Cryptocurrency: Virtual Investments Have Real Tax Consequences
Trading in virtual currency, or cryptocurrency, is definitely on the rise. Prices have skyrocketed, which has investors taking notice. For example, in August 2015, the Ethereum price was around $1.25 USD; in June 2021, that price reached nearly $2,900. Any time a type of financial transaction starts occurring regularly, or with increased frequency, you can also count on the IRS to take notice. It is essential for taxpayers to understand when these transactions create reportable income or, possibly, foreign account reporting requirements.
While cryptocurrency itself is virtual, the resulting tax liabilities are most assuredly actual.
According to the IRS, virtual currency, or cryptocurrency, “is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Although their virtual nature may make these transactions feel as though they occur somewhat “under the radar,” that is not the case. Transactions made with cryptocurrency are not verified by a bank or government authority but, instead, are published in a digitized ledger called a “blockchain.” Platforms such as Coinbase are used to exchange Bitcoin into U.S. dollars and are also no stranger to the watchful eye of the IRS.
The IRS started asking 1040-filers about virtual currency transactions in 2019. According to the Wall Street Journal, of the millions of individuals who own cryptocurrency in the U.S., the number of taxpayers that claimed those transactions on their 2019 tax year tax returns was likely fewer than 150,000. In 2020, the IRS moved the question front and center on Form 1040 to immediately follow taxpayer’s name and address.
For tax purposes, the IRS considers cryptocurrency property.
The general tax principles used to account for property transactions also apply to the exchange of cryptocurrency. Just as you do for other capital assets, you must track your basis and record the sale or exchange as a capital gain or loss at disposition. As with stock trades, you may fully offset capital losses with capital gains. Additionally, a net capital loss is limited to $3,000 against your other types of income, and an excess capital loss is carried forward to the subsequent tax year.
Because cryptocurrency is taxed the same way as property, trades of the coin-to-coin variety are also taxable events. If you trade Bitcoin to Ethereum, for example, the same capital gains and losses rules apply.
When acquiring and selling cryptocurrencies, timing matters if you want to lower your tax liability.
The way the cryptocurrency is acquired determines whether it is a taxable event. The way the sale or the use of cryptocurrency to purchase goods or services is recognized depends on timing. For example, if you purchased a single Bitcoin in January 2021 for $32k and sold it in June 2021 for $33k, you will be taxed for a short-term capital gain of $1,000 based on your income tax bracket in 2021, which could be anywhere from 10% to 37%.
If, on the other hand, you mined a single Bitcoin in 2013 at a market price of $1k and sold it in 2021 for $33k, you would have to report the $1k in taxable income on your 2013 tax return and a long-term capital gain of $32k (sale price minus basis) on your 2021 return. Depending on your taxable income for 2021, the long-term capital gain would be taxed at a rate of 0%, 15%, or 20%. Because the tax rate on your long-term gains is based on your taxable income, you can also lower your tax liability by planning to sell in years of lower income.
If you receive cryptocurrency as payment for goods or services, you must include the fair market value as of the date received in your gross income. If you pay an employee or independent contractor in cryptocurrency, it must be reported on the employee’s W-2 or independent contractor’s 1099. That income will be taxed at the same rate the taxpayer’s other income is subject to, based on tax bracket and self-employment status.
Tax law associated with trading in cryptocurrency is continually evolving, and the tax implications vary from transaction to transaction.
In the future, your transactions may trigger Foreign Bank and Financial Accounts (FBAR) reporting requirements under FinCEN regulations as well. With proper guidance and planning, you can remain in compliance while minimizing your tax exposure.
L&H provides comprehensive tax, accounting, and consulting services to individuals, families, and businesses. My team can help you secure your future by assisting you in making informed investment decisions and submitting compliant filings. If you are thinking about investing, or have already invested, in cryptocurrency, contact me today to make a strategic tax plan.
by Steven J. Haynes, MBA
Steven Haynes, MBA, is an administrative partner at Livingston & Haynes. Steve’s firm, Emerging Business Partners (EBPI), became an affiliate of L&H in 2007. Steve specializes in bookkeeping, payroll, and business advisory services, including tax, M&A, and funding and equity transactions, for technology, entrepreneurial, and emerging growth firms.