Produced by Cryptocurrency Tax Attorneys and Blockchain CPA’s
Did you know that cryptocurrency needs to be reported to the Internal Revenue System (IRS)? The IRS is cracking down on crypto taxation and audits, so it is no longer feasible to simply try to avoid these taxes entirely.
Just thinking about crypto taxes is enough to give anyone a headache. But worry no more! This guide will walk you through all the nitty-gritty on how to report cryptocurrency on your taxes. We’ll cover everything from what a crypto taxable event is, to how cryptocurrency is taxed.
July 14, 2021 / New Crypto Reporting Requirements in Infrastructure Bill
The IRS included the following question on Form 1040 for 2020 and on Schedule 1 for 2019:
"At any time did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
All taxpayers had to answer either “yes” or “no”. So, what kind of implications does this question have?
First, if anyone who answered “no” is found to have taken part in cryptocurrency transactions, the IRS could charge them a heavy fine on the grounds that they deliberately hid such transactions.
Second, the IRS will pay close attention to whether anyone who answered “yes” did indeed report their crypto-related income properly. To avoid any fines, legal action, or other serious consequences, you must report your cryptocurrency on your tax return.
As the IRS lays down more regulations to collect taxes on crypto, it would be wise for you to correct your past tax returns by including any missing transactions.
1. What Crypto Activity is a Taxable Event?
For taxation purposes, the IRS considers crypto as property, unlike stocks, which are considered securities. Your transactions can fall into the following three categories: capital gains, ordinary income, and nontaxable income.
1) Capital Gains
Your gains from selling cryptocurrencies are all taxable and your losses are deductible.
Suppose you buy 1 BTC at $5,000, then sell 1 BTC at $10,000 a month later. Your capital gain of $5,000 will be subject to taxes. However, if you sell at $4,000, you'd have a capital loss of $1,000, which can be used to offset other capital gains.
Trading for another cryptocurrency
Trading or converting one crypto for another is considered a sale of the first crypto and a purchase of the second, making this a taxable event that leads to either a capital gain or loss.
Suppose you buy 2 ETH for a total of $2,000. Later, you trade them for 0.1 BTC when they are worth $5,000 total. Your capital gain of $3,000 will be subject to taxes.
Using cryptocurrency to purchase goods or services
Paying for goods or services using cryptocurrency generates capital gains. In this case, the capital gain is the difference between the price of the good or service and the purchase price of the cryptocurrency used.
Suppose you buy 2 BTC for a total of $10,000. One year later, you use the 2 BTC to pay for a Tesla car worth $60,000. Then a capital gain of $50,000 will be subject to taxes.
Investing in Initial Coin Offerings (ICOs)
An initial coin offering (ICO) is the crypto version of an initial public offering (IPO). The company seeks investments to develop a new cryptocurrency by offering it at a low price. The taxable event occurs when receive the newly developed cryptocurrency and also later when you sell or convert it.
Suppose you invest 1 BTC worth $50,000 into a new token, ABC. When the token is launched, you receive 4 ABC tokens. One month later, you sell your 4 ABC tokens for $80,000. Your capital gain of $30,000 will be subject to taxes.
Margin transactions involve borrowing money from the exchange or platform to purchase cryptocurrency. Capital gains that occur when selling this cryptocurrency are taxable. You can also deduct the interest charged on the borrowed margin by reporting it on Schedule A of your tax return.
Suppose you invest $20,000 and borrow $40,000 from your exchange to buy 2 BTC for $60,000 total. Three months later, you sell 2 BTC for $80,000 total and incur $600 in interest for borrowing $40,000 over the past months. Your $20,000 capital gain is taxable, and the $600 interest can be deducted using Schedule A (only when you choose to use the itemized deduction).
2) Ordinary Income
Mining is the process of solving extremely complex computational math problems to create new blocks in the blockchain and receiving new crypto tokens as a reward for the work. The cryptocurrency that is received as the mining reward is taxable. *Depending on whether you engaged in mining as a business or hobby, the rewards will be categorized as a different kind of income. Please refer to IRS guidelines on how to distinguish a business from a hobby.
Suppose you mine for business and earned a reward of 1 BTC that was worth $19,500 at the time. The $19,500 will be taxed as business income.
Staking is like mining, but only involves locking up your cryptocurrency in a wallet or pool to contribute to the operations of a blockchain. You will receive anywhere from 1% to 20% of the amount you’ve staked as rewards, as long as you keep your crypto staked. The IRS hasn’t provided any specific guidelines regarding staking, so the best we can do is assume that the same rules for mining will apply.
