How Are Cryptocurrencies Taxed?
The past year has seen a huge surge in the popularity of cryptocurrencies. Everybody and his brother are looking to make a quick buck by buying new cryptos for pennies and selling them for dollars.
As the income comes pouring in, so do tons of tax-related questions, such as: “Do you need to pay taxes on cryptocurrencies?,” “Are there any cryptocurrency taxes in the U.S.?,” “Who needs to pay taxes on cryptocurrencies?,” “How are cryptocurrencies taxed?,” and “Who do I pay taxes to?”
We’ll answer all of these questions and and more, and provide specific details like how to pay your Bitcoin tax.
Cryptocurrency Taxes in the U.S.
In 2014, the Internal Revenue Service (IRS) issued guidance to taxpayers, making it clear that virtual currency will be treated as a capital asset and that capital gains rules will apply to any gains or losses.
Simple, right? Wrong; taxes are rarely simple.
The IRS notes that any digital currency that has a value equivalent to real currency, or that acts as a substitute for real currency, is referred to as “convertible” virtual currency. Bitcoin is one example of a convertible virtual currency because it can be purchased for—or exchanged into—U.S. dollars, euros, or other real or virtual currencies. Hence, Bitcoin tax has to be paid.
For U.S. tax purposes, all transactions done in virtual currency must be reported in U.S. dollars. (Source: “Notice 2014-21,” Internal Revenue Service, last accessed March 8, 2018.)
And yes, All taxes must be paid in fiat currency.
Frequently Asked Questions on Cryptocurrency Taxes
Q: Who needs to pay taxes on cryptocurrencies?
A: Only people who have sold their digital currency, or have used it to buy something else, have to pay taxes. The IRS doesn’t tax cryptocurrency holdings that have simply increased in value.
People who mine cryptocurrencies also have to pay taxes on the mined currencies. Also, although the IRS is still not completely clear on the forking issue, people who got coins from the Bitcoin fork in August 2017 will have to pay taxes.
Q: How to Pay Your Cryptocurrency Tax?
A: First you have to create a record of all of your cryptocurrency transactions. You can download a history of your transactions as comma-separated values (CVS) files from the publicly available blockchain transaction history.
Some cryptocurrency exchanges will send you a 1099 Form if you sold a minimum of $20,000 in cryptocurrency over a minimum of 200 separate transactions.
Next you’ll need to calculate how much each transaction was worth in U.S. dollars at the time of sale. While this is not an easy task, there are several web sites that show the value of cryptocurrencies on any given day in the past.
Once you have the correct dollar value of all your transactions, you pay tax on the total value. (Source: “What you need to know about cryptocurrencies and taxes,” Lifehacker, January 29, 2018.)
Note: There are certain web sites like Bitcoin.Tax and CoinTracking.Info that will do all the math and tell you how much you owe in taxes. All you have to do is upload your CSV files (and other relevant information) to these sites and they’ll do the work. The former offers free service up to 100 transactions and the latter offers free service up to 200 transactions.
Q: How do taxes on cryptocurrencies work?
A: All of the following three types of transactions are taxable:
- Exchanging cryptocurrency for fiat currency like U.S. dollars.
- Exchanging one cryptocurrency for another.
- Using a cryptocurrency to purchase goods or services.
For points 2 and 3, you have to calculate the fair market value in U.S. dollars at the time of the trade. For point 3, you may also end up owing sales tax.
However, you do not need to pay taxes on the following:
- Giving cryptocurrency as a gift (unless you exceed the gift tax exemption amount). The recipient inherits the cost basis).
- Transferring from one cryptocurrency wallet to another, transferring from a cryptocurrency exchange to a wallet, or transferring from a wallet to an exchange.
- Buying cryptocurrency with U.S dollars. You don’t realize gains until you trade, use, or sell your cryptocurrency.
(Source: “The Basics of Cryptocurrencies and Taxes,” CryptoCurrency Facts, last accessed March 8, 2018.)
Note: If you if you hold on to your cryptocurrency for less than a year, you realize short-term capital gains and losses. If you hold on to it longer than a year, you can realize long-term capital gains.
Q: How to pay your Bitcoin tax?
A: The same rules apply for Bitcoin or any other cryptocurrency. According to Uncle Sam, Bitcoin is not currency; it is property. That means, whenever you buy something with Bitcoin, it is two transactions because what you are doing is selling property for a cash value and then using money from that sale to buy a product.
There is even tax on Bitcoin mining.
