through Form 1099-B, Broker Earnings, and Barter Exchange Transactions, they will report your trade to the IRS.
Additionally, the IRS uses blockchain analysis tools to identify cryptographic activity in Crypto wallets and link them to individuals in cases of suspected tax evasion or money laundering. Therefore, you should make sure to report all cryptocurrency activity on your tax returns for the year.
Are you facing a crypto tax nightmare?
Mark Steber, Jackson Hewitt’s chief tax information officer, said taxpayers can work out a payment plan with the IRS if they can’t make the payment by the tax day deadline. Telling the IRS that you didn’t realize your cryptocurrency transactions were being taxed isn’t enough. According to EY tax partner Thomas Shea, if you trigger a taxable transaction but lack fiat currency to pay the taxes, you can exchange the additional assets for fiat currency, which is essentially a sell-covering.
If you’re a bit concerned about screwing up your crypto tax bill, you’re better off consulting a tax professional. There are several deductions available for capital gains liabilities and taxpayers can use a variety of tax credits and reliefs to reduce the income tax they owe, Walker claimed.
Finally, here are some practical ways to reduce crypto taxes:
Holding profitable cryptocurrency investments for at least a year before selling or using them, long-term gains are taxed at a lower rate than short-term gains.
Take advantage of tax loss compensation. If you make a profit and a loss on various types of cryptocurrencies, you can sell both cryptocurrencies at the same time and use the losses to offset your gains.
Consider setting up a crypto IRA. This type of account, like other IRAs, allows you to make tax-free contributions and is only taxed when you withdraw the funds.
Crypto natives who want to play by the rules, or at least the few existing ones, still have some options. They can manually calculate their crypto taxes and hope to pay the correct amount; or they can use a tax deduction tool that allows them to keep more crypto after taxes.