The explosive growth in cryptocurrency is naturally followed by an equal need to understand the tax implications of cryptocurrency transactions. As many people don’t seem to understand exactly what cryptocurrencies are, likewise few seem to have a handle on the tax implications of crypto transactions.
For many people, the taxation of these assets is as mysterious as the assets themselves.
The first cryptocurrency, Bitcoin, came into being in 2009 and is coming up on its teenage years. Lest we find our crypto transactions as unruly as teenagers are alleged to be, a brief primer on their taxation is in order. The Internal Revenue Service (IRS) offers guidance through IRS Notice 2014-21. Here is a top-level view of the taxation of these increasingly popular assets.
Treatment as Property
The IRS considers cryptocurrency to be property for tax purposes. As with other property, you recognize gain or loss on the sale or exchange of cryptocurrency for cash or another property. There are some positives, as well as some negatives, for crypto investors.
If you sell or exchange crypto that you have held for over one year, it is a long-term capital gain and currently receives favorable tax treatment.
If you sell or exchange crypto that you have held for one year or less, it is a short-term gain, which is treated as ordinary income for tax purposes. You do not get favorable tax treatment for short-term gains.
There is still a little silver lining: You can net these gains as you would other gains, using losses to offset your gains. You are still limited to a net total loss of $3,000 for any tax year; losses in excess of that amount cannot be used to offset other income and need to be carried forward.
In the evolving world of crypto taxation, specific identification remained for a time the much-hoped-for yet much-missing piece.
Many people are familiar with specific identification from their stock transactions. You can use specific identification to deem the sale of whatever shares of a particular stock best suits your tax needs. You do not have to do “first in first out” or “last in last out.”
Instead, you can select the ones most to your liking — generally those with the highest cost basis and therefore the lowest taxable gain.
Though specific identification did not come in Notice 2014-21, the IRS, through its FAQ section, does provide guidance that specific identification can be used. To use specific identification, the taxpayer needs to have detailed records to support the identification of the units; most crypto tax software should be able to handle this recordkeeping for you.
No Like-Kind Exchanges
Coin-to-coin exchanges are not eligible for preferential section 1031 like-kind exchange treatment. Though this was doubtful before, the Tax Cuts and Jobs Act of 2017 made this explicit.
To be clear on what this means: If you exchange your crypto for another crypto, it is a potentially taxable event. If you had gain or loss in your original crypto, you need to recognize that gain at the time of the exchange; the basis does not transfer to the new coin. You cannot exchange one coin for another coin and defer the taxation.
Income Is Income
If you receive payment in the form of crypto, it is taxable as if it were received in cash. For example, if an employer pays your wages to you in cryptocurrency, it is taxable just as if they had paid you in cash on that date.
It’s the same if you are self-employed: If you receive self-employment income in crypto, it is no different than if you received it in cash from a tax standpoint. You receive the dollar equivalent as income on that date, and that dollar equivalent becomes the basis in your crypto asset if you hold the crypto you received as payment for your goods or services.
You cannot escape or postpone the recognition of income by receiving it in the form of cryptocurrency.
The basics of crypto taxation are not overly complex or difficult. There are, however, practical considerations for users of crypto.
If you are going to be making frequent payments or exchanges of crypto, it is important to make sure you are using tax software that captures your transactions and can do the calculations for you. Using crypto to buy your morning coffee every day could result in many transactions; you might not be keen on doing that all by hand.
It is also important to understand that making many trades chasing crypto prices also generates potentially taxable transactions.
Active traders of crypto can create a sizable volume of transactions, each with potential tax consequences. Taxes, as always, should not be the reason to make or not make a trade, but they are a factor and should be given consideration.
The Bottom Line
The markets giveth and the IRS taketh, and that holds true for crypto as well. As with other assets, there is no free lunch: If you make profitable gains with crypto, the government will be there for its share, just like any other time you make a gain.
The key for individual taxpayers is to know the rules, so as to avoid unnecessary taxation. Sometimes it might be better to use another form of payment for a latte, and not create a taxable event where you don’t need to make one.
And be real careful to understand the tax implications of making large purchases with appreciated crypto assets. Big gains can mean big taxes.
The world of cryptocurrency continues to evolve. The IRS taxation of crypto is by no means onerous or more complex than other property. Many people may not know that each crypto transaction is a potentially taxable event. This isn’t a reason to not use crypto, but it is a reason to use it in a knowledgeable and responsible manner.