You may have bought some crypto recently and are now stuck trying to figure out how to prepare and report Bitcoin and cryptocurrency taxes. With limited guidance from the Internal Revenue Service (IRS), the popularity in cryptocurrency has created challenging tax reporting issues. Whenever cryptocurrency is bought, received, spent, issued, traded, sold, or given away—there’s generally a tax impact. Let’s take a few minutes to boost your cryptocurrency tax knowledge.
How to Report Bitcoin and Cryptocurrency Taxes
The cryptocurrency phenomenon unleashed a plethora of tax questions related to anyone who traded in cryptocurrencies. The IRS has attempted to address the most common types of transactions. However, there are still many circumstances that have yet to be addressed. This can make reporting a unique situation difficult for those not familiar with cryptocurrency tax knowledge.
Over the last few years, some cryptocurrency holders have experienced huge profits, while others have incurred significant losses. Folks may find themselves a bit perplexed as to how to address the opaque tax laws. This is because some of the cryptocurrency guidelines haven’t even been established yet. How do we report or tax something that the IRS and other regulators are still in the process of understanding?
How Cryptocurrency Relates to Virtual Currency
The IRS describes a cryptocurrency as a “virtual” currency. Interestingly enough, the term is so informal that you may struggle to find the term “crypto” on the IRS.gov website. Virtual currency is only available in electronic form and is used to pay for goods or services, or held for investment purposes.
An example of using a virtual currency that’s not a cryptocurrency is in the online game FarmVille. Here, players can purchase items for their virtual farm using Farm Coins. It’s important to note that the Farm Coins are only able to be used within the game, and therefore they don’t carry any real-world value.
All virtual currencies that act as a substitute for “real” currency, or have an equivalent value in real currency, are referred to by the IRS as “convertible” virtual currencies. Convertible virtual currencies may be directly exchanged for U.S. dollars (USD). For example, Bitcoin can indirectly be exchanged for USD, like with all other altcoins.
Real Currency Transactions Generate Real-World Tax Consequences
When one type of convertible virtual currency is transferred into another type of convertible virtual currency, or when it is used to pay for goods or services, a real-world transaction has occurred. The referral code is a clever option to be used to get trading discounts during the investment. According to the IRS, these transactions will be treated similarly to property transactions.
This means that trading cryptocurrencies are the same as trading in stocks. This means that profits from these transactions will generally be subject to capital gains tax unless you’re considered a full-time trader, which is fairly rare.
Understanding Capital Gains Tax
There are three instances when a cryptocurrency holder will incur a capital gains tax. These include when a cryptocurrency is:
- Exchanged for another cryptocurrency.
- Exchanged for “real” currency.
- Used to pay for goods or services.
Your cost basis is the purchase price plus any additional costs such as commissions and transaction fees. The basis is used in calculating the capital gain, which is equal to the difference between the asset’s basis and the fair market value of the asset when it’s sold.
Update IR-2019-167, October 9, 2019: Cost basis should be calculated by summing up all the money spent to acquire the crypto, “including fees, commissions and other acquisition costs in U.S. dollars.”
If you sell cryptocurrency for more than your basis, then the difference is a capital gain. If you sell cryptocurrency for less than your basis, then the difference is a capital loss. Remember, your basis not only includes the cost of the cryptocurrency, but also any transaction fees you incurred during the purchase.
Don’t Forget to Include Transaction Fees When Calculating Your Basis
It’s extremely important to keep track of the transaction fees that you incur while purchasing cryptocurrencies because they will increase your basis and thus decrease your tax liability. For example, if you purchased $100 of Bitcoin but there were $20 of transaction fees, then your basis in the transaction is $120. In other words, your $100 of Bitcoin would need to surpass $120 before a capital gain tax is incurred.
Transaction fees may consist of exchange fees, network fees, or withdrawal fees. When calculating a basis, all transaction fees should be added to the amount of cryptocurrency that you received. Transaction fees include:
- Exchange fees: The “commission” paid to fulfill a buy or sell order.
- Network fees: The processing fee associated with moving a cryptocurrency from one wallet to another.
- Withdrawal fees: The processing fee associated with withdrawing a cryptocurrency from an exchange and moving it to a wallet.
Most major regulated exchanges, such as Coinbase, Kraken, and Gemini, will provide custom reporting which will calculate your basis based on your trades using the First In, First Out accounting method. Remember, transactions that occur wallet to wallet will need to be manually computed by the seller and buyer.
Accounting Methods for Calculating Gain/Loss on Cryptocurrency
There are three accounting methods for disposing of cryptocurrency. They are:
- First In, First Out (FIFO).
- Last In, First Out (LIFO).
- Specific Identification.
Determining which method to use may seem overwhelming depending on the number of transactions. Many taxpayers will simply use the basis report that’s generated by their exchange. For example, Coinbase utilizes the FIFO method and provides its users with a simple report. It displays the total capital gain/loss for all of their transactions over a set period.
Cryptocurrency Transactions May Have Been Anonymous in the Past—Not Anymore
For a long time, convertible currency transactions were completely ignored by central banks and regulators. There was total anonymity behind transactions and no one questioned whether you paid taxes on the profits. Those days are long gone.
Now, to buy or sell cryptocurrency on exchanges participants are required to have their identity verified with the exchange. For example, Coinbase will report all of your transactions to the IRS once you’ve reached $20,000 in cash sales or complete over 200 transactions in a calendar year.
