With increasing cryptocurrency adoption, the IRS is increasing efforts to enforce crypto tax compliance. From tracking cost basis and noting effective realized prices to reporting transactions as required by regulations, you may owe taxes for cryptocurrency transactions.
Like with any capital asset, when selling cryptocurrency for more than its cost basis you’ll owe taxes. How long you held onto it will also affect this liability.
Capital Gains
As with other investments, cryptocurrency comes with its own set of tax obligations. When selling it for more than what you bought it for, any capital gains must be reported to the IRS and cryptocurrency exchanges may need to abide by standard know-your-customer and withholding rules. But even with these new reporting requirements in place, tax authorities find it challenging to penetrate this ecosystem because of its anonymity and rapid turnover rate.
If you use cryptocurrency to purchase goods and services, your transactions are recorded in a digital ledger and any gains or losses are calculated by subtracting its cost basis from its fair market value at the time of exchange.
This calculation takes into account the price you paid for your cryptocurrency and any fees paid during its ownership. Depending on its length of ownership, you may owe short-term or long-term capital gains taxes; short-term gains will be taxed at your regular income tax rate while long-term ones at a lower capital gains rate.
Mining cryptocurrency can also be considered a taxable event, since miners typically are compensated through cryptocurrency mining. As part of a business enterprise, the costs related to hardware and electricity expenses can be deducted; otherwise, mining activities should be reported on your taxes as income earned from such mining activities.
Cryptocurrency taxes also apply to any cryptocurrency you receive as wages from your employer, just as with other forms of income tax withholding and Social Security/Medicare/Federal Unemployment Tax Act taxes. You should expect your employer to submit Form W-2G with the IRS for tax reporting purposes – failure to report such events correctly can lead to penalties from an accuracy-related fee to criminal prosecution charges related to tax fraud.
Short-Term Gains
Uncle Sam expects his share of any profits you realize from buying, selling or exchanging cryptocurrency. That is because, according to the IRS, most cryptocurrencies are convertible virtual currencies which serve as mediums of exchange, stores of value and units of account – as such they should be subject to taxes similar to other investments and property investments.
Cryptocurrency taxes are determined based on capital gains, which is calculated as the difference between what you paid and what was realized upon selling a cryptocurrency. To calculate this gain, subtract your cryptocurrency‘s “cost basis”, including transaction fees and original investment, from its sale or exchange price. Keep in mind that certain circumstances of each transaction could allow for capital losses too!
As with any asset, when selling crypto for cash or exchanging it to another cryptocurrency you must report the gains as income. Any cryptocurrency received as income must also be declared, including airdrops which distribute free tokens as an incentive for adoption and brand awareness; trading/purchasing cryptocurrency exchanges/companies as well as referral bonuses/incentives etc.
Note that unless and until you sell or convert your crypto, no gains or losses will accrue to you. Taxable events only arise if you sell or exchange it for cash, convert it to another cryptocurrency or spend it on goods or services.
Governments often struggle to incorporate cryptocurrency into the current tax system due to its rapid evolution and anonymity, particularly when it comes to sales and value-added taxes (VAT). If governments fail to address this challenge, widespread use of crypto could result in significant VAT and sales tax evasion which reduces revenues significantly for government.
Long-Term Gains
Cryptocurrency is an asset, just like any other investment, which means it will be taxed when sold or exchanged for something else. How much tax you owe will depend on how long you owned the coin, as well as whether its gains were short- or long-term.
Any time you exchange or sell cryptocurrency for cash, goods, or services you create a taxable event and must report it to the IRS. If your cryptocurrency sale yielded a profit you must calculate your original cost basis as well as when and how you bought or exchanged it before being able to determine if there has been a short- or long-term capital gain.
If you sell cryptocurrency at a higher price than what it cost you initially, any gains accumulated must be taxed at either your ordinary income tax rate or capital gains tax rate. If your cryptocurrency remains held over 12 months and then sold off later for more than it cost initially, any gains must be taxed at capital gains tax rate.
Another taxable event arises when you receive additional crypto tokens from a blockchain project that hasn’t yet launched – an event known as an airdrop – from one that hasn’t officially launched yet. Many crypto projects use airdrops to promote early adoption by giving away free tokens to users and community participants as early as possible; usually this event should also be considered taxable.
One of the major obstacles in integrating crypto into traditional finance is its anonymity. While industry is developing solutions, government agencies and companies still struggle with tracking activity between centralized and decentralized exchanges.
IRS penalties could become significant if they discover you’re misreporting crypto activities accurately. To mitigate this situation, many experts advocate that centralized exchanges comply with standard “know your customer” rules and may withhold taxes; this would encourage compliance and disincentivize individuals from concealing their activities on decentralized exchanges or peer-to-peer trades.
Ordinary Income
Like stocks, bonds and other investments, cryptocurrency‘s value becomes taxable when sold for more than you originally paid for it. This applies whether selling cryptocurrency for cash, exchanging it directly for another crypto or using it to buy goods or services. To determine your cost basis and sales proceeds accurately when selling cryptocurrency you will need your initial purchase price and current value when selling; due to fluctuating cryptocurrency values this can be challenging so accounting software that automatically tracks your transactions may help calculate these numbers more accurately than you could manually do; they may also assist in applying IRS guidance such as FIFO (first in, first out) accounting methods or tax accounting methods when filing your taxes returns.
For example, when you sell crypto for more than it was worth when purchased, capital gains taxes must be paid. Likewise for purchasing items with cryptocurrency; though this type of transaction usually counts as an ordinary purchase rather than sale. Exchanging one crypto for another counts as selling; however you may reduce taxable gains or losses by subtracting the fair market value of what was received in an exchange from its original cost basis.
If an employer pays you in crypto, that income should be taxed as any other salary would. Likewise, any time someone accepts crypto in exchange for goods or services or mines it themselves (miners typically receive cryptocurrency compensation for verifying transactions on blockchain networks and adding them into it), that too should be included as income to tax as self-employment income.
Governments are working hard to integrate cryptocurrency into their tax systems as its popularity surges, which will likely involve tracking owners, imposing sales taxes, and reporting trading activities to prevent tax evasion. Until that day arrives, cryptocurrency should always be treated with caution when spending or investing. Moving to a state offering low or no income taxes might also help mitigate potential gains or losses when transacting using digital currency.