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Cryptocurrency and Taxes – What You Need to Know

Legal Assistant Administrative Law, Business Law, Regulatory Law, Resources, Tax Law

2021 was a great year for cryptocurrency. It saw many first-time investors buying in, most of whom began investing in the last nine months or so. The market recorded several all-time highs and lows throughout the year, resulting in massive profits and losses in equal measure for many investors.

If you’re part of this new crop of investors who got into crypto this past year, one of the questions on your mind this tax season is: Is cryptocurrency taxed, and how does it work? Here’s everything you need to know.

Do You Pay Taxes on Crypto?

Is crypto taxable? The short answer is – yes, Uncle Sam needs you to pay up. According to the IRS, crypto assets are a form of property. Bitcoin, Ethereum, and other forms of cryptocurrency are all taxable.

If you’re a taxpayer and have been trading in crypto, you need to pay taxes on any gains you derive from it. If you haven’t been doing so, it effectively means that you’ve not been complying with the existing IRS regulations, the consequences of which could inevitably catch up with you someday. The only way to avoid getting penalized by the federal agency would be by proving “reasonable cause.”

The fact that the IRS categorizes cryptocurrency as property is nothing new. This classification of crypto assets has been in effect since 2014. The federal tax code requires taxpayers to report the equivalent dollar value of all transactions involving virtual currency on their tax returns.

Virtual Currency Meaning

The IRS defines a virtual currency as the digital representation of value that works as a store of value, unit of account, and/or a medium of exchange. Cryptocurrency is considered a type of virtual currency that relies on cryptography technology to secure and validate each transaction before being recorded digitally on a distributed public ledger. A great example of a distributed ledger would be blockchain.

Convertible virtual currency is a virtual currency that acts as a substitute for fiat currency or has an equivalent value in fiat currency. Bitcoin is one such example of what would be considered convertible virtual currency. Users can trade with it, purchase it using US dollars and other fiat or virtual currencies, and convert it into US dollars and other fiat or virtual currencies.

When reporting transactions involving virtual currency on your tax returns, you need to determine what its fair market value is on the date you transact. To do this, you need to convert the currency into its US dollar equivalent or into any other currency that you can convert into US dollars.

Keep in mind that the prevailing exchange rate will be determined by the market demand and supply.

Do You Need to Back-Date Your Taxes?

The short answer is—yes, you do. Remember, the IRS classified crypto assets as property in 2014. It essentially means that if you’re a US taxpayer who’s held cryptocurrency since 2014, you’re effectively on the hook for all transactions dating back to that year.

Moreover, the IRS has since sent out notices to taxpayers involved in crypto transactions, letting them know that they are required to file amended returns and remit back taxes. Form 1040 – Individual Income Tax Return now includes a phrase that asks taxpayers whether they received, sold, sent, exchanged, or otherwise disposed of any financial asset in virtual currency in 2021. This removes any confusion as to whether cryptocurrency is taxed. If your answer to that question is “Yes,” the IRS expects you to report it on your return.

Are All Cryptocurrencies a Capital Asset?

The first question you need to ask is: What is a capital asset? Suppose you are moving out of state and, as a result, end up selling your home and cashing in a profit. Suppose you own some stocks and sell them at a higher price than what you bought them at, making a profit in the process. Those properties, i.e., your home and your stocks, would be considered capital assets.

A capital asset is defined as any property or item you hold for personal or investment purposes. When you sell a capital asset, it either earns you a capital gain or capital loss, depending on the prevailing market rates.

Virtual currencies work the same way. You’re required to pay either long-term or short-term capital gains on them. If you’ve held the crypto-assets for less than a year, they would be taxed in the same way normal income would. If you’ve held them for longer, you would report the gains or losses on Schedule D.

How Is Crypto Taxed?

To calculate capital gains taxes on crypto trading, you take the amount you initially paid for the currency (cost basis) and calculate how much the value has increased or decreased since the date you paid for it. The applicable cryptocurrency tax rate for crypto gains tax can be 0%, 15%, or 20%, depending on what constitutes your taxable income.

If you sell property or an item as part of a trade or business transaction, the property in question is not considered a capital asset. As a result, it will be taxed as ordinary income. This same rule applies to the sale of virtual currency. The IRS considers the intent behind the sale to determine the “character” of the capital gains or losses.

Do I Need to File Form 8949?

As stated earlier, any short-term capital gain for crypto assets that you sell will be taxed as ordinary income based on the current IRS income tax brackets. To reconcile your capital gains and losses, you’ll need to use IRS Form 8949 to do so before reporting them on Form 1040 using Schedule D.

If you’re a Non-Fungible Token hobbyist or investor, you can also report your NFT trades and NFT minting gain or loss on Schedule D as well. Ensure you input “C” in column (f). By doing this, you’re telling the IRS that you sold an NFT. That way, the agency knows to treat it as a collectible.

