If you look closely at your most recent tax return, you may notice a question at the top of Form 1040, just below your name and address. The question asks, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
Simply put, the Internal Revenue Service (IRS) is asking if you own cryptocurrency.
This isn’t the first time the IRS has asked about cryptocurrency. In fact, the agency started asking about crypto on 2019 tax returns. However, on tax forms for the 2019 tax year, the question appeared on Schedule 1, where it was a little easier to overlook than it is now on the front page of your tax return.
This change isn’t just for appearance’s sake or because the IRS ran out of room on Schedule 1. It signals the IRS’s growing interest in catching taxpayers who aren’t reporting taxable cryptocurrency transactions. Which begs the question, how is cryptocurrency taxed?
How Cryptocurrency Transactions Are Taxed
Cryptocurrencies like Bitcoin, Ethereum, and others are often called virtual currencies, but they aren’t true currencies for tax purposes. IRS Notice 2014-21 states that the IRS considers cryptocurrency to be a capital asset, similar to shares of stock.
Like other capital gains and losses, gains can be short-term or long-term, depending on how long you held on to the cryptocurrency before selling or exchanging it.
- Short-Term. Short-term capital gains and losses result from sales or exchanges of cryptocurrencies that you held for less than one year (365 days). Short-term capital gains are taxed at your ordinary income rate — the same rate you pay on wages from a job or income from self employment. Ordinary income tax rates range from 10% to 37%, depending on your tax bracket.
- Long-Term. Long-term capital gains and losses result from sales or exchanges of cryptocurrencies that you held for one year (365 days) or longer. Any long-term capital gains from cryptocurrency transactions are taxed at lower long-term capital gains tax rates, ranging from 0% to 20%.
For example, say you bought one bitcoin (BTC) for $1 just for fun back in March of 2011. Currently, that one BTC is worth around $47,000, so you decide to sell it. You would have a taxable gain of $46,999 — your $47,000 sales price less your basis of $1. It’s a long-term gain because you owned the BTC for a year or more.
Now, let’s say you decide to take some of those profits and invest in another digital currency you think has a lot of potential.
You buy 10 Litecoin (LTC) at $200 each, investing a total of $2,000. Two weeks later, the price of Litecoin has fallen to $150, and you decide it wasn’t such a good investment after all, so you sell all 10 LTC. You have a capital loss of $500 ($2,000 basis minus the $1,500 sales price). It’s a short-term capital loss because you owned the shares for less than one year.
Tax Implications of Other Cryptocurrency Transactions
The above rules cover sales and exchanges of cryptocurrency. But what about when you receive cryptocurrency income?
One way to earn income from cryptocurrency is to engage in crypto mining. Mining is solving cryptographic equations with computers and receiving cryptocurrency as a reward for the work you complete.
If you earn cryptocurrency by mining it, it’s taxable income. As a result, you owe tax on the entire value of the cryptocurrency on the day you received it at your regular income tax rate. This essentially treats cryptocurrency income just like wages from a job.
Cryptocurrency Payments for Goods or Services
Many businesses now accept Bitcoin and other cryptocurrencies as payments for goods and services. So let’s say you’re a freelance designer and a friend asks you to design a logo for their business. Rather than pay you by cash, check, or credit card, they offer you $500 worth of Ethereum.
That payment counts as taxable income, just as if they’d paid via cash or credit card. You owe tax on the fair market value of the cryptocurrency on the day you receive it. The payment also counts as self-employment income, so you have to pay self-employment tax on it as well.
Exchanging One Cryptocurrency for Another
Crypto investors and crypto traders can also exchange or trade one type of cryptocurrency for another. This kind of transaction also creates a capital gain or loss. For example, say you have $1,000 worth of Bitcoin and want to trade it for $1,000 worth of Litecoin. If you originally paid $500 for the Bitcoin, you have to recognize and pay taxes on a $500 capital gain when you exchange it.
