The rapid fluctuations in the value of cryptocurrencies like Bitcoin and Ethereum have raised significant tax concerns among crypto traders. The United States Internal Revenue Service (IRS) is intensifying its regulatory actions, and it’s crucial for everyone involved with cryptocurrencies, whether through holding or trading, to be aware of the legal implications to avoid potential legal issues. The complexities of these regulations are noteworthy, especially considering the way the IRS categorizes cryptocurrency.
Brian R. Harris, a tax lawyer at Fogarty Mueller Harris, PLLC in Tampa, highlights the importance of this issue, stating, “The IRS is currently very focused on enforcement in the area of cryptocurrency. They are actively pursuing individuals involved in the holding, trading, or use of cryptocurrencies, potentially leading to audits or compliance checks.”
Despite the perceived anonymity or pseudo-anonymity that cryptocurrencies like Bitcoin offer, law enforcement agencies, including the IRS and FBI, have increasingly become adept at tracking and tracing cryptocurrency movements, particularly in criminal investigations. Harris notes that these agencies have the authority to seize assets if necessary.
Given these developments, it’s crucial for individuals dealing in popular cryptocurrencies to understand the relevant laws and the tax liabilities that may arise from their transactions.
On a positive note, the IRS typically handles cryptocurrencies in a manner similar to other capital assets like stocks and bonds. However, this classification complicates the use of cryptocurrencies for purchasing goods and services.
Here are several essential aspects to consider regarding cryptocurrency taxation and staying compliant with the law.
Topics covered on this page:
- You’ll be asked whether you owned or used cryptocurrency
- You don’t escape being taxed just because you didn’t get a 1099
- Just using crypto exposes you to potential tax liability
- Gains on crypto trading are treated like regular capital gains
- Crypto miners may be treated differently from others
- A gift of crypto is treated the same as other gifts
- Inherited cryptocurrency is treated like other inherited assets
- The wash-sale rule does not apply to cryptocurrency
8 important things to know about crypto taxes
1. You’ll be asked whether you owned or used cryptocurrency
The U.S. Internal Revenue Service (IRS) has mandated on Form 1040 that taxpayers declare if they have engaged in any transactions involving digital assets, including receiving, selling, transferring, trading, gifting, or any other form of disposing of cryptocurrency during the tax year. This requirement places individuals in a situation where they must provide a straightforward response about their cryptocurrency dealings, risking legal consequences if they fail to be truthful. Misrepresenting or withholding information from the IRS could lead to serious legal implications, as the agency is known for its stringent stance against tax fraud and dishonesty.
Despite this requirement, a significant number of American cryptocurrency users seem to have not reported their dealings to the IRS. A recent report by DIvly, a firm specializing in cryptocurrency tax solutions, suggests that only about 1.62 percent of U.S. cryptocurrency owners disclosed their transactions to the IRS in 2022.
Nevertheless, the IRS has provided some additional guidance on this matter. They clarified that individuals who have only bought virtual currency using actual currency do not need to respond affirmatively to the question on the tax form. This clarification provides a distinction between different types of cryptocurrency activities and their reporting requirements.
2. You don’t escape being taxed just because you didn’t get a 1099
The tax reporting for cryptocurrency income differs significantly from traditional income streams such as stocks, interest, and other payments. Unlike banks or brokerages that issue a Form 1099 to both the taxpayer and the IRS, cryptocurrency exchanges like Coinbase have not historically provided the same level of detailed reporting.
According to Harris, the IRS has struggled to obtain comprehensive reporting from cryptocurrency exchanges. This gap in reporting has been a significant issue in the realm of digital assets.
To address this, a new legislation passed in November 2021 aimed to enhance tax reporting in the cryptocurrency sector, starting from January 1, 2023. This law mandates that brokers, and controversially, anyone involved in transferring digital assets on behalf of others, must report these transactions to the IRS using a 1099 form or a similar document.
The law has faced opposition, particularly over concerns that it would indiscriminately encompass various participants in the cryptocurrency market, including miners and wallet operators. Many of these individuals may not have access to the necessary information for such reporting. As a result, the enforcement of this rule has been delayed while legislators seek to refine the scope of who is affected by these requirements.
However, the absence of a 1099 form doesn’t exempt taxpayers from their obligations. Individuals who earn income through cryptocurrency must still report their gains and pay the appropriate taxes. On the flip side, if they incur capital losses, these can be reported to reduce taxable income, offering a potential tax benefit.
This shift in regulation reflects an evolving approach as authorities try to adapt to the unique challenges posed by the burgeoning cryptocurrency market.
3. Just using crypto exposes you to potential tax liability
It’s a common misconception that if you only use cryptocurrencies without trading them, you won’t have any tax obligations. However, this isn’t accurate. Whenever you exchange digital currency for real money, goods, or services, there’s a possibility of incurring a tax liability. This happens when the value of what you receive for your cryptocurrency – whether in goods or real money – exceeds your initial investment in the digital currency. In other words, if the return is higher than your initial cost, you’re looking at a potential tax liability.
