The IRS and Cryptocurrency
According to IRS Notice 2014-21, Bitcoin and other cryptocurrencies should be treated as property for tax purposes — not as currency. This is true for all cryptocurrencies such as Ethereum, Litecoin, XRP, etc. Earlier in 2019, the IRS sent warning letters to taxpayers who have made virtual currency transactions, telling them to pay back taxes and file amended returns. The IRS is asking whether you have acquired, exchanged or sold a financial interest in virtual currency. But the question everyone is asking is: How is cryptocurrency handled for tax purposes?
Cryptocurrencies must be treated like owning other forms of property such as stocks, gold, or real-estate. Just like you would with trading stocks, you are required to report your capital gains and losses from your cryptocurrency trades on your taxes. Failing to do so is considered tax fraud in the eyes of the IRS.
Taxable Events for Cryptocurrency
A taxable event is simply a specific action that triggers a tax reporting liability. In other words, whenever one of these ‘taxable events’ happens, you trigger a capital gain or capital loss that needs to be reported on your tax return. It is as simple as that. The following have been taken from the official IRS guidance from 2014 as to what is considered a taxable event in the world of crypto. If any of the below scenarios apply to you, you have a tax reporting requirement.
- Trading cryptocurrency to fiat currency like the US dollar is a taxable event
- Trading cryptocurrency to cryptocurrency is a taxable event (you have to calculate the fair market value in USD at the time of the trade)
- Using cryptocurrency for goods and services is a taxable event (again, you have to calculate the fair market value in USD at the time of the trade)
- Earning cryptocurrency as income is a taxable event (from mining or other forms of earned cryptocurrency)
What is Not Considered a Taxable Event?
- Giving cryptocurrency as a gift is not a taxable event
- A transfer is not a taxable event (you can transfer crypto between exchanges or wallets without realizing capital gains and losses)
- Buying cryptocurrency with USD is not a taxable event (you don’t realize gains until you trade, use, or sell your crypto)
It is important to keep track of your transactions and your cost basis because the IRS will want to know about your cryptocurrency holdings.
Eagle-eyed taxpayers will notice that the IRS threw in an extra question on the form: “At any time during 2019, did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?” This is the agency’s latest effort to gather additional information on taxpayers’ virtual currency holdings.
Moving your own virtual currency from one crypto wallet to another, for instance, could be considered “sending,” so maybe the most conservative approach that a taxpayer can take is to consider any interaction you’ve had with virtual currency and whether there’s any way this can fall under this very broad list of what you could’ve engaged in during 2019.
Indeed, the IRS has signaled that it would be taking a closer look at cryptocurrency.
The IRS just released a new Schedule 1 for the 2019 tax season, spelling out the details on above-the-line deductions.
Here are the tax basics on cryptocurrency:
Varying tax treatments
If you sold your cryptocurrency, you need to report the transaction. If you wound up with a capital gain, you must pay the appropriate tax.
Cryptocurrency you receive from an employer is subject to federal income tax withholding, FICA tax and federal unemployment taxes, just like wages. These should be reported on your Form W-2, the IRS said.
Meanwhile, independent contractors who are paid in virtual currency must pay self-employment taxes.
For those who mine cryptocurrency, the fair market value of it as of the day of receipt is included in your gross income, according to IRS guidance.
Failure to properly report these transactions can be costly: You may be audited and held liable for penalties and interest.
“A taxpayer who is investing in virtual currency should have a system for tracking the purchase and selling price of the assets,” said April Walker, lead manager for tax practice and ethics at the American Institute of CPAs.
“For tax purposes, the virtual currency is treated as property, similar to a security,” she said. “Therefore, taxpayers should maintain cost records similar to the way records are kept for stocks and securities, although there will be no monthly statements.”
Gathering the data for computing these taxes is easier said than done. Why Can’t My Cryptocurrency Exchanges Provide Me With Accurate Tax Reports? This is where the big problem exists. Because users are constantly transferring crypto into and out of exchanges, the exchange has no way of knowing how, when, where, or at what cost basis you originally acquired your cryptocurrencies. It only sees that they appear in your account. The second you transfer crypto into or out of an exchange, that exchange loses the ability to give you an accurate report detailing the cost basis and fair market value of your cryptocurrencies, both of which are mandatory components for tax reporting.
That’s because to calculate what you owe, you’ll need your cost basis — that is, the original value of the asset for tax purposes.
“Back in 2018, the reporting requirements were still catching up to the times,” said Dan Herron, CPA at Elemental Wealth Advisors in San Luis Obispo, California.
“We would have to go through 50 pages of transactions, throw it into a spreadsheet and figure out what did you buy this for, what did you sell it for,” he said.
If you need to hunt down the cost basis of some long-held stocks and your brokerage firm does not have that information, you could dig up historical prices and dividend payments to figure it out.
The process is less straightforward with cryptocurrency, which any investor can trade on multiple platforms — and the exchange price can differ across platforms. The onus is on the taxpayer to keep track of the cost basis.
Indeed, some providers, such as Lumina and Bitcoin.Tax, have stepped up to aggregate crypto transactions and help calculate cost basis.
Crypto Tax Software
CryptoTrader.Tax is a software built for cryptocurrency traders to solve the tax reporting problem. It allows cryptocurrency users to aggregate all of their historical trading data by integrating their exchanges and making it easy to bring everything into one platform. Once the historical data is in the system, the tax engine auto-generates all of the necessary tax reports for cryptocurrency traders to file.
“If you are a trader of bitcoin or other cryptocurrency, you will want to invest in some accounting software specific to crypto that will allow you to track transactions, otherwise finding out your basis is going to be a disaster,” Levine said.
How Do I Actually File My Crypto Taxes?
To properly file and report your crypto transactions, you need IRS form 8949 and 1040 Schedule D.
What Happens if I Don’t Pay My Crypto Taxes?
A lot of traders are convinced that because of the anonymous, decentralized nature of Blockchain and crypto transactions, that there is no way for the government to see or know that they are making money trading/buying/selling cryptocurrency. This is not true.
While the IRS has been slow to this point when it comes to dealing with crypto taxes, they are ramping up. The IRS win against Coinbase, which required the popular exchange to turn over records for individuals who have $20,000 or more in any transaction (buy/sell/ or receive), is the beginning.
The Blockchain is a distributed public ledger, meaning anyone can view the ledger at anytime. Figuring out an individual’s activities on that ledger essentially comes down to associating a wallet address with a name. Choosing not to report your crypto transactions is a risky decision that exposes you to tax fraud to which the IRS can enforce a number of penalties, including criminal prosecution, five years in prison, along with a fine of up to $250,000.
Disclaimer – This post is for informational purposes only and should not be construed as tax or investment advice. Please speak to your own tax expert, CPA or tax attorney on how you should treat taxation of digital currencies.
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