Cryptocurrencies are becoming increasingly popular. They are used as an alternative form of currency, and also as a way to invest in the future. However, there are many people who are unsure whether their cryptocurrency trading is taxable.
If you are thinking about investing in cryptocurrencies, then you should know that you could potentially owe tax on your gains. In this article, we will discuss the basics of cryptocurrency taxation, and give you some tips on how to be smart with your cryptocurrency trading.
1. Understand the Basics on Current IRS Guidance
Why is it that cryptocurrency was immediately considered taxable by the IRS without Congress passing any new tax laws? Because the tax code defines gross income by exclusion, meaning that gross income is all income from whatever source derived.
The definition of “income” based on longstanding case law is:
- an undeniable accession of wealth;
- that is clearly realized by an objective identifiable event; and
- over which taxpayers have control.
Therefore, the definition of income and gross income is intentionally broad and overinclusive. And without Congress passing a law that specifically excludes taxation on gross income, the income is taxable under the Internal Revenue Code.
So, for example, what happens if you find a bag of money on the street? Taxable. Why? Because there is no code section excluding it from gross income. And the same applies to cryptocurrency – even though it was never considered by Congress before it existed, it was immediately taxable because there was no exclusion to tax built into the tax code.
Even though it was immediately clear that cryptocurrency was taxable income, the lack of Congressional and IRS guidance left taxpayers unaware of exactly how to report it on their tax returns.
Some of the early IRS guidance provided the basics on IRS taxation of cryptocurrency:
- For federal income tax purposes, it is considered property, not currency
- Investment gains and losses are treated similarly to securities trading
- It is subject to similar reporting requirements already existing for cash payments, such as issuing 1099s when using cryptocurrency to pay for goods or services
- Whether it is capital or ordinary gain or loss depends on whether it is a capital asset in the hands of the taxpayer
- Receipt of cryptocurrency may be taxed as ordinary income when received as payment for services or as a part of an active trade or business
If you’re looking to take a deeper dive into the tax code and relevant case law referenced above, then see IRC Section 61 for the definition of gross income, Commissioner v. Glenshaw Glass Co, 348 U.S. 426 (1955) for the definition of income, and IRS Notice 2014-21 for cryptocurrency FAQs.
2. Understand and Defer Gain Triggering Events
Selling virtual currency for cash is not the only type of disposition that results in a taxable event. In fact, virtually any disposition of cryptocurrency will result in a deemed sale that is considered a taxable event. Exchange for “other property” is considered an exchange that generates a gain or loss. At this time, if the FMV of the cryptocurrency exceeds the basis, then the taxpayer has a taxable gain; if the basis exceeds the FMV, then the taxpayer has a loss.
Exchange for other property would also include using the digital asset to purchase a good or service. For example, if you bought the cryptocurrency for $100 and then, at a time when it is worth $1000, you use it to purchase a $1000 piece of equipment, then you have a $900 taxable gain.
This is the most basic taxation behind cryptocurrency that is undisputed, but the complexity comes in when:
- determining the character (capital or ordinary) of the gain;
- tracking the basis since usually taxpayers do not generally purchase or sell all their cryptocurrency at one time like in the previous example; and
- keeping up with substantial and often unclear reporting requirements.
3. Avoid Capital Losses and Wash Sales
The character of cryptocurrency gains or losses can be either capital or ordinary.
- If you have a loss, then you want it to be considered ordinary because the full loss would be deductible compared to capital losses that have a $3,000 net loss limitation per year.
- If you have a gain, then you want it to be considered capital to receive favorable tax rates if held over one year.
Since the character is determined at the time of acquisition and usually does not change since it is based on the intent of the purchase in the hands of the taxpayer, you will want to pay close attention to the character before disposing of the asset and having an unintended tax consequence.
If the cryptocurrency is a capital asset, then it is subject to capital gains and losses. Capital assets, much like gross income, are defined by exclusion in the tax code. Capital assets are not inventory, depreciable property used in a trade or business, land used in a trade or business, certain intangible assets, accounts receivable, and a few other more specific items not expected to be applicable to cryptocurrency.
The simplest way to view this is that cryptocurrency is a capital asset when held as an investment in the hands of a taxpayer, and it is not a capital asset when acquired in an active trade or business. For example, if you buy a cryptocurrency and hold onto it in hopes of it going up in value, then it would be a capital asset. However, if you are mining cryptocurrency as an active trade or business or acquire it in receipt of services, then it would be characterized as ordinary.