A hard fork occurs when a radical change or upgrade to a blockchain network’s protocol splits it into two. Holders of the original tokens are granted an equal number of tokens in the new fork. The new tokens received are considered taxable ordinary income, even if you did not intend to receive them. If you do not receive the new token after a hard fork, you will not be taxed.
Suppose you have 1 BTC. After a hard fork, you receive 1 Bitcoin Cash (BCH), which is worth $500 at the time. The $500 will be taxed as ordinary income.
An airdrop is a marketing method used by crypto startups. It involves delivering either new or existing tokens to a user’s wallet either for free or in return for a small promotional service. Airdrops are taxed based on what the tokens were worth at the time of receipt. You can refer to IRS Rev. Rul. 2019-24 for more details on airdrops.
Say you earn 500 Crypto A tokens through an airdrop, which is recorded in the distributed ledger on the same day. If each token is worth $2 at the time of receipt, $1,000 will be taxed as ordinary income.
Payments received for goods or services
If you provide goods or services in return for cryptocurrency payments, the value of the cryptocurrency at time of receipt is taxed as ordinary income.
Suppose you provide a service and the client pays you 1 ETH, which has a market value of $1,500 at the time. The $1,500 will be taxed as ordinary income. *When a self-employed individual receives cryptocurrency payments for his or her work or services, the payment is categorized as self-employed income and is subject to Self-Employment Tax.
3) Nontaxable Income
Buying and holding cryptocurrency
Simply buying cryptocurrency or holding it in a wallet or other form of storage is not a crypto taxable event.
Transfers from your wallet or exchange to another wallet you own
Transferring crypto between wallets that you own, or between your own accounts at different exchanges is not a taxable event.
Receiving gifts of cryptocurrency is not a taxable event, but you will have to report and pay taxes on any profit or loss that occurs later when trading or selling any portion of the gift. Either the price of the cryptocurrency at the time of receiving the gift or the price at which the giver purchased the cryptocurrency—whichever is lower—is the cost basis when you sell crypto gifts and report taxes on them.
Donating crypto to a 501(c)(3) non-profit organization is not a taxable event and the donation can even be deducted from your income.
Soft forks are simply changes or upgrades to a blockchain protocol. Unlike hard forks, they do not create or add new tokens, so the IRS clearly states in its FAQs on crypto that soft forks are not taxable events.
2. How is Cryptocurrency Taxed?
1) Crypto Tax Rate
As we learned in Chapter 1, there are two different kinds of taxes: ordinary income tax and capital gains tax. Take a look at the tables below for the tax rates.
Ordinary Income Tax Rates
Crypto that is considered ordinary income is taxed at the following rates:
Capital Gains Tax Rates
Tax rates for crypto capital gains are different depending on whether you've held your cryptocurrency short-term or long-term: Short-term capital gains (held less than 1 year): Ordinary income tax rate of 10% to 37% Long-term capital gains (held more than 1 year): 0, 15%, 20%
2) How to Calculate Crypto Capital Gains
A capital gain or loss is the difference between the purchase price and the selling price when selling cryptocurrency.
1. The selling price is the fair market value (FMV)* or amount realized when you sell.
*Here, the fair market value (FMV) is the US Dollar price at which the cryptocurrency is sold. Unlike stocks, the FMV of crypto is slightly different on every exchange.
2. The purchase price is also called the cost basis. If you made more than one purchase, you can choose which purchase to use as your cost basis when you sell, based on the cost basis method you use.
3. Exchanges charge a trading fee when you buy or sell cryptocurrency. Purchasing fees can be added to your cost basis and selling fees can be deducted from the amount realized. Simply put, the total trading fee amount is deducted* from your capital gain.
*You can’t claim deductions on trading fees with stocks, but you can with crypto because it is considered property.
Let's assume you paid a 1% trading fees for both buying and selling. If you buy crypto for $5,000 total, your real cost is $5,050. When you sell the same crypto for $10,000 total, you realize $9,900 after accounting for the selling fee. This means your actual gain is $4,850.
If you don't account for the trading fees, you'll have a $10,000 selling price, a $5,000 purchase price, and a $5,000 capital gain. In other words, you can reduce your capital gain by calculating fees into your cost basis or selling price.