The Trouble With Crypto’s Tax Treatment
If you buy cryptocurrency and hold onto it, or have very few transactions, then tracking your capital gains and losses isn’t too complicated. However, things get really complex when you load your cryptocurrency onto a crypto debit card or have multiple currencies spread across several crypto wallets and exchanges.
For example, say you purchase 1 ethereum (ETH) for $1,000 and load it onto a crypto debit card. For the next month, you use the card around town to purchase a cup of coffee for $3, put $30 of gas in your car, spend $150 online shopping, $60 on dinner out, and so on.
Because the IRS treats cryptocurrency as a capital asset rather than a true currency, you have taxable events every time you swipe that card.
Reporting Cryptocurrency Transactions: An Example
So let’s say Ethereum was worth $1100 per coin on the day you bought the coffee. Technically, you sold 0.0027 Ethereum coins ($3 divided by the $1100 price per coin) to pay for your cup of coffee. On your tax return, you would have a short-term capital gain of $0.30.
That’s your $3.00 of “proceeds” — which you used to buy the coffee — minus your $2.70 basis in the 0.0027 shares of Ethereum.
The tax liability on that transaction alone won’t amount to much, but imagine if you had hundreds or thousands of tiny crypto transactions each year. Then, the tax bill (and tax reporting headache) could add up quickly.
Maybe you’re thinking, “No problem, I’ll just print out a report from my cryptocurrency exchange.”
True, the major crypto exchanges like Coinbase and others provide some sort of transaction report — usually available as an Excel worksheet or PDF file. The trouble is most reports don’t include all of the information you need to report taxable transactions.
They might show the date you purchased or sold crypto assets and the transaction amount, but if you transferred the cryptocurrency from another exchange, it wouldn’t have information on your cost basis.
Also, if you’re holding crypto in a cryptocurrency wallet, you might not even be able to get a report of all transactions into and out of the wallet during the year. Instead, you might have to manually track transfers to and from the wallet on a spreadsheet or subscribe to a crypto tracking solution like Coin Market Manager or Kubera.
IRS Interest in Crypto Tax Reporting
The IRS believes only a fraction of people earning, selling, and trading cryptocurrencies properly report those transactions on their tax returns.
According to an affidavit from IRS agent David Utzke, the agency searched its database to see how many taxpayers reported cryptocurrency transactions from 2013 through 2015. They found that only around 800 taxpayers reported capital gains or losses from crypto each year.
When you consider that Coinbase had roughly two million verified users in 2015 and 56 million verified users as of the first quarter of 2021, it’s easy to see why the IRS is making taxing cryptocurrency gains a priority.
So back to that virtual currency question at the top of your tax return. Moving that question to the front of Form 1040 was no accident.
If you checked the “no” box for this question when you did, in fact, sell or exchange cryptocurrency, the IRS could consider that tax evasion, and you could face harsher penalties if the IRS uncovers your omission.
And there’s a good chance the IRS will discover people who are avoiding reporting cryptocurrency transactions. In the past few years, the IRS sent “John Doe” summonses to several major crypto exchanges, including Coinbase, Circle Internet Financial, Inc., and Kraken.
These summonses allow the IRS to obtain information about account holders, including their name, taxpayer identification number, date of birth, address, and record of all account activity.
In March 2021, the IRS even gave their enforcement efforts a name: “Operation Hidden Treasure.” This is a joint effort between the IRS’s Office of Fraud Enforcement and its Criminal Investigation Division, and its goal is to search for unreported cryptocurrency income using sophisticated data analytics.
For now, the IRS is encouraging voluntary compliance. So if you’re engaging in crypto transactions and not reporting them, it’s a good idea to get ahead of it.
Tracking the ins and outs of crypto transactions on your own can be challenging. So work with a CPA or other qualified tax professional with knowledge and experience in cryptocurrency tax rules. They may have preferred cryptocurrency tracking software to ensure you have all of the information needed to properly report taxable transactions on your tax return.