Just like with securities, one of the worst tax results is ending up with large net capital losses because they are non-deductible except for $3,000 per year, so many taxpayers will carry forward this type of loss for years and years before receiving the tax benefit. However, even worse is when a sale is considered a wash sale. A wash sale is when a type of security is sold and repurchased within 30 days.
While this rule is currently limited to securities, Congress has included in its recent tax reform proposal to apply this rule to crypto assets as well. Taxpayers often accidentally run into an issue with wash sales when they are actively trading and finding out at year-end that losses incurred are not deductible purely due to the timing of the sale or disposition.
4. Minimize Ordinary Income from Mining or Receipt of Crypto for Services
The IRS has provided guidance that states that a mining operation is a trade or business unless undertaken as an employee. This means the income is not only subject to ordinary income but also subject to self-employment tax.
Fortunately, this also usually means that the expenses from the business can be considered a business deduction as long as the business is intended to make a profit. Properly recording and accounting for business expenses attributed to the mining will decrease both the ordinary income and self-employment tax.
Mining often has substantial energy costs associated with it, especially with a Bitcoin transaction, so we recommend keeping records that show the electricity costs directly attributed to the mining business so you can minimize your tax obligations. Even when your ordinary income tax rate is only in the 20% tax bracket, the self-employment tax of 15.3% leaves many business owners surprised looking at their tax return as they are left paying a 35% effective tax rate, which is a rate that is usually expected only for the highest of earners.
In cases where taxpayers engage in crypto exchanges for services, a similar tax result occurs – it is considered ordinary income. If the services you are performing are as an employee, then it should be wages issued on a Form W-2 with social security taxes withheld, and if it is as an independent contractor then it is subject to the full 15.3% self-employment tax on the year-end tax return. The amount of cryptocurrency taxed as ordinary income is the fair market value on the date of payment.
5. Choose the Most Tax Advantageous Method for Gain Calculations
Since cryptocurrency is considered property for federal income tax purposes, each individual item of cryptocurrency you sell is considered to have its own cost basis. The problem with cryptocurrency versus other types of property, like real estate, is that the purchase price is very difficult to track individually, especially if you’re actively trading.
Since the industry is also mostly unregulated, the exchange platforms often do not provide the tax documents that would assist with tracking. Because of this, combined with unclear and changing regulations from Congress and the IRS, taxpayers, and tax return preparers are left with difficulty at year-end trying to properly report the crypto activities.
There are several methods to use in calculating your taxable gain and you should choose the one that’s most favorable based on your situation. Once you choose a method, you are expected to stay with the same accounting method unless you file a form to formally change it.
- Specific identification method: Exactly what it sounds like – specifically identify each exact unit that is being sold to determine the cost basis for the taxable gain. This method requires keeping detailed records, including the date and time the units were acquired, the basis and FMV of the unit at acquisition, the date and time of disposal, and the FMV at the time of disposal.
- Last in, first-out method (LIFO): This method assumes the cryptocurrency sold is from the coins most recently purchased. Those prices may be closer in cost to the sales price and can create a favorable result. This method requires the same detailed recordkeeping as the specific identification method, which can prevent some taxpayers from using it.
- Highest in, first-out (HIFO): This method sells the coins with the highest cost basis first. It may likely result in a lower taxable gain. This method also requires the same detailed recordkeeping as the specific identification method.
- First in, first-out method (FIFO): This is the default method if you don’t have enough information to do specific identification, LIFO, or HIFO. This method assumes that when you sell a certain cryptocurrency, you are selling the first purchase. This method is often unfavorable to the taxpayer if the cryptocurrency has been increasing over time, just like stocks do in the long term. If the cryptocurrency you purchased earlier is lower than the ones purchased later, then your taxable gain will be higher upon sale since the cost basis will be lower.
To choose the most tax advantageous method for taxable gain, you’ll want to keep detailed records, so you and your tax preparer are in a good position when it comes time to tax plan and prepare your return.
6. Minimize Tax Liability by Keeping Detailed Records in Real Time
In tip five, we just briefly covered why it’s crucial for you to keep detailed records to minimize your own crypto taxes, but thorough recordkeeping not only helps you utilize the best accounting method possible, it also gives you the support needed to prove any basis at all in an IRS audit.
