April 19, 2022

Understanding Crypto Tax Laws 101

Written by Mark Kang, CPA Updated April 19, 2022

Over the past couple of years, crypto regulation has become a crucial subject for the government. As the IRS continues to make efforts to clarify and enforce cryptocurrency tax laws and regulations, investors should understand how laws can affect them and should have a good tax strategy in place. This way, they can stay in compliance with updated laws and defuse any surprise tax bombs beforehand.

Read on to learn what's been happening with cryptocurrency tax laws.

 

1. How the IRS Defines Cryptocurrency

The IRS refers to cryptocurrency as virtual currency. It defines crypto as “a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”)”.

In other words, the IRS considers something as virtual currency if it can be exchanged for real currency, be substituted for real currency or store of value, or be used like money as a medium of exchange. With this definition, any profit or loss on Bitcoin, Ethereum, or other cryptocurrency; transactions and trades on crypto exchanges such as Coinbase; mining or staking income; crypto received from hard forks and airdrops; and even DeFi transactions are subject to taxes.

The key here is that the IRS categorizes virtual currency as property, not money. And it’s reported on your taxes in a way that’s quite similar to stock trading. In other words, you would follow the rules of reporting property based on capital gains and losses.


2. Why Do You Have to Report Crypto Taxes?

The IRS states,

“The sale or other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences that could result in tax liability.”

All U.S. taxpayers had to answer the following question on Form 1040 for the year 2020:

“At any time in 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”  

 

The IRS added a question on Form 1040 for 2020 to further enforce cryptocurrency tax laws

 

If you answered “yes” to the above question, you had to report all crypto profits – big or small – to the IRS. By signing your tax return, you are declaring under penalties of perjury that the information on your tax return is true and correct. This means the IRS can audit your return or charge a penalty and interest if you don’t report crypto income on your taxes. Here’s a more detailed example of how the IRS has enforced cryptocurrency tax laws in the past.

A federal court ordered Coinbase, the largest crypto exchange in the US, in 2016 to submit its users' transaction records from 2013 to 2015 to the IRS. The court ordered two additional exchanges, Kraken and Circle, to send the IRS details on transactions they hosted between 2016 and 2020 that involved more than $20,000. Furthermore, the IRS collected crypto taxes in 2019 by actively issuing notices to roughly 10,000 crypto investors regarding missing cryptocurrency income on their tax returns.

As you can see, the IRS has clearly expressed their intention to collect taxes on crypto. Reporting cryptocurrency income on your tax returns is mandatory.


3. How The IRS Taxes Crypto Income 

Based on the IRS’s guidelines from 2014, cryptocurrency is treated as property for taxation purposes. This means that any capital gain or loss generated from selling your assets is taxable, while assets that you simply hold or possess are not taxable until you sell them.

The federal tax rate on crypto capital gains is the same as those for sales of financial assets such as stocks and bonds. This means that short-term gains are taxed between 10% and 37%, and long-term gains are taxed at 0%, 15%, and 20% depending on your income tax bracket. Selling your cryptocurrency asset after holding it for one year or less results in a short-term gain, and selling your asset after a holding period longer than one-year results in a long-term gain.

Taxable events are usually categorized as either capital gains or income. For example, profits from transactions of assets – like selling crypto, using crypto to pay for goods or services, or exchanging one crypto for another – are all considered capital gains. On the other hand, crypto received from mining activity is considered ordinary or business income. Here are more examples of taxable and nontaxable events: 

*While giving crypto is not a taxable event for federal income tax purposes, it could have gift tax consequences. 

For example,
1. Suppose you buy 1 BTC (nontaxable).
2. You also earned 0.5 BTC from mining (taxable).
3. Then you send all 1.5 BTC to your account at another exchange (nontaxable).
4. Here, you convert 1.5 BTC to 3 LTC (taxable).
5. Finally, you sell 3 LTC (taxable).

Not only is there a mix of taxable and nontaxable events in your cryptocurrency activity, but there may be different reporting requirements and tax rules to follow for each of those taxable events. So you'll need to plan and prepare well to successfully report your crypto taxes.
 

4. Other Crypto Tax Implications

The IRS hasn’t provided clear guidelines yet for some areas like staking, NFTs, and DeFi transactions. While tax professionals wait for additional clarification from the IRS on how these crypto activities will be taxed, let’s see how they’re typically reported:


Staking

Staking refers to earning rewards by locking up cryptocurrency that operates on a proof-of-stake (PoS) consensus mechanism to verify and secure transactions on the blockchain. On the surface, it appears similar to the process of earning interest at a bank, but the underlying mechanisms are more like mining and are usually reported as ordinary income.


NFTs

Non-fungible tokens (NFTs) are cryptographic tokens on the blockchain that can be owned by only one person and cannot be replicated. They’re new types of digital assets that represent ownership of digital music, digital art, and even Twitter tweets. They enable people to invest and transact with such digital possessions. NFTs are typically considered property because of their nature, just like cryptocurrencies, and are reported as capital gains or losses.


DeFi

Decentralized finance (DeFi) refers to a system where financial services are available on public decentralized blockchain networks, without relying on any centralized entity. You can earn interest from lending your crypto, receive incentives for participating in liquidity pools ( “liquidity mining”), yield farming, and more. Each DeFi transaction is currently reported on tax returns following the rules for the type of taxable or nontaxable event that it resembles.

Click here for more updated crypto taxation news.


Stay In Compliance With The Ever-Changing Tax Laws

Keep in mind that cryptocurrency tax laws are always changing and updated as the field develops, so they’re subject to abrupt changes that resemble the volatility of the crypto market.

Do you want an accurate tax report? Want to know what tax-saving opportunities are waiting for you? Our experienced Cointelli team is here to help you get the most tax-saving results with minimal cost and effort!

DISCLAIMER: This post is for informational purposes only and should not be interpreted or relied upon as a substitute for the advice of financial, legal, or tax professionals. This content also only addresses U.S. federal income tax consequences for U.S. citizens and residents and does not address tax consequences that may be relevant to a particular person subject to special rules, such as dealers or traders. You should consult with your own financial, legal, or tax professionals to report and file your crypto taxes or make decisions on your particular circumstances. The laws, regulations, or interpretation of the existing laws could change, which may adversely affect either prospectively or retroactively. The content of this post is subject to changes.
About the Author
Mark Kang, CPA
CEO & Co-founder of Cointelli
Mark Kang is a CPA with a Ph.D. in Physics. He helped build Cointelli’s foolproof formula for accurate crypto tax reporting. Passionate about crypto tax topics, Mark is here to share the knowledge.

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What Happens If You Don’t Report Crypto Transactions to the IRS?
About the Author
Mark Kang, CPA
CEO & Co-founder of Cointelli
Mark Kang is a CPA with a Ph.D. in Physics. He helped build Cointelli’s foolproof formula for accurate crypto tax reporting. Passionate about crypto tax topics, Mark is here to share the knowledge.
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