Cost Basis Method
Cost basis methods, or accounting methods, are ways to select your selling price based on the date you purchased a cryptocurrency, the amount you purchased it for, and its price. It’s important to note that once you select your cost basis, it can’t be used again for future capital gains calculations. The IRS allows for First-In, First-Out (FIFO), Last-In, First-Out (LIFO), Highest-In, First-Out (HIFO), and Specific ID methods.
First-In, First-Out (FIFO)
FIFO is the simplest method that assumes the first units purchased are sold first. In other words, the cryptocurrency you’ve held the longest becomes the cost basis for your sale. Using the FIFO method increases your holding period, which increases the probability of getting taxed at the lower long-term capital gains tax rate.
Last-In, First-Out (LIFO)
LIFO is the exact opposite of FIFO and assumes that the most recently purchased units are sold first. This decreases your holding period, which makes it more likely to get taxed at the higher short-term capital gains tax rate. However, since prices tend to increase with more time, the LIFO method can reduce the total capital gain for the year.
Highest-In, First-Out (HIFO)
HIFO assumes that the units with the highest purchase price are sold first. This method is the most effective at minimizing capital gains. But it could increase your capital gains in future years, so be sure to consult with a tax professional when choosing the strategy that will benefit you most.
With the Specific ID method, you simply choose which units to sell first, unlike FIFO, LIFO, and HIFO, which each follow a particular rule. If you choose to use any of the Specific ID methods, you will need to maintain accurate transaction records as proof for the IRS.
Check out the table below for an example of how your total capital gain can change based on the cost basis method you use.
As you can see, FIFO yields the highest capital gain while HIFO yields a capital loss. Like this, you can reduce your capital gain by using the cost basis method that will benefit you most.
Whether you choose to use a FIFO or a Specific ID (LIFO, HIFO) method, either one makes a difference in how much you save on taxes. While you might choose one that both decreases your total capital gains and yields more long-term gains than short-term gains, consider whether having more short-term or long-term capital gains is beneficial for you in that tax year. Also, remember that you’ll need to maintain accurate transaction records, especially for the Specific ID methods.
3) How to Avoid Crypto Taxes
Did you know there are more ways to reduce your tax bill? Choosing the best cost basis method to decrease your total capital gains, while increasing the proportion of long-term capital gains isn’t the only solution!
HODL for Long-Term Gains
Before selling your crypto, check how long you’ve held it. You might significantly reduce your tax bill by waiting a bit longer for long-term capital gains. As we explained above, long-term capital gains are taxed at lower rates than short-term capital gains are. Take advantage of these lower rates to avoid paying extra taxes on your crypto.
Tax Loss Harvesting
Reduce your crypto capital gains tax by offsetting any capital gains with capital losses.
If the price of your cryptocurrency drops below your purchase price, you can sell* to realize or “harvest” the loss. This loss can then be used to offset your capital gains from other investments, thus reducing or even eliminating your capital gains tax.
After offsetting your capital gains with your losses, you can use the remaining losses to deduct up to $3,000 from your ordinary income, which will lower your income tax bill and possibly even put you in a lower tax bracket.
*Wash sale rule: If an investment is sold at a loss and repurchased within 30 days, this is considered a wash sale and the loss cannot be used toward reducing taxes. However, cryptocurrency is currently not subject to the wash sale rule, so you can harvest your losses while keeping your portfolio as is by buying back your crypto within 30 days of selling. Unlike stocks, cryptocurrency is treated as property by the IRS. This means the wash sale rule applied to stocks does not apply to cryptocurrencies. However, on September 13, 2021, the House Committee on Ways and Means proposed to subject digital assets to the wash sale rule for transactions made after December 31, 2021. This proposal did not go through, so you don’t need to worry about it yet.
Tax Loss Carryover
Apply remaining losses after offsetting capital gains and deducting $3,000 from your income to future tax years.
You can use the remaining losses to offset your capital gains and up to $3,000 of your income tax every year until no more losses remain. Basically, if you happen to harvest a substantial capital loss in one year, it could help reduce your capital gains and income tax liabilities in multiple years to come.
Reduce Your Taxable Income
Lowering your taxable income not only reduces your total tax bill, but it might also put you in a lower tax bracket, minimizing your tax liability further. Several common ways to do this are contributing to a retirement account such as a traditional IRA or 401(k) plan, a health savings account (HSA), or donations to charity.
