The number of people holding cryptocurrencies and NFTs hits new heights every day. More people got into crypto in the last year than they ever did. In 2021, there were said to be 300 million crypto users worldwide, with 18,000 businesses accepting payments in crypto.
8.31% of the US population holds assets in crypto. That comes around to 27 million people! The majority of the owners of crypto are in the age bracket of 18-44. So, largely they are owned by the young, the educated, and the tech-savvy. Since this age group is determined and futuristic, the government has done away with any attempts at a total ban of crypto. They have now decided to take crypto in their stride. It makes complete sense if the government wants a piece of the pie that will only increase in the years to come.
IRS’ take on cryptocurrency
The IRS states that transactions in virtual currency are taxable by law just like any other property. They define virtual currency as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value”. Cryptocurrency is a subset of virtual currency in the sense that it utilizes cryptography to validate its transactions.
Convertible virtual currencies are those that have an equivalent value in real currency. Bitcoin is one such convertible virtual currency. It can be digitally traded for USD, Euros, or other virtual and real currencies.
What does the IRS consider as cryptocurrency transactions for the purpose of taxation?
If crypto is purchased with fiat currency and simply stored in a wallet, then it will not be considered a transaction by the IRS.
Trading is the most prominent use-case scenario of cryptocurrency, and this is where the IRS cashes in.
Trading in crypto attracts a capital gains tax by the IRS. The period for which it is held is referred to as the “holding period”. It begins on the day after the purchase is made, and ends on the day the sale or trade is made.
For example- if you purchased Bitcoin on April 1, 2021, and sold it on April 5, 2021, then the holding period would be 4 days i.e. April 2, 3, 4, 5. April 1 would not be counted as counting begins after the purchase is made.
If the currency was held for a year or less, then it would attract a short-term capital gains tax. If it was held for more than one year before selling or trading it, then it will attract a long-term capital gain tax. Short-term gains are taxed from 10% up to 37% and long-term gains can be taxed at 0%, 15%, 20% depending on taxable income.
The gain or the loss is determined by the difference between the adjusted basis (also known as cost basis, and includes fees, commissions, and acquisition costs) in the virtual currency and the amount received in exchange for the virtual currency. If sold at a loss, then just like selling any other investment at a loss, it could be used to offset other income taxes.
If crypto is earned by mining, or as a promotion, it is considered as a part of regular income. Tax will be owed on the fair market value on the day it is received, at the regular income tax rate of the receiver.
When it comes to staking, there are no specific instructions by the IRS.
In 2021, couple Joshua and Jessica Jarrett filed a lawsuit claiming that staking coins are not taxable until and unless they are traded. They sought $3,200 in refund for the taxes they paid on staking rewards. The IRS conceded. But, neither did the IRS nor did any of the courts put on paper that staking rewards will not be taxed in the future. Regardless of the lack of concrete proof, this is being seen as a precedent and crypto enthusiasts are hopeful that the IRS will not tax staking rewards in the future.
As of now, since staking involves only the creation of a new property, it is taxed when it is sold or traded, and not at the time of discovery/receipt.
Cryptocurrency received in exchange for rendering professional services is also considered as income. If it was received due to services as an independent contractor, then it is included in self-employment income.
Here are some scenarios wherein one gets cryptos, apart from trading and earning.
- Sometimes cryptocurrencies go through something termed as “hard fork”. It is essentially a change in the crypto network’s protocol. This may cause the creation of a new cryptocurrency that is “airdropped” to the user. This airdropped crypto is also taxable based on which tax year the airdrop was received.
- If the virtual currency was received as a bona fide gift, then the income for that will be realized only when it will be traded or sold, and that is when taxes will also apply. The holding period for such a trade will include the holding period of the giver of the bona fide gift as well.
In a nutshell, taxable events include – selling crypto for fiat money, trading crypto for crypto, using crypto for purchase or sale of goods.
Non-taxable events include – buying crypto with fiat currency, donating to a tax-exempt organization, gifting crypto if the value is less than $15,000, transferring from one wallet to another provided the owner is the same.
Filing and reporting cryptocurrency
The only case wherein you don’t have to report crypto is when it is purchased with a fiat currency like USD. For every other transaction, the IRS suggests that a record be kept for ease during filing. It should include how much was paid, how much was sold, what the holding period was, etc.
The forms to be filed depend on the transaction done.
- Form 1040 should be used to report crypto received as ordinary income. It has the question”At any time during 2021, did you receive, sell, exchange or otherwise dispose of any financial interest in any virtual currency?”.If the only transaction that had been done was the purchase of crypto using fiat money, then “NO” needs to be checked. If trading was done, then “YES”.
- Form 8949 should be used to report sales and capital transactions that involve crypto as an investment. It should contain details like the number of coins bought/sold, the date of buying/selling, and the gain/loss for each transaction. It provides evidence for net capital gain/loss that will be reported later. Separate 8949 forms are required for those reported on Form 1099-B and those not reported on Form 1099-B.
Form 8949 has separate sections for long-term and short-term as well.
- A Form 1099-B is provided by crypto exchanges to report crypto transactions. It is sent to the trader as well as the IRS. But not all exchanges send them out.
- Schedule D to report total capital gains and losses. Details on all the Form 8949 need to add up to the details being furnished in schedule D.
- Schedule 1 needs to be filed if crypto mining is considered a hobby by the taxpayer. Self-employment tax will not be owed here, but there is a limit on what can be deducted as expenses.
- Schedule C is to be filed if the filer runs a crypto-mining business. Self-employment taxes may also be included in the picture here.
Some tax tips for cryptocurrency
- Hold crypto assets for the long term. This could reduce the tax rate by going from 37% for short-term gains to 20% maximum for long-term gains.
- Use a traditional or Roth IRA to invest in crypto. Investment gains can be deferred or avoided entirely. The process to open a crypto-IRA is still complex, but there are boutique firms that offer this service.
- Keep track. Always. Every month. Do not wait until the last moment to get everything in order. Make sure that the paperwork is in place whenever there is a transaction involving cryptocurrency, whether it is receiving crypto as payment or executing a trade. Software like Koinly can be used to keep track as well
- Use the gains to offset losses on other investments and vice versa. Use it like you would any other investment. Up to $3,000 can be used to offset any gains. Unused losses can also be carried forward to offset future investment gains.
If the taxpayer is a crypto miner, then the income can be used to offset expenses on computers, electricity, servers, ISP charges, etc.
- Use a professional service like a CFO consulting service when filing returns so that the correct forms are filed. Keep in mind the filing status as well. Especially if the taxpayer is involved in mining and Defi transactions, then it is recommended to take the help of a CFO.
What does the future hold for crypto taxation?
A bill has been reintroduced in the US House of Representatives that would exempt taxpayers from paying taxes on crypto payments worth less than $200. It aims to reduce tax liabilities for daily crypto users who presently need to report even small capital gains.
2023 onwards, crypto brokers such as Coinbase are required to record transactions the way stock and bond brokers do. Names, addresses, phone numbers, gross proceeds will have to be disclosed. Businesses receiving payment of $10,000 or more in crypto will need to report the identity of the payer to the government to address the issue of money laundering.
There is a huge difference between what crypto was when it first started, and where it is now. Hence, the way it is being treated by the government is also different. Reporting and taxation of crypto are being watched very closely by the IRS. If taxable crypto is not reported, then the taxpayer risks facing an audit and incurring penalties or charges.