The IRS website has several resources you can use to help you figure out what your cryptocurrency-related tax liability is and the right way to report it on the agency’s website. If you’re dealing with large amounts of money, consider hiring a crypto CPA to file the tax returns for you.

When Should I Report Cryptocurrency Trades on My Tax Return?

A person holding a Bitcoin
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Below is a list of the three potential scenarios when you’re required to report cryptocurrency transactions on your tax return.

1. When You Purchase Cryptocurrency Using Dollars

If you buy virtual currency using US dollars and keep it in the crypto exchange you used to purchase it or transfer it to your crypto wallet, you won’t owe any taxes on it at the end of the financial year. If the only activity you engaged in was buying cryptocurrency with US dollars, you don’t need to report this transaction to the IRS as per the guidance listed on Form 1040

2. When Trading Cryptocurrency

If you use crypto assets as a medium of exchange, that’s the point at which your income becomes taxable. Activities that fall in the realm of trading cryptocurrency include paying for commodities using crypto, exchanging one crypto asset for another – for instance, purchasing Bitcoin using Ethereum, or selling your crypto asset for its equivalent in US dollars.

A taxable transaction occurs anytime you exchange one investment for another or sell the asset entirely. If you engage in a lot of trading, ensure that you keep track of and log every trade you make since each of them constitutes a taxable event.

3. When Minting or Trading Non-Fungible Tokens

Non-fungible tokens, or NFTs for short, are tokens created on a blockchain proving that you have sole ownership of a single, unique digital item. An NFT could be anything from an animated, flying-saucer shaped like a samurai sword to a digital collectible item. NFTs can be purchased and sold on popular digital marketplaces like SuperRare and OpenSea.

Just like cryptocurrency, NFTs are taxed. Navigating the tax guidelines surrounding them can be quite confusing since the IRS has not provided any tax guidance on them. The tax implications of a particular NFT depend on whether you’re an NFT investor or creator and the frequency and extent to which you interact with them (i.e., as a hobby or a business).

Identifying the taxable events when minting or creating NFTs and how they are taxed is an important piece of the puzzle. An example of this would be if you paid gas fees to mint a specific NFT. This constitutes a taxable transaction.

NFT hobbyists can report income but cannot claim business-related expenses as a tax deduction. On the other hand, if you’re minting NFTs as part of your business, you can claim any business-related expense as a tax deduction.

If you decided to sell your NFT to purchase crypto or exchange it for another NFT, that transaction would trigger a taxable event and would be taxed as part of your income.

How to Report Cryptocurrency Income

Some individuals and entities receive payment for services in the form of virtual currency. This mode of exchange means that their income would be in the form of crypto as opposed to cash, mining new coins to earn Bitcoin, or receiving rewards for certain activities in the form of coins of tokens (such as the Earn Rewards Program run by Coinbase).

Regardless of the method used to earn it, the crypto asset’s value in US dollars at the point of receipt needs to be recorded. That’s the income value you’ll report on your tax return. For instance, suppose a customer pays you one Bitcoin for services rendered.

You’ll need to record that asset’s Fair Market Value (FMV) as soon as you receive it. For instance, if the FMV of one Bitcoin is $41,000, you’ll need to indicate $41,000 worth of revenue as personal income.

According to the IRS, any taxpayer who receives payment in the form of virtual currency for goods sold or services rendered needs to include the FMV of the virtual currency when calculating the gross income. This value needs to be recorded on the date they received the currency.

The FMV you capture will stick to that coin, and that’s what will be used as the cost basis. Likewise, if you later use the cryptocurrency you earned to purchase something else, the IRS requires that you reconcile that cost basis you recorded earlier with the current value when using it to pay for commodities.

How to Keep Track of Your Crypto Activity

One of the key things to keep in mind when trading or transacting in cryptocurrency is that you’re responsible for keeping track of all your taxable events and the FMV of your crypto assets throughout the lifetime of those events. While it’s easy for anyone to get into the crypto space, keeping track of the cost basis and ensuring you’re doing it the right way is where things can start to get a little dicey.

Depending on the exchange you’re using, you might be issued with a Form 1099-B to help you figure out what your crypto gains and losses are, although this approach isn’t that common. Ultimately, you’ll need to come up with a system that helps you track your currency’s FMV and taxable events.

The good news is—President Biden signed into law the bipartisan infrastructure bill that makes it mandatory for crypto exchanges to issue Form 1099-B. It means that from the 2023 tax year, exchanges will be notifying the IRS directly of taxpayers’ cryptocurrency transactions. That said, don’t expect any 1099-B forms for the 2021 and 2022 tax years.

To easily track your crypto transactions, the best thing to do would be to leave your crypto assets in your wallet. That way, you can generate reports about all your transactions. It’s easy to see how you might have a hard time keeping track of your taxable events if you keep moving your assets between different private wallets or if you have them stored in different places. Consider working with a crypto CPA if you’re conducting complex cryptocurrency transactions.