The tax code has many other tax deductions and credits that can lower your taxable income, so you might want to ask a tax professional for help with uncovering them.
Invest in a Crypto Individual Retirement Account (IRA)
Some self-directed IRAs allow you to invest in crypto assets. With traditional IRAs, which are tax-deferred, you can get a break from taxes now, but you’ll have to pay taxes on your gains later when you withdraw funds from the account. With Roth IRAs, you pay taxes upfront, but won’t have to pay taxes on any gains when you withdraw.
An important factor to consider when deciding between a traditional and Roth IRA is determining whether you’ll be in a higher tax bracket or a lower one during retirement. If you expect to be in a higher tax bracket, a Roth IRA would work better, while a traditional IRA would be more advantageous if you expect to be in a lower tax bracket.
Gift Your Crypto
Rather than selling your crypto and realizing capital gains, you can gift your crypto to someone and receive tax-savings in return for your generosity. You can give up to $15,000* per person without any of it being subject to a gift tax. It’ll be as if you never had that crypto to begin with.
The recipient will be subject to the capital gains tax when he or she sells your crypto gift. But, if you provide the recipient with the date and purchase price of the crypto, the IRS allows the recipient to adopt your holding period, which can help qualify the gift for long-term gains and your cost basis. This might help decrease the recipient’s capital gains.
There are two advantages to donating to a 501(c)(3) non-profit organization:
You won’t need to pay a crypto capital gains tax for what you donate.
You can deduct the amount donated from your income.
The amount you can deduct from your income depends on how long you held your cryptocurrency. For crypto held longer than one year, you use the price of the crypto at the time of donation. If you held the donated crypto for less than one year, you use either the price at the time of donation or the price at the time of purchase—whichever is lower.
To ensure the accuracy of your tax return, you must receive a donation acknowledgment letter from the non-profit organization as evidence for your donation.
i.e.) Suppose you buy 1 ETH at $2,000 and donate it to a non-profit organization six months later when it's worth $2,500. Since you held it less than one year, you deduct the lesser value, $2,000, as your donation.
Hold your crypto for longer than one year before selling to take advantage of the lower long-term capital gains tax rate.
Use losses in your crypto investment to offset other capital gains and income to reduce your overall tax bill for this year and future years.
Take advantage of tax deductions and credits to lower your taxable income and potentially enter a lower tax bracket.
Invest your crypto in a self-directed IRA to defer taxes, or a self-directed Roth IRA to eliminate capital gains taxes.
Gift your crypto to someone in need and eliminate your capital gains tax liability in return for your generosity.
Donate to a 501(c)(3) nonprofit charity to avoid crypto capital gains tax and even deduct your donation.
3. How to Report Cryptocurrency on Taxes
1) Tax Forms for Reporting Crypto
Of the many IRS forms, there are a few you should know about when you report cryptocurrency on your taxes. Capital gains are reported on Form 8949 and Schedule D, while ordinary income is reported on forms such as Schedule C or Schedule 1.
Capital Gains: Form 8949 and Schedule D
Form 8949: This form lists all your transaction details, such as the purchase prices, selling prices, holding periods, etc. Based on the information provided on this form, the IRS will calculate your crypto capital gains tax.
Schedule D: This is a summary of the information provided in Form 8949 that states your total short-term and long-term crypto capital gains. This is also where you claim any loss from previous years and indicate the loss to carry over to the following year.
Ordinary Income: Schedule C, Schedule 1, etc.
Schedule C: Profits from business, such as mining or staking, requires a Schedule C. Business costs can be deducted from your income here.
Schedule 1: Income from airdrops, mining as a hobby, hard forks, etc. are considered “other income” and can be recorded on Line 8 of Schedule 1.
2) Reporting Deadline
The deadline for reporting crypto taxes is the same as for ordinary taxes. Taxes must be filed and paid to the IRS by April 15 of every year.
So, if you had crypto capital gains or other crypto income in 2021, you must report such gains and income to the IRS by April 15, 2022.
Deadline to File Taxes: April 15 of Every Year
If the deadline falls on a weekend or federal holiday, the first weekday after becomes the deadline. Taxpayers who live outside of the U.S. are automatically granted a two-month extension until June 15.
If you’re unable to file on time, you can also request an extension of your filing deadline until October 15. Not filing your tax return on time will result in a 5-25% failure-to-file penalty on the tax owed for every month.