Even with increasing regulation over time, cryptocurrency exchanges do not have the same detailed information on your cost basis that security exchanges have. As a result, while 1099-B forms can usually be relied upon by taxpayers for accuracy, 1099-B forms for cryptocurrency usually have an incorrect or incomplete cost basis, and this is not expected to be improved anytime soon. In an IRS audit, the burden is on the taxpayer to prove the cost basis, otherwise, agents usually assume it is the least favorable option, which is a $0 basis.
It’s important not only to keep accurate records but to keep organized records in real time. Most IRS agents are unfamiliar with cryptocurrency, which means they will usually not want to put in extra effort to understand your records if they are not easily understood. In addition, the IRS and courts weigh records created at the time of the event much more heavily than records created at the time of the audit. This means that even if you are able to compile your records after the fact, they are usually provided less credibility when considered during your IRS audit.
7. Be Proactive with Reporting to Minimize Risk of Potential Penalties
The IRS has a penalty for almost every type of noncompliance and cryptocurrency is no exception.
The IRS tax forms are showing that cryptocurrency is now becoming a priority of the IRS. The 2019 federal individual income tax return was the first tax return where the IRS explicitly asked taxpayers whether they had dealt in cryptocurrency. On Schedule 1, the 2019 tax return asked “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency.” In 2020, the IRS moved this question to page 1 of the tax return, showing even higher prioritization. The IRS is now asking about cryptocurrency before they even ask about your dependents.
Even if you do not have a taxable event from cryptocurrency in a tax year, you want to stay on the conservative side and answer “yes” if you have had any type of activity or involvement with cryptocurrency in the respective tax year. The reason this question is crucial, even if you do not have taxable income in that year, is that this question can be used to show willful (vs. non-willful) behavior for any future noncompliance. If you check “no” in a year when you traded cryptocurrency, the IRS has a much clearer argument to say that you were intentionally noncompliant, opening the door to many more severe penalties as well as potentially increasing the number of past tax returns the IRS can go back and open up for audit.
Even though Uncle Sam is just getting a handle on cryptocurrency compliance, we are familiar with how the IRS uses these ‘yes’ ‘no’ checkbox questions because that is what they’ve done with the foreign compliance. The one small checkbox on Schedule B, asking about foreign bank accounts, has resulted in devastating consequences for taxpayers trying to prove non-willful noncompliance for foreign accounts. Since your income tax return is signed under penalties of perjury, all representations on it usually provide strong evidence for tax court cases and reliance on a tax preparer usually carries little weight.
All of the usual penalties apply to noncompliance for cryptocurrency, including the substantial understatement penalty, negligence penalty, late payment penalty, and interest, and in more severe cases, civil or criminal prosecution or fraud penalties. There’s also the potential for foreign penalties since cryptocurrency can be hosted abroad in foreign bank accounts.
8. Avoid Gray Areas in the Tax Law That May Result in Retroactive Noncompliance Penalties
Even if you’re compliant based on current guidance, there is always the potential for new guidance to be released that is considered retroactive. This is usually the case when there is a gray area for compliance that is later clarified, rather than new law altogether.
One of the areas where there is no clear guidance is the exact foreign reporting requirements for certain types of cryptocurrency activity. We recommend always staying conservative on compliance, especially since it should not result in additional tax, and if the forms are later determined to not be needed, then there was no harm in filing them. However, if they are later determined to be necessary, you may be left in a situation where you’re trying to get penalties abated by the IRS.
9. Stay Up to Date on Tax Reform and Current IRS Guidance for Cryptocurrency
If you consider yourself a crypto trader or want to begin trading cryptocurrency, it is important to stay up to date with current IRS guidance and potential tax implications. If you have any questions, it’s important to consult with an experienced CPA or qualified professional who is up to date on the latest tax legislation and filing requirements. They will provide information and gather the information required to report on your trading activity during the year. This will allow your tax professional to make any necessary adjustments to keep you in compliance and avoid any stressful tax issues during tax season.
Consult with an Experienced Tax Professional
At DiLucci, our experienced team of tax professionals is here to help you with your individual or business tax needs, including assistance with cryptocurrency and digital currency trading.
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