Welcome to Part II of our three-part cryptocurrency series! With the fame, and not to mention value, of cryptocurrency exploding in the past few years, it has caught the attention of the U.S. Government. The intention of this series is to guide you through the tax implications of transacting in cryptocurrency. As mentioned in Part I, each article in this series will cover one of the following topics:
- Part I: Cryptocurrency reporting requirements
- Part II: Taxation of cryptocurrency
- Part III: Maintaining cryptocurrency records
In Part I, we discussed how cryptocurrency transactions must be reported to the U.S. Government. Part II will go into further detail and explain how cryptocurrency is currently being taxed. If you have not read Part I, it is recommended that you go back and learn more about reporting your cryptocurrency.
The same caveat from Part I must be mentioned again: new laws and regulations are being proposed and written all the time (especially concerning this field), so the rules outlined today may be out-of-date next week. If you are involved in this industry, we highly recommend that you stay current on regulations to keep compliant.
Now, let’s get started!
Taxable vs. Nontaxable Transactions
As mentioned in Part I of this series, virtual currency, such as cryptocurrency, is considered property or securities (depending on the type of transaction) and not currency by the IRS. Therefore, for certain transactions, cryptocurrency is subject to many of the same tax laws regarding buying and selling stocks and other securities.
When transacting in property or securities, there are three simple rules you can follow to determine taxation:
- The acquisition of property or securities is generally not taxed when purchased with cash
- The acquisition of property or securities is generally taxed when acquired through goods or services provided
- The disposal of property or securities usually is taxed
The same rules apply to cryptocurrency. Later in this article, you will find a list of common transactions. It is vital that the owner of cryptocurrency investments maintain excellent records to determine the appropriate tax treatment of each transaction type.
How are My Transactions Taxed?
Once you figure out that a transaction is taxable, you must determine how it is taxed. There are two ways your cryptocurrency is going to be taxed: as ordinary income or as capital gains income.
All forms of income, unless otherwise stated in the tax code, are taxed at ordinary rates. Examples of ordinary income include your wages earned from a job, interest income received, and business income earned and received. Some cryptocurrency transactions, such as airdrops or mining, are also considered ordinary income.
Capital Gains Income
The government encourages certain behaviors through the tax code by giving certain transactions favored tax treatment. One type of transaction that may get preferential tax treatment is a capital gains transaction. To be considered a capital gains transaction, the taxpayer simply buys an asset and then sells it again at a later date.
If the asset is held for longer than one year, then the proceeds minus costs of the sale minus the basis in the asset is a Long-Term Capital Gain subject to preferential tax treatment. If the asset is held for one year or less, then the sale minus costs minus basis is taxed at ordinary income tax rates and is called a Short-Term Capital Gain.
Some cryptocurrency transactions, such as selling and exchanging cryptocurrency, are capital gains transactions.
Types of Cryptocurrency Transactions
While the list below is not a comprehensive list of all activities that you may engage in with cryptocurrency, it contains several of the most common. Each one has a specific tax treatment. It is important to maintain excellent records to determine the proper tax treatment.
- Donation of cryptocurrency
- Exchange from cryptocurrency to cryptocurrency
- Gifting cryptocurrency
- Hard fork
- Purchase of cryptocurrency
- Purchase of products or services using cryptocurrency
- Sale of cryptocurrency
- Soft fork
- Transfer between exchanges/wallets
The virtual currency market is changing daily, and new coins and types of transactions can be created at any time. Additionally, new regulations and legislation are being proposed and written frequently to keep up with the changing marketplace. If you are invested in cryptocurrency, it is important to stay informed of new developments that may affect your investment.
Potential Future Tax Ramifications
As mentioned in Part I, the infrastructure bill passed in November 2021 has reclassified the sale and exchange of cryptocurrency as a capital gains transaction taxed similar to the sale of securities (rather than property). This change in how cryptocurrency is viewed for capital gains could allow the SEC to enforce quarterly filings and impose regulations sometime in future.
One potential change that has been rumored to be coming down the pike due to this change is that cryptocurrency transactions may become subject to the wash sale rule. The wash sale rule is enforced when you sell a security at a loss and buy a “substantially identical” security either 30 days before or after the sale. The IRS treats such a sequence of transactions as one singular transaction and disallows the loss.
Cryptocurrency is currently not subject to the wash sale rule. This is beneficial because a taxpayer who owns a cryptocurrency with a market value significantly lower than the purchase price can sell it at 5:00 PM and then buy it again at 5:01 PM for a very similar value. The taxpayer recognizes the loss today while potentially still owning the exact same amount of cryptocurrency prior to the sale.
If cryptocurrency becomes subject to the wash sale rule, this tax-loss harvesting technique will disappear.
It is imperative that you know what transactions involving cryptocurrency are subject to income tax and how they will be taxed by the U.S. Government. In many cases, you can avoid paying the full ordinary income tax rate and be taxed at the preferential capital gains rate instead.
However, knowing what type of tax you must pay is one thing. Did you know that you can potentially decrease your tax bill by maintaining good records of your cryptocurrency transactions? Part III explains how to do this.
If you have any questions regarding cryptocurrency taxes, please contact us and we will be happy to assist you.