Cryptocurrency (“Crypto”) such as Bitcoin, Ethereum, and Dogecoin and similar concepts (Non-Fungible Tokens, anyone?) may be all the rage for speculative investors but as with any potential moneymaking venture, the IRS is sure to have its hand out if you actually realize income from such investment activity.
Make sure you report your activity in CRYPTO.
Beginning with the 2020 form 1040, the IRS added a question right at the top of the form, right under Taxpayer Names and Address asking if “At anytime during 2020, did you receive, sell, send, exchange, or otherwise acquire financial interest in any virtual currency?”. That should be enough to alert us that the IRS thinks there may be income taxpayers are inclined not to report, maybe not intentionally, but because many taxpayers don’t understand how Cryto is taxed, or how to report it.
So why is the IRS asking if I posses(-ed) Crypto, you ask?
To date, the IRS is still developing rules on how to handle Cryptocurrency. While virtual currency can function as a unit of exchange just like other currency, it is not considered legal tender in any jurisdiction. It is also not considered a security. In some ways, it is handled as a property, but without the tax benefits. However, for tax purposes, cryptocurrency can be treated as currency, security, property, or even earned income, depending on the situation. This can lead to even more confusion when it comes to taxes.
Perhaps more importantly, Crypto exchange services, such as Coinbase or Kraken are not currently required to report their users’ transactions to the IRS, like more traditional investment brokerages are. They may send you a report at the end of the year that includes all your transactions and the information necessary for you to calculate any taxable gains or losses you may have incurred, but they don’t do it for you and they don’t report to the IRS.
While IRS rules on Crypto are still unfolding, the IRS is focusing on voluntary reporting compliance and if a taxpayer doesn’t voluntarily comply, you can expect enforcement come at you with their full bag of tricks, including penalties and even potentially criminal consequences. So it’s important to understand potential tax issues and prepare for them now.
It seems obvious that Crypto has created confusion with taxpayers. Still, it continues to rise in popularity, which means it is a vital part of year-end tax planning to ensure proper compliance, maximize potential tax benefits, and avoid being hit with a large tax liability.
Just what crypto transactions are taxable?
There are a number of ways Crypto can be taxable. These include:
- Receiving crypto for free (as in prizes or awards); the amount of the taxable transaction is the value in US $$ of the particular Crypto you received on the day you received it
- Receiving Crypto for goods or services; the amount of the taxable transaction is the value in US $$ of the particular Crypto you received on the day you received it, less your basis in any goods you give up.
- The Sale of Crypto – the difference between your basis in said Crypto verses what you sell it for is generally a taxable gain (or loss) and since the IRS treats Crypto like property, it may qualify for long term capital gain treatment, depending on how long you have owned it before you sell;
- The exchange of virtual currency for other property – which could create more than one form of taxable income. For example, let’s say you purchased one Bitcoin worth $31,000 in January 2021 and February you exchange that bitcoin for 35 Ethereum then worth $40,000. Then in June, you used the 35 Ethereum you received back in February to buy $50,000 worth of office supplies for your thriving small business. First, you have a $9,000 taxable gain from spending your one bitcoin to buy the 35 Ethereum, equal to the increase in value of the Bitcoin between when you purchased it and when you spent it on the Ethe. Then you have a second gain of $10,000 from spending appreciated Ethereum on office supplies. Lastly, your business should get a $50,000 deduction for the office supplies, the same as if you paid cash for them.
What do you need to do?
- Keep detailed records of all cryptocurrency transactions, and keep in mind that different cryptocurrency situations are taxed differently.
- Track basis when you buy cryptocurrency. Use a spreadsheet or crypto portfolio tracking program to make sure all information is tracked.
- Record all purchases made with cryptocurrency and remember that they may be taxable.
- Understand details of any cryptocurrency dividends, converts, rewards, earn transactions, or mined Crypto which will determine how they are taxed.
- Carefully follow all reporting guidelines. Don’t assume that you can misreport or ignore without consequences.
Don’t wait until tax time to understand and record your cryptocurrency use. It is important to seek the advice of a tax professional. The tax team at Rodefer Moss continues to follow the developing guidance. They understand that each situation is different and can help you determine the best plan to remain compliant with current tax law.
Look for more articles in this series, including CRYPTO in your IRA, taxation of non-fungible tokens, and trading tricks to minimize taxes.