Updated: Oct 4, 2020
As cryptocurrencies and blockchain technology continue to pose as a legitimate threat towards the traditional banking/financial system, governments and regulators are doing their best to regulate the space so that they can maintain as much control as possible so that they can profit. The best way they can gain control over this emerging new asset class is through what the IRS determines to be a taxable event. After reading this article you will know exactly how digital assets are taxed in the United States, how to legally maximize your tax benefits, and my opinion on the future of digital assets integrated into our world given the current tax laws.
Disclaimer: this article is for informational purposes only and shouldnʼt be considered tax advice or an individualized recommendation. Please consult a tax-planning professional regarding your personal tax circumstances.
In the U.S., you are taxed on the income you earn. So it shouldn’t be a surprise then that the income you generate via cryptocurrency is also taxable, and it needs to be reported on your taxes. The first step for properly reporting cryptocurrency on your taxes is to learn how the IRS treats this asset class for tax purposes. You don’t need to become a tax expert, however, it’s good to gain an understanding of how the basics work so you can properly report and maximize your tax benefits.
So let's start with the basics. According to the IRS, Bitcoin and all other cryptocurrencies (Ethereum, Litecoin, Dash, etc) are considered property for tax purposes , not currencies. This means that crypto must be treated like owning other forms of property such as stocks, gold, or real-estate. Just like you would with trading stocks, you’re 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. While calculating capital gains and losses for your cryptocurrency trades can be tedious, it’s pretty straightforward. But before I show you how to do the calculations, you need to understand taxable events.
A taxable event by definition is 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. The following have been taken directly from the official IRS guidance from 2014 as to what is considered a taxable event in the digital asset sector.
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).
Earning cryptocurrency as income is a taxable event (from mining or other forms of earned cryptocurrency).
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).
For clarity, let me also list what 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).
Giving cryptocurrency as a gift is not a taxable event.
Buying cryptocurrency with USD is not a taxable event (you don’t realize gains until you trade, use, or sell your crypto).
Now that you understand how cryptocurrencies are taxed, let's talk about the process on how to do so.
First, you will want to determine the cost basis of your crypto holdings. Cost basis is how much money you invested into purchasing your crypto. This includes the purchase price plus all other costs associated with purchasing the cryptocurrency. Other costs usually include things like transaction fees and brokerage commissions from the exchanges you purchase crypto from. You can calculate your cost basis using this formula:
(Purchase Price of Crypto + Other fees) / Quantity of Holding = Cost Basis
Next, you will need to know your fair market (the price of the asset at the time of purchase) value so that you can subtract your cost basis from it, in order to determine your capital gain or loss. You can use the formula below:
Fair Market Value - Cost Basis = Capital Gain/Loss
Now that you understand how the process works regarding how to determine your capital gains and losses, let’s now go over how to actually file your taxes. To properly file and report your crypto activity, you need IRS form 8949 and 1040 Schedule D. List all cryptocurrency trades and sells onto Form 8949, along with the date you acquired the crypto, the date sold or traded, your proceeds (Fair Market Value), your cost basis, and your gain or loss. Once you have each trade listed, total them up at the bottom, and transfer this amount to your 1040 Schedule D. Include both of these forms with your yearly tax return. The good news is, if you experience a loss, you can use it to offset capital gains from other assets. Now that you understand how to file your taxes, let's discuss the actual rate of your capital gains tax.
You have short term and long term capital gains taxes, let's cover both and how to know which one will apply to you. The most common rate in the world of digital assets is the short-term capital gain which occurs when you hold a cryptocurrency for less than a year and sell the cryptocurrency at more than your cost basis. Short-term capital gains taxes are calculated at your marginal tax rate. On the other hand, if you’ve held your cryptocurrency for a year or more, you qualify for a lower long-term capital gains rate. The long-term rate is much lower and rewards investors if they hold, continuously, for a year or more. If you mine cryptocurrency, you will incur two separate taxable events. The first is as income from the USD value of the cryptos you mined, and the second is the capital gain or loss you incur when you sell or trade your mined coins. You report this income differently depending on whether or not you mined the crypto as a hobby or as a business entity. Lastly, lets cover how you will be taxed by participating in the Defi through borrowing and lending. Receiving interest income from a crypto loan or similar service is treated as a form of taxable income, similar to mining or staking rewards. This type of income should be reported under the “other income” section of line 21 of Schedule 1 — Additional Income and Adjustments to Income — as part of your income tax return.
A lot of investors are convinced that because of the decentralized aspect of blockchain technology, that there is no way for the government to see or know that they are making money with cryptocurrency. This is far from the truth. 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 just the beginning. I think it’s safe to assume that as more serious capital flows into this small and relatively new asset class, the IRS will make sure that they’re getting their piece of the pie. Figuring out an investor's activities on that particular blockchain comes down to associating a wallet address with a name. Choosing not to report your crypto transactions is not a wise 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.
Infact, just last week the IRS issued a $650,00,000 bounty to anyone who can hack Monero’s blockchain and Bitcoin’s Lightning Network. Like it’s competitors Dash and Z-Cash, Monero is in the category of what is defined as “privacy coins”. This means that the transactions on these kinds of blockchains are private and cannot be seen by the public. As you can imagine, this kind of blockchain attracts a lot of criminals who want to keep their transactions hidden from authorities. According to sources, the “IRS-CI is seeking a solution with one or more contractors to provide innovative solutions for tracing and attribution of privacy coins, such as expert tools, data, source code, algorithms, and software development services."
You now know the basics behind the ins and outs of how your digital assets are taxed. But you’re probably thinking to yourself, “That’s a lot of work that I don’t want to do!” The good news is that there are a lot of tax softwares that were designed to automate this process for you such as Zenledger, Tokentax, and Taxbit, just to name a few. All you do is connect the software to all the exchanges and wallets that you use and they will pull all of the data and even generate your tax forms for you. At that point you’ll probably want to bring in your CPA for assistance. As promised, now that everything's covered, I will explain how I think current tax laws will impact the digital asset sector moving forward.
To start, I am very passionate about the digital asset space and the implications it can have on individual sovereignty and connecting the global economy, so I really want to see it thrive. However, as we’ve seen with other technologies in the past, mainstream adoption won’t happen until it's easy to use for the laman and accepted by regulators. While crypto is becoming easier to use by the day, we still have a ways to go with regulators. I think I speak for the majority of people when I say I’m not going to use my cryptocurrencies for everyday purchases if I’m going to have to pay capital gains every time (I’ll just remain an investor). At this point, the work required to keep track of all my gains at the time of my purchase outweighs the convenience of using my crypto to make a purchase. Thankfully, people are taking action on this issue in an effort to create a de minimis tax exemption for day-to-day cryptocurrency purchases.
The Virtual Currency Tax Fairness Act of 2020, was published in early January of this year by Washington, D.C.-based crypto advocacy group Coin Center, and was introduced by Congresswoman Suzan Delbene of Washington and Congressman David Schweikert of Arizona. The argument was that charging capital gains on all transactions would hinder the use of cryptocurrencies in day-to-day transactions. The objective of the new bill is to exempt transactions involving cryptocurrencies if the calculated gain in question is below $200. Even if this bill is passed, I think we still have a ways to go, but it’s definitely a step in the right direction. As usual I’ll end this article with one of my favorite quotes as it pertains to this article, “What gets measured gets done”.