Deadline to Pay Taxes: April 15 of Every Year
Unlike the filing deadline, the payment deadline cannot be extended. Not paying your taxes by April 15 results in a 0.5% failure-to-pay penalty on the unpaid taxes every month until it gets paid, even if you qualify for an automatic extension or applied for an extension. So, make sure to keep well-organized, up-to-date records of your transactions to ensure you can file and pay your taxes on time.
Taxes must be paid by April 15 of every year, regardless of whether you received a filing extension or not.
Did You Already File Your Returns Last Year Without Reporting Your Crypto?
Many people inadvertently omit crypto income on their tax returns because we have such limited information on how to report cryptocurrency on taxes. So, be sure to fix errors on your past tax returns before you get a notice from the IRS. You can do this by including the missing information and corrected income on an amended return, Form 1040-X, and submitting it to the IRS together with payment for any additional tax due.
The IRS has recently taken more proactive measures to track down U.S. taxpayers who provide incorrect crypto income or omit it altogether on their tax returns. In 2019 for example, they sent a warning notice (Letter 6173, Letter 6174, Letter 6174-A) to roughly 10,000 taxpayers who did not properly report their crypto income.
As the IRS and the government crackdown on crypto taxes, it’s now more important than ever to ensure that even individual retail investors report cryptocurrency on their taxes accurately and thoroughly.
2) Form 1099 from Exchange
Form 1099-MISC is designed to report cryptocurrency transactions to the IRS, meaning the IRS already has a copy of all your transactions.
Beginning 2020, Coinbase issued a 1099-MISC to users who earned at least $600 from Coinbase Earn, staking rewards, etc. on the Coinbase platform.
Kraken, Bianance.us, Uphold, and many other exchanges also submitted similar forms to the IRS. Going forward, it’s very likely that more exchanges will follow suit.
Even though the exchanges may provide forms for you to use when reporting cryptocurrency on your taxes, you must still combine all of the transactions you made on all exchanges you used.
Before issuing 1099-MISC to users in 2020, Coinbase used to issue Form 1099-K, which reports only the total amount sold and not the actual profit or loss. This often resulted in over-calculation of profits and created a lot of confusion.
If a taxpayer omits cryptocurrency gains or losses from his or her tax return, the IRS sends a CP2000, Notice of Underreported Income. But, because taxation guidelines on crypto are still very unclear, many people don’t know what needs to be reported. For help responding to a CP2000 notice, we recommend reaching out to a tax professional.
5. Other Transactions to Report
Currently, crypto investment generate capital gains in the same way stock transactions do and are categorized into either short-term or long-term gains depending on the holding period. When day trading cryptocurrency, buying and selling often occur within the day, thereby generating short-term gains. However, because wash sale rules don’t apply to cryptocurrencies, you can buy the same crypto within 30 days of selling and still claim a loss on it.
Decentralized finance (DeFi) has become increasingly popular in the last year because it enables users to buy, sell, lend, and borrow directly with each other based strictly on software instead of relying on a bank or brokerage. Earning interest by lending on DeFi is a new way of earning income, but it’s still important to follow the IRS’s crypto tax guidelines when reporting and paying taxes on DeFi transactions. While the IRS hasn’t provided specific tax guidelines on DeFi transactions, there is speculation that they will release some information soon.
Non-fungible tokens (NFTs) are unique cryptographic tokens on a blockchain that cannot be replicated and can represent artwork, real estate, people’s identities, property rights, digital images or videos, and even Twitter tweets. NFTs basically act as a digital certificate on the blockchain and are usually purchased with cryptocurrencies. However, the IRS considers these as cryptocurrency transactions, so you must report any capital gain or loss if you sell an NFT after it gains or loses value.
Conclusion: An Excellent Strategy for an Accurate Tax Return
This has been the Cointelli Tax Guide, which covers the various types of crypto taxable events and how to report crypto taxes to the IRS. We hope it helped you gain a better understanding of how cryptocurrency is taxed!
When you report cryptocurrency on taxes, it’s important to combine all your profit and loss data from all the platforms you use before analyzing it. It’s unlikely that all your income comes from a single platform or exchange. And because the crypto scene only continues to grow, the IRS also continues to update their guidelines. To minimize your taxes, you not only have to keep up with all these developments, but you also need to apply those updates to your tax returns. This can prove to be an extremely taxing (pun intended) chore!
Fortunately, the Cointelli team is here to save the day. We’ll help you save both time and money so you can work on preparing your tax return as efficiently as possible!
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.
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