Taxpayers that have traded in cryptocurrency must file a federal income tax return regarding all convertible virtual currency transactions. Remember, the IRS can audit your cryptocurrency transactions and when deemed appropriate, you may be liable to pay penalties and interest.
In extreme cases, participants of cryptocurrency trading may be subject to criminal prosecution for filing a false return and tax evasion if they haven’t properly reported their cryptocurrency income correctly.
Calculating Tax on Cryptocurrency Held for Investment as a Capital Asset
When convertible virtual currency is exchanged for property, including other cryptocurrencies, taxpayers must report the capital gain to the IRS unless they’re considered a full-time cryptocurrency trader. A cryptocurrency that’s been owned for more than one year may be taxed at the lower long-term capital gains rate. While cryptocurrency that’s been owned for less than one year is taxed at the higher short-term capital gains rate.
There’s a significant advantage to holding cryptocurrency for one year or more. Taxpayers will generally pay about 10 to 20 percent less tax as compared to a short-term capital asset. Individuals in the lowest tax brackets pay a zero percent tax rate on long-term capital gains.
A capital gain or loss is calculated by taking the difference between the basis (the price paid plus transaction fees) and the fair market value of the cash or property received. In cases where the convertible virtual currency is not a capital asset, the taxpayer will realize an ordinary gain or loss.
This mainly occurs when cryptocurrency is considered inventory and is being sold to customers in the normal course of business. Remember, business transactions in cryptocurrency are subject to the normal rules for withholding, sales, and information reporting.
Using Cryptocurrency to Pay for Services and Goods
Taxpayers that receive cryptocurrency in exchange for goods or services must report the transaction as gross income on the date that it’s received. The fair market value of the cryptocurrency that is paid as wages must be reported on Form W-2 and is subject to payroll withholding.
In cases where the cryptocurrency is paid to an independent contractor and it exceeds $600, it must be reported to the payee and the IRS on Form 1099. If the fair market value of the virtual currency payments are paid as fixed and determinable income to a U.S. nonexempt recipient and it exceeds $600, it must be also be reported.
Accounting for Cryptocurrency Earned Through Mining
Mining for cryptocurrency can either be treated as a hobby and reported as:
- “Other income” on line 21 of Form 1040
- Self-employment income and reported on Schedule C
The distinction between whether the income is treated as self-employment income is identified below:
- The mining activity generates a profit and was profitable in the prior year.
- The method of operation has been analyzed to improve profitability.
- You depend on the income that is generated from the mining.
- The effort and time spent mining is intended to make a profit.
If you’re mining cryptocurrency from your home computer, it’s most likely a hobby. In cases where a serious mining rig was purchased and you spend most of your working hours mining, then you will most likely treat the profits as self-employment income.
Cryptocurrency Earned From Hobby Mining
Cryptocurrency earned from hobby mining will be treated as ordinary income with limited deductions (deduct ordinary and necessary hobby expenses). Additionally, it will be taxed at your marginal tax rate.
In other words, it’s considered like any other earned income. The one fine distinction to this is the capital gain or loss that’s created between the time the cryptocurrency is mined and when it’s converted to cash or exchanged for a service or good.
For example, let’s say in January you mined a net profit of $500 worth of cryptocurrency as a hobby. Six months later in June, you decide to sell the cryptocurrency for $400 creating a $100 short-term capital loss. You should recognize $500 as other income and $100 as a short-term capital loss.
When mining cryptocurrency as a business venture, gains will be treated as self-employment income and will be taxed at the fair market value of the mined cryptocurrency less qualifying expenses. It is important to remember that the self-employment income is also subject to self-employment tax.
What to Do with Airdrops and Hard Forks
Airdrops occur when “free crypto” is received from new blockchains looking to promote their project or initial coin offering (ICO). These free tokens are distributed to existing holders of specific cryptocurrencies to build excitement, brand recognition, and attract users.
A hard fork occurs when a cryptocurrency is split into two or more blockchains, and all share a common historical ledger. A hard fork will typically occur because two or more groups of miners want something different from the current cryptocurrency. When the hard fork takes place, the holder of the original coin will automatically receive a proportionate number of the newly created cryptocurrency.
Update IR-2019-167, October 9, 2019: New cryptocurrencies created from a fork of an existing blockchain should be treated as “an ordinary income equal to the fair market value of the new cryptocurrency when it is received.” In other words, third parties can now create a tax reporting obligation for you by simply forking a network whose coins you own, or imposing on you an undesirable airdrop.
The IRS Has Failed
To some degree, the IRS has failed to keep up with the fast-changing world of cryptocurrencies. There are still many types of transactions that the IRS has failed to provide detailed guidance on. This includes airdrops and hard forks. Therefore, taxpayers must stay consistent with their approach and focus on existing tax law to provide proper guidance.
The most conservative approach to addressing airdrops and hard forks is to report the fair market value of the new cryptocurrency as “other income” on the date of receipt, and a capital gain or loss on the sale date.
A more aggressive approach to accounting for airdrops and hard forks is to assign a basis of $0 upon receipt. The application of this logic stems from the fact that many times holders of the new coin will not have any control or dominion over the new cryptocurrency, and more often than not these types of transactions do not amount to anything. The holder would only recognize a capital gain upon sale of the coin.
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Disclaimer: Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by The Budget Savvy Travelers or the writer to invest in cryptocurrencies or other ICOs. Since each individual’s situation is unique, a qualified professional should always be consulted before making any financial decisions. The Budget Savvy Travelers makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date, this article was written, the author owns no cryptocurrencies.