The world of investing has gotten much more interesting in recent years, especially if you are an investor in crypto and aren’t sure exactly how to figure out your tax exposure on cryptocurrency.
Crypto enthusiasts tell you that you can remain anonymous while trading. That sounds good, but actually you are responsible for the gains and losses you experience, just as you would be in any other investment transaction. And the IRS is cracking down in this area, so the best way to avoid getting in trouble is to look for a CPA who understands all the ins and outs of how cryptocurrency is taxed, how it impacts your overall annual income, and what could happen if you don’t get it right on your tax forms.
There are several factors to be aware of as to how to figure out your tax exposure on cryptocurrency, including:
1. Short-term asset – If you bought crypto and held onto it for less than a year, your investment is considered to be a short-term capital gain. In this case, it would be taxed at the same rate as your annual income. This typically falls within the range of 10% – 37% depending on how much you earn.
2. Long-term asset – If you have held the asset for more than a year, it is considered to be a long-term investment, and your capital gains tax rate would be 0, 15% or 20% depending on your income level. Your CPA will know the rules that apply to long-term capital gains as it pertains to you.
The Internal Revenue Service has followed cryptocurrency trading from the beginning and they are beginning to crack down on people who have invested in crypto and not claimed it on their taxes. In fact, the IRS has made a point of letting the general public know that there are compliance verification laws and audits taking place for those suspected of not properly handling their taxes with regard to how to figure out your tax exposure on cryptocurrency. Legislation is already in the works to require the trading platforms to allow the IRS full access to the back-end (both the blockchain and the trading platforms databases).
When and How Cryptocurrency is Taxable
- Crypto does not act like any other type of asset. Sometimes it transacts like a precious metal, sometimes like a stock, sometimes like a foreign currency and sometimes like a piece of artwork.
- When you buy crypto (convert your US Dollars to a crypto currency), you have a single unique asset. If you make multiple buys, you have multiple unique assets. This can get very complex very fast.
- Example 1: You make one purchase of 3 Ethereum. You have one asset equal to 3 ETH. Crypto functions like a stock.
- Example 2: You make three separate purchases of 1 Ethereum. You have three assets equal to 3 ETH. Crypto functions like a gold nugget.
- If you sell your Ethereum and convert back to US Dollars, you will have a gain or loss upon conversion. This is similar to foreign currency exchange.
- If you sell a fractional percentage of your Ethereum (literally a decimal amount), it does not matter what you converted to, there will be a gain or a loss. This ability to trade decimals is unique to crypto. You can’t really trade a quarter a stock or quarter of a car.
- If you sell your Ethereum for Monero, you will have a gain or loss on the trade.
- If you sell 1 Ethereum for 9 Monero, then trade 8 Monero for 6,500 Dogecoin, convert half the Dogecoin to US Dollars and sell the other half for 0.4 Ethereum, you have gains and losses for each leg of the transaction.
- If you move your 1 Ethereum to a cold storage wallet, no taxable event.
- If you buy a non-fungible token, you own the rights to some digital asset in a video game or movie or to a real asset like a painting in real life. You don’t take physical possession of the underlying asset, just the rights to own or use it. These rights are themselves an asset and tradable and function just like a crypto coin.
- All mined coins are 100% taxable as ordinary income when you receive them. Capital gains/losses are realized when you sell them.
- All free coins (usually from newer coins) are 100% taxable as ordinary income when you receive them. Capital gains/losses are realized when you sell them.If you buy goods or services with your crypto, you will immediately recognize a gain or loss at the time you made the purchase and more than likely, you will pay sales tax on the thing you are buying. That is tax on tax.
- If you are given crypto from your friend, it is a gift and subject to potential gift taxes.
Many investors buy and sell crypto at a high rate. It can be confusing to keep track of when you bought, how much you bought, and how long you held onto it. It can be a nightmare keeping track of all of the exchanges when it comes to understanding your tax exposure.
This is where a qualified CPA can help you navigate, as every time you trade, buy goods, and sell, it is considered to be a taxable transaction.
Here is what a CPA will look for in how to figure out the tax exposure on cryptocurrency:
- What was the rate at the time of the purchase and what was the rate at the time of the sale?
- If accepting crypto as payment, what was the fair market value of the crypto on the day it was accepted?
- Do you have a form 1099-B from the exchange where you bought your currency that can be used as part of your tax return? Maybe 1099-K? Maybe an 8949? Maybe just a super huge spreadsheet of transactions?
- Are you tracking every single trade made? You will need to show proof of these transactions when you calculate your tax returns. Software does exist to help with this. And don’t forget that the IRS will soon have full access to the back-end of all the trading platforms.
- Have you discussed tax planning with your CPA before you start your crypto transactions? Your CPA may have a strategy for keeping track that includes a monthly reconciliation if you plan to invest heavily throughout the month. The last thing you need is to have to figure this out during tax season.
- Did you buy in 2017 because you thought it was cool, forgot about it, and only recently realized your balance is huge?
The IRS has issued specific rules and guidelines that a qualified CPA is aware of to help with the process of tax liability and exposure with regard to cryptocurrency. While this is a relatively new space for the IRS and CPAs alike, the IRS has released something called an “IRS NOTICE 2014-21 which has established how they view cryptocurrency as a form of money, and how it is used for various exchanges should be viewed as “convertible” virtual currency. This means they will be looking to see how you are buying and trading it, and whether it is in US Dollars, Euros, or other forms of currency.
The best practice for your crypto investment strategy is to work with a reputable CPA and make sure your records are kept in very good order. The IRS is getting serious about auditing those who are in this space, mainly due to the very complications that it creates through ongoing transactions.