2021 – 05/17 by Andrew Turpin, CPA
For casual observers, cryptocurrencies may seem like a new financial phenomenon, but the leading crypto, Bitcoin, actually launched in 2009. More than four thousand others have followed in the years since. The big changes recently are the wider availability of some cryptocurrencies on popular trading platforms like Robinhood, and the growing ability to pay for goods and services using these digital currencies. What once seemed like an esoteric fad is becoming increasingly mainstream.
With this popularity comes the inevitable question: How are crypto transactions taxed? To answer that question, we need to go over some basics.
It’s money, but with big differences
Cryptocurrency is a digital store of value and medium of exchange. Generally there are no physical tokens (like a dollar bill); instead the value is held in cloud-based digital wallets. And unlike physical currencies, crypto is not issued by national governments or regulated by any centralized government entity.
On one level, crypto is meant to be a replacement for cash. However, it is also an investment vehicle. Most people who hold Bitcoin, Ethereum or others expect it will increase in value. And in many cases that has been true. Experiencing volatile swings both up and down, Bitcoin has increased by 2000% in just the last few years, and by far more than that since its inception.
With the high likelihood that its value will change significantly before you either sell the crypto or use it to pay for something, it is subject to special tax rules unlike those for traditional cash. In brief, the IRS has deemed that cryptocurrencies be taxed like capital assets instead of normal currency.
Tax triggering events
Due to this rule and the nature of how you might acquire or exchange cryptocurrencies there are a multitude of taxable events that could occur. Here are some of the most common:
- Receiving crypto through mining or staking
- This results in ordinary income. Your income will be the fair market value at the time you receive the cryptocurrency.
- If you are a hobby miner, this would be reported as “other income not subject to self employment.” If you are operating as business, the income appears on your Schedule C.
- The fair market value at acquisition will be your basis in the cryptocurrency when you sell or exchange it at a later date.
- Receiving crypto in exchange for goods or services
- In this case you would treat the crypto received the same way you would treat cash, the only difference being that the amount of income you recognize is the fair market value of the currency at the time you receive it.
- Example: You agree to sell a piece of art for one Bitcoin token on Monday when the value of Bitcoin is $50,000. The buyer transfers the token to you on Thursday when the value has fallen to $42,000. Your income would be $42,000.
- That same fair market value ($42,000) will be your basis when you sell or exchange the Bitcoin token at a later date.
- Selling crypto for local currency
- This one is treated as a straightforward capital gain or loss.
- Your gain/loss is the amount you sell it for, less your basis. Your basis is what you paid for it or its fair market value when you received it through mining or payment (as described in two previous cases).
- This capital gain/loss is either short- or long-term, depending on if you held the cryptocurrency for less or more than a year.
- This is very similar to exchange traded securities, except for the fact that wash sale rules do not apply to cryptocurrencies.
- Exchanging cryptocurrency
- If you exchange your cryptocurrency for a good or service (use it to make a purchase), you will need to recognize a capital gain or loss for the time you held it.
- The gain/loss is the fair market value of the crypto on the day of the exchange minus your basis. This gain will be short- or long-term depending on your holding period.
- Example: You exchange one Bitcoin token for a Tesla Model S. Bitcoin is currently valued at roughly $58,000, and let’s assume you bought in during 2018 at $6,000. On this transaction you would have a taxable gain of $52,000 ($58,000-$6,000). This gain would be long-term and taxed at the current long-term capital gains rates of 0-20% and possibly subject to net investment income tax.
- This same concept holds true when exchanging one cryptocurrency for another.
Tracking taxable events
Unlike most exchange traded securities there is no default form you receive when tax time comes around to summarize your crypto transactions for the year. Instead, it is up to you to track and report your transactions. Currently there are several free and paid applications available that interface with popular crypto trading platforms like Coinbase. These will help you track things like buying, selling and exchanging for other cryptocurrencies, but you will need to keep track of your own mining and other transactions. For these types of transactions I would suggest keeping an Excel sheet that records the date, quantity, and fair market value of the cryptocurrency involved.
Fees can also play a large role, since most exchange platforms charge fees to use their services. When you sell crypto and incur a fee that fee will reduce your gross proceeds on the sale resulting in a lower gain (or increased loss). Likewise, when you purchase crypto, those fees will increase your basis, which results in a lower gain (or increased loss) when you sell or exchange the crypto.
Investigate before you invest
Cryptocurrency is a complicated subject both technically and with regard to taxes. We encourage you to be well informed before investing in Bitcoin or other digital assets. Be aware that values can change rapidly and do not always go up. Further, digital wallets are not insured by the FDIC like traditional bank accounts.
There’s far more to cryptocurrencies than we can cover in this brief article, but this should help you understand the basic tax principles that apply so you can avoid any nasty surprises when it comes time to file your taxes. We are happy to answer any questions you may have.