The following table will give you a clearer picture of the Bitcoin taxes owed, based on various factors.
|Method Obtained||Duration Held||How to Report||Additional Taxes|
|Received for Services||Not Applicable||Ordinary Income||State Income Tax|
|Bought for Investment||Less than a Year||Ordinary Income||State Income Tax|
|Bought for Investment||More than a Year||Capital Gain||3.8% for Top Three Tax Brackets|
|Mined||Not Applicable||Ordinary Income||Self-Employment Tax Where Applicable|
|Bitcoin Fork||Not Applicable||Ordinary Income||To Be Announced|
Tax for Cryptocurrencies on “HODL”
“HODL” is nothing but “hold” misspelled, but ,for some reason, the bad spelling caught on and it came to mean “hold on for dear life.” Nevertheless, cryptocurrency taxes have to be paid.
Let’s say you have held onto Bitcoin as an investment and want to cash out. If you held the Bitcoin for less than a year, you will be taxed on income, but if you held it for over a year, be ready to shell out 20% of what you gained.
Tax on Airdrops
An “airdrop” is a form of cryptocurrency distribution in which the coins or shares are given out for free to a specific subset of future owners. These coins will be given out to anyone holding that particular cryptocurrency in a private wallet or enabled exchange.
This becomes a serious problem if you have no interest in these coins, since you could be expected to claim a taxable property gain on a coin you didn’t want.
If the price of these airdropped coins goes to zero, all holders will have had a realized taxable gain when they acquired the coin and nothing to show for it. In other words, whether the users claimed their coins or not, they could end up with nothing and big tax bills on their initial property “gains.”
Short-Term Gains vs. Long-Term Gains
If you have sold a digital asset this year and have made a gain, the tax on short-term gains (less than one year) can be as high as 39.6%. You may also be subject to state taxes of anywhere between three percent and 13%.
Tax on long-term gains (assets held for at least one year plus one day) are decidedly lower. How low? It’s difficult to tell for sure, but the tax rates range from zero to about 20%.
Thanks to the recent cryptocurrency revolution, the pace of initial coin offerings (ICOs) has been feverish. Before jumping into an ICO, it’s important to understand the various tax implications.
While the tax regulations surrounding virtual currencies continue to evolve, the IRS has maintained that virtual currencies are considered property and that general taxation regulations apply to ICOs
Many companies that pursue ICOs structure their distributions in such a way that a portion of tokens are distributed to employees, advisors, and/or board members.
Such distributions are taxed as compensation by the IRS. The potential tax liabilities to both the company and the individuals to whom the tokens are distributed depend on the size of the distributions. They could be significant, and there could be penalties of as much as 15% if taxes are not paid on time.
Tax Liability on Swapping Cryptocurrency
Just as you have to pay tax on purchasing goods and services with a cryptocurrency, there is a tax liability on swapping a cryptocurrency.
You might ask, “Hey, isn’t there a tax rule that allows like-for-like property exchanges to be tax-free?”
There is. According to Section 1031 of the IRS tax code, in some cases, exchanging one kind of property for another can be a non-taxed event. Swapping cryptocurrencies, however, does not fall under those “some cases.”
Under the tax code, as it stands, cryptocurrency swaps will almost certainly be regarded as sales and be taxed as such. In fact, to rule out any ambiguity, the House and the Senate are both currently calling for the restriction of Section 1031 swaps to only apply to real estate.
Tax on Foreign Holdings
If you think you can get away from paying taxes on foreign assets, think again. There used to be a loophole for exchanges between cryptocurrencies by classifying them as like-kind exchanges. This is no longer the case.
So, how are cryptocurrencies taxed now?
Foreign assets that have a value of more than $10,000 have to be declared—even if these assets are being held in cryptocurrency wallets or exchanges that are not on U.S. soil. Non-U.S. holdings need to be reported to the Treasury using FinCEN Form 114. Or they could be reported directly to the IRS via Form 8938.
Tax Exemptions on Cryptocurrencies
Digital assets like Bitcoin and Ethereum are great for non-cash charitable contributions. For example, if you buy $1,000 worth of Ethereum and it appreciates to $10,000, you can give the cryptocurrency to a charity and claim a $10,000 charitable tax deduction and avoid paying tax on the $9,000 capital gain.
However, if you sell the Ethereum and give the U.S. dollars as a donation, you will not receive the same tax benefit. Ethereum must be gifted directly, since selling it would trigger a tax on the gains.
The IRS is determined to make sure that people pay what they owe. The agency has noticed that there is a disparity between tax returns and the growing cryptocurrency craze, and they are doing everything to close the gap. Last month, a federal judge in San Francisco directed Coinbase to give the IRS information about users who made more than $20,000 in annual transactions in recent years.
So, if you’re jumping into the cryptocurrency maelstrom, make sure you stay in the good books of the IRS.