Conversely, you might experience a tax loss if the value of what you receive is less than your investment in the cryptocurrency.
In both scenarios, understanding your initial investment or ‘cost basis’ in the cryptocurrency is crucial for calculating potential gains or losses.
It’s essential to recognize that this isn’t a tax on the transaction itself. Rather, it’s a capital gains tax, which applies to the net change in value of the cryptocurrency. Similar to how stocks are treated, as long as you hold onto the cryptocurrency and don’t exchange it for something else, you haven’t realized any gain or loss for tax purposes.
4. Gains on crypto trading are treated like regular capital gains
When you experience a profit from trading or purchasing cryptocurrencies, the IRS approaches this situation similarly to other types of capital gains.
For assets you’ve held for less than a year, any profits are subject to standard income tax rates, which could be as high as 37% in 2023, depending on your taxable income. On the other hand, for holdings that surpass one year, the tax rate applied is that of long-term capital gains, which are typically lower, falling into brackets of 0%, 15%, or 20%.
Additionally, the practice of offsetting capital gains with losses is applicable to cryptocurrencies as well. This means you can use capital losses to reduce your taxable income, with a permissible net loss deduction of up to $3,000 annually. Should your net losses go beyond this threshold, you have the option to carry over the excess to subsequent years.
5. Crypto miners may be treated differently from others
Mining cryptocurrency as a business venture allows you to deduct related expenses similar to any other business. The income you recognize is equivalent to the market value of the cryptocurrency you produce.
According to expert Harris, when you mine cryptocurrency, the income you recognize is based on its fair market value at the time of mining. This value becomes your basis in the cryptocurrency. Significantly, if your mining activities constitute a trade or business, you may be eligible to deduct your operational expenses.
However, the crucial aspect here is the nature of your operation. To avail these deductions, your activities must be classified as a trade or business. Simply running a mining setup as a hobby does not entitle you to the same tax benefits as a formal business entity.
6. A gift of crypto is treated the same as other gifts
When you present cryptocurrency to someone, like a younger family member, to kindle their curiosity, the transaction is regarded as a conventional gift. This means that if the value of the gift exceeds $17,000 in 2023, it could be liable for gift tax. Moreover, when the beneficiary decides to sell the cryptocurrency, the original purchase cost of the giver becomes the basis for any gain or loss calculation.
However, there are strategies to avoid the gift tax, even if the value surpasses the yearly limit. One such method is utilizing the lifetime exemption option available in tax regulations.
7. Inherited cryptocurrency is treated like other inherited assets
Cryptocurrency, when passed down as an inheritance, is managed similarly to other assets that are transferred across generations. If the total value of the estate surpasses specific limits ($12.92 million as of 2023), it may be liable for estate taxes.
Cryptocurrency also benefits from a readjustment in its cost basis, which is aligned to its market value at the time of the original holder’s passing. Therefore, for the majority of individuals, handling inherited cryptocurrency is comparable to dealing with standard capital assets, according to Harris.
8. The wash-sale rule does not apply to cryptocurrency
The tax treatment of cryptocurrencies by the IRS is largely similar to that of other capital assets, but there is a significant distinction when it comes to handling wash sales, which is actually favorable for those trading in cryptocurrencies.
Typically, for most assets, if a trader incurs a loss upon selling an asset, they are not permitted to claim this loss for tax purposes if they have repurchased the same asset (or a substantially similar one) within a 30-day period before or after the sale. This is known as the wash-sale rule. In such scenarios, any loss is deferred and cannot be used as a tax deduction until the trader avoids repurchasing the asset within this 30-day timeframe.
However, this wash-sale rule does not currently apply to cryptocurrencies. This allows cryptocurrency traders to sell their holdings, record a loss for tax purposes, and then promptly repurchase the same cryptocurrency, still retaining the ability to claim the loss. This rule is particularly advantageous as it enables traders to realize the full benefit of a tax loss while maintaining their investment position, essentially offering a risk-free opportunity to benefit from tax write-offs.
Nonetheless, it’s important to note that there has been legislative discussion aimed at eliminating this discrepancy, which could mean this beneficial circumstance for cryptocurrency traders might not be available in the future.
Conclusion
Using cryptocurrencies can be a complex and challenging process. It involves meticulous record-keeping of transaction costs, identifying the realized price, and understanding tax obligations, often without the benefit of a standardized Form 1099. Additionally, the Internal Revenue Service (IRS) is intensifying its efforts to monitor and enforce tax compliance in the realm of cryptocurrency transactions. This heightened scrutiny aims to curb potential tax evasion. These complexities and regulatory actions add layers of difficulty to using cryptocurrencies, potentially hindering their widespread adoption.
One thought on “Cryptocurrency taxes: A guide to tax rules for Bitcoin, Ethereum and more”