What is Cryptocurrency? – The IRS refers to Cryptocurrency as “Virtual Currency” and they provide the following definition: “Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the United States dollar or a foreign currency.” These currencies are typically called coins or tokens, and some of the most common coins are:
- Bitcoin
- Ethereum
- DogeCoin
For the average Cryptocurrency investor these coins or tokens are bought, sold, and traded on exchanges such as but not limited to:
- Coinbase
- com
- FTX
- Binance
These are similar to stock exchanges, such as the New York Stock Exchange, except they are wholly digital and, for the time being, are loosely regulated.
Tax Treatment – Per IRS notice 2014-21 Cryptocurrency is treated like property for tax purposes. This means that a sale of Cryptocurrency typically receives capital gain treatment. If the property is held for more than a year, then any gain on the sale is subject to long-term capital gains tax, which can be anywhere from 0%-20%, depending on your income level. If the property is held for less than a year, then income is subject to short-term treatment and is taxed at ordinary income tax rates. For high income taxpayers, a net investment income tax (NIIT) of 3.8% might also apply.
What should you do? – In order to properly compute the gain on a sale of Cryptocurrency, taxpayers must know their tax basis in the property sold. The tax basis of property is typically the cost of acquisition increased by any fees paid on the purchase. While that doesn’t sound too difficult, it is a challenge for investors that transact in Cryptocurrency hundreds or thousands of times per year. It is further complicated when individuals exchange one Cryptocurrency for another. While that doesn’t appear to be a taxable sale, it is a taxable exchange, and the transaction is treated the same way as a sale for tax purposes.
An example might help illustrate the complexity of the tax reporting. Assume you purchased 1 Ethereum coin for $4,000. One month later, when the price has reached $5,000, you decide to trade your 1 Etherum for 0.1 Bitcoin that is worth $5,000. Even though you did not receive any cash from the transaction, it is still considered a taxable event. The gain would be computed by taking the value received (0.1 Bitcoin = $5,000) and subtracting out your tax basis (original purchase price of Ethereum of $4,000), resulting in a taxable gain of $1,000. Your tax basis in the 0.1 Bitcoin is $5,000, which represents what you gave up, or paid, to get the 0.1 Bitcoin.
Now imagine in the same year that you did a Cryptocurrency-for-Cryptocurrency trade ten more times before finally deciding to convert the last Cryptocurrency owned to cash of $7,000. You may look at the entirety of the year and see one transaction to report: a purchase of $4,000 of Cryptocurrency for $7,000 of cash, which would result in a gain of $3,000. The reality is that the year has a total of 12 taxable transactions, each of which would need to be reported to the IRS: 11 Cryptocurrency-for-Cryptocurrency trades and one Cryptocurrency-for-Cash trade. The end result would be the same – an overall gain of $3,000 – but the reporting required is much more detailed and complex. It is difficult to track the correct tax basis from one trade to the next, but it is required to know how much gain or loss to recognize each time Cryptocurrency is sold or traded.
This same challenge does not exist for transactions of public stock, because sales and exchanges of stock, including the gains or losses on each transaction, are reported to taxpayers and the IRS on a Form 1099-B. Financial institutions are required to provide that information, but that is currently not true of Cryptocurrency exchanges. In most cases, a Cryptocurrency exchange can provide a detailed transaction report from which, in theory, you could get all the information needed to accurately report your Cryptocurrency transactions. However, the reports are not easy to follow, especially when the transactions number in the hundreds or thousands. You could easily end up with a transaction report in Excel with 1,000 rows or more, at which point accurately figuring out the correct tax reporting becomes nearly impossible.
If you find yourself in this situation, you might consider using one of the many online Cryptocurrency software companies such as:
- Koinly
- TaxBit
- Legible
These companies link directly to your exchange accounts and provide complete tax reports for an annual fee ranging from around $50 – $500, depending on the types and amounts of transactions you have. That may seem like a lot of money to pay for a “simple” tax form, but it will be less than the potential additional fees your CPA will charge you to do the calculations for you!
Future Legislation– The Infrastructure Investment and Jobs Act of 2021 (IIJA), which was signed into law in November 2021, included IRS reporting requirements for Cryptocurrency exchanges. Generally, this will require reporting of gains and losses to the IRS and taxpayers beginning in 2023. This should ease the reporting burden of Cryptocurrency activity for taxpayers.
Cryptocurrency can be volatile and complex. Don’t wait to start addressing your tax filing requirements as it relates to your Cryptocurrency investments!
For more information about this topic, contact Larson & Company today.
