Maybe you’re one of the millions of Americans who jumped on the Bitcoin bandwagon in 2021. Or perhaps you’ve become an active crypto trader. Or maybe digital currency bonuses have become part of your compensation package at work. You might have even used some of it to buy something or pay someone else for their services.
Perhaps you’ve been thinking, cryptocurrencies aren’t physical currencies; they aren’t even regulated by the U.S. government. That means I don’t have to pay taxes on profits I make from trading crypto, right?
Wrong.
Even though the U.S. Internal Revenue Service’ rules around crypto are sketchy in many areas, they’ve made it clear that virtual currency is treated as an investable asset for tax filing purposes.
Taxable gains and losses
For calculating taxable gains and losses, crypto transactions are treated exactly the same as those involving stocks, bonds or mutual funds.
- If you sell crypto for more than you paid for it, the profit will be taxed as a short-term capital gain if you held the currency for less than a year. Generally, people try to avoid short-term capital gains because they’re taxed as ordinary income.
- If you make a profit selling crypto you’ve owned for more than a year, it will be taxed as a more preferable long-term capital gain. The tax rate will either be zero, 15% or 20%, depending on your income.
- If you sell crypto for less than what you paid for it, you can take a capital loss, which can reduce your taxable income or offset capital gains from the sale of other assets.
If you’re going to trade crypto frequently, your options for using capital losses to offset capital gains may be limited.
Seems relatively simple, right? But what if you’ve traded Bitcoin, Ethereum, or other cryptocurrencies throughout the year, profiting from some transactions and losing money on others?
Will your crypto exchange help you accurately calculate how much you’ll owe Uncle Sam?
The answer is: It depends.
Fuzzy tax support
Since crypto exchanges aren’t regulated by the U.S. Securities and Exchange Commission, they’re not legally required to offer the same level of tax reporting that discount brokerages and custodians must provide to stock, bond and mutual fund investors.
While some U.S.-based crypto exchanges offer basic summaries of taxable proceeds from crypto-related trading activities, many do not.
And, to the best of our knowledge, none currently generate IRS Forms 1099-B and 8949, which brokerage companies and custodians deliver to consumers to help them report income and capital gains and losses from the sales of investable assets.
While the basic taxable summaries some crypto exchanges provide may be helpful, their numbers could potentially increase your tax burden.
Why? Without getting into arcane details, the often-creative yet perfectly legal methods some exchanges use to pair purchases and sales to minimize profits may inadvertently result in a higher percentage of these profits being characterized as short-term capital gains.
If you don’t trust your exchange to provide accurate tax summaries, you can download a spreadsheet listing all of your raw transactions. You can then manually calculate gains and losses yourself or hand it off to your accountant.
Another option is to use an online crypto tax resource to generate these IRS-ready reports for you.
For example, CryptoTrader and ZenLedger can import historical transactions from most crypto exchanges, let you review your transactions, and prepare annual IRS Form 8949 forms.
Crypto’s unique tax-management challenges
Many investors and financial advisers use a strategy called tax-loss harvesting to reduce capital gains taxes. The idea is that you sell one security at a loss to offset profits from the sale of another.
This strategy poses unique problems for traders who are constantly buying and selling a particular crypto throughout the year. Why? Because these activities may run afoul of the IRS’ rules regarding wash sales.
What is a wash sale? To keep it simple, if you want to claim a capital loss from the sale of any investable asset, whether it’s a stock, mutual fund or crypto, you must wait 31 days before purchasing that same asset again. If you purchase it before 30 days have passed, the IRS considers this a “wash sale” and won’t allow you to claim the loss.
So, if you buy and sell Bitcoin every month, you probably won’t be able to claim losses from transactions that didn’t pan out.
The lesson here: If you’re going to trade crypto frequently, your options for using capital losses to offset capital gains may be limited.
Other crypto-taxable situations
Profits from trading aren’t the only crypto-related activities the IRS requires you to report.
If you receive crypto as payment for a service provided, you’ll have to report this income on your tax return. The actual amount is based on the price of the crypto on the day you received it. Even if you don’t sell it immediately, you still have to report this income.
What if you use a bit of your bitcoin to buy a new outfit or iPhone from a leading-edge online retailer? Since you’re selling bitcoin to purchase something, you’ll need to report the purchase and selling price for that particular transaction to the IRS as well.
Proceeds from sales on foreign exchanges
Many U.S. investors use foreign crypto exchanges to buy and sell crypto. Since these exchanges don’t have to comply with IRS tax reporting rules, the level of tax-related information they provide may be very limited.
That doesn’t mean you’re off the hook. While the IRS hasn’t yet established clear guidelines for reporting proceeds from overseas crypto transactions, the agency has hinted that it will soon require these transactions to be reported on Form 8938, Statement of Specified Foreign Financial Assets.
What happens if you don’t report these taxes? Just because the IRS’ rules around crypto are still evolving doesn’t mean that you’ll be able to claim ignorance as an excuse for noncompliance. After all, we know that the IRS has no problem penalizing people who underreported taxable income in previous years.
We’re already seeing the U.S. government becoming more aggressive about regulating the crypto industry. For example, starting in 2023, U.S.-based crypto exchanges will have to generate 1099-B reports for traders and pass this information on to the IRS. Businesses that participate in crypto-related transactions of $10,000 or more will have to report them to the IRS.
The IRS is also stepping up its efforts to uncover and prosecute crypto-related tax-dodging and cybercrimes. In 2021, the agency subpoenaed dozens of crypto exchanges to identify crypto-tax scofflaws.
In February, the IRS Criminal Investigations Cyber Crimes Unit arrested two people who were trying to launder $3.6 billion in crypto stolen from Bitfinex, a virtual currency exchange, in 2016. We’re likely to see many more such cases in the future. Try not to be one of them.
Don’t gamble on noncompliance
The cost of failing to report — or incorrect reporting of — proceeds from crypto-related activities could be extremely high if the IRS gets you in its crosshairs.
If you don’t feel you have enough knowledge to figure out your reportable crypto income on your own, you should meet an accountant or tax preparer who has experience working with those who own and trade crypto and other digital assets.
The information in this article does not constitute financial advice and is for general informational purposes only.