Cryptocurrencies have officially gone mainstream with prices skyrocketing in 2017. Massive gains throughout last year caused regulators across the globe to take notice.
In the U.S., the Internal Revenue Service (IRS) has made it a definitive point that they expect cryptocurrency investors, traders, and holders to report their crypto activities on their tax return. This might sound like bad news for people who made handsome returns over the past year, but the taxman isn't someone to take lightly. And with tax season coming to an end, the deadline to file taxes, including any cryptocurrency holdings, is looming.
The confusing cryptocurrency guidance from a handful of U.S. regulators doesn't make matters any easier for law-abiding taxpayers. So here is what you need to know about your tax obligations if you participated in any cryptocurrency activity in the past year.
How Does the IRS View Cryptocurrency?
For the most part, the crypto community refers to Bitcoin and other altcoins as cryptocurrencies because they view them as just that... currencies in digital or virtual form.
The IRS has a slightly different perspective and treats 'digital currencies' as property for tax purposes. Under this classification, any activity with cryptocurrency has tax implications, including but not limited to, selling, spending or exchanging cryptocurrency; receiving payment or compensation in cryptocurrency; and accumulating cryptocurrency through mining operations.
What are the Specific Tax Implications of Cryptocurrency Transactions?
So we know that most activity and cryptocurrency transactions create some sort of taxable event. Let's take a quick look at the specific implications for each type of transaction:
- Exchanging: Trading or exchanging one cryptocurrency token for another creates a taxable event. The token is considered sold in order to buy the new token. For example, if you trade Bitcoin for Ethereum, you are selling Bitcoin and buying Ethereum, creating a capital gain or loss on your sold Bitcoin.
- Receiving: Receiving cryptocurrency payments or compensation in exchanges for products or services is treated as taxable income. For example, if an employee receives wages in Bitcoin it's counted as taxable income. The same is true for merchants who accept payments in cryptocurrency.
- Spending: Spending and paying for goods and services in cryptocurrency creates a taxable event as well. Spending cryptocurrency is considered selling it, just like exchanging tokens, leading to capital gains or losses. For example, if you bought a token for $100, then spent it on a $150 purchase, you have a $50 taxable gain.
- Converting: Converting cryptocurrencies into U.S. dollars or fiat currency is another taxable event creating either capital gains or losses. Again, the IRS treats this as the cryptocurrency being sold.
- Mining: Mining cryptocurrencies and receiving tokens is treated as ordinary income, using the fair market value the same day the token was mined. For example, if you mined Bitcoin last year at $3,000 per coin, that's the value used for income purposes.
- ICOs: Initial coin offerings are treated as ordinary income for both individuals and businesses.
- Air Drops: The same theory applies for air dropped coins. They are treated as ordinary income using the value on the same day as the airdrop. If the token is sold, traded or exchanged, this creates another capital gain or loss situation.
How to file taxes on your cryptocurrency?
So if you’ve been a part of the cryptocurrency world in the past year, you’ve probably come to the conclusion that you need to report your activity to the IRS. But there’s still some lingering confusion as to how you are supposed to properly include cryptos when filing your tax return.
The first step is to determine which of the activities above apply to your situation. Were you simply a trader, exchanging one coin for another throughout the year? Or were you an employee receiving Bitcoin as your form of payment?
Then you want to calculate your capital gains or losses on sold cryptocurrencies. This part can be tricky because none of the exchanges adequately record your cost basis for each cryptocurrency transaction, which means it’s up to you at the moment to keep track of your cryptocurrency performance.
For purposes of reporting to the IRS, your cost basis simply needs to represent the fair market value of the virtual currency in U.S. Dollars on the date of purchase or receipt. If the virtual currency is listed on an exchange, the fair market value can be determined by using the exchange rate on the day of purchase or receipt.
For example, if Bitcoin was trading at $1,000 last year on the day you bought it, that is your cost basis. If you received the Bitcoin as payment for employment, the $1,000 represents general income on your tax return. Then if you sold the Bitcoin for $5,000 later in the year, that gain represents a capital gain. So your $5,000 sale price minus the $1,000 fair market value when received generated a $4,000 capital gain.
So cryptocurrencies require tax reporting for both the receipt and sale of the coin. Capital gains tax rules apply to cryptocurrencies as well, so if you held your coin for over one calendar year, your capital gains are subject to long-term rates, rather than the normal short-term tax rates.
How Do Miners Report Their Cryptocurrency Rewards?
The IRS treats mining rewards, or coins received and earned from mining the blockchain, as income for tax purposes. Anyone that received cryptocurrency from mining must report it as gross income based on the fair market value. If the miner is qualified as self-employed, the gross earnings are subject to deductions and self-employment tax.
How Does the IRS Treat Cryptocurrency Payments?
The main objective behind virtual currencies is to create an easy digital way to transact and make payments. Some have already jumped on board and make regular payments in Bitcoin or other cryptocurrencies. Some people pay their employees in crypto, while the amount of merchants accepting crypto payments is increasing as well.
However, all of these payment types are subject to IRS reporting to the same extent as other payments made in property. According to the IRS guidance, “a person who in the course of a trade or business makes a payment of fixed and determinable income using virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a taxable year is required to report the payment to the IRS and to the payee. Examples of payments of fixed and determinable income include rent, salaries, wages, premiums, annuities, and compensation.”
Many of the early investors of virtual currencies like Bitcoin and other cryptos initially turned to these innovative forms of money to avoid regulation, oversight, and taxes from national governments. Hosting transaction records on the blockchain remove the necessity for central points of authority like many U.S. government agencies.
However, as this sector has blossomed over the past year, most regulators are eager to get into the game, especially the IRS. There’s the common cliche, only two things are certain in life: death and taxes. And that holds true when it comes to your cryptocurrency activity. The IRS has put the American public on notice that they expect cryptocurrency transactions to be included in their tax reforms, and subsequently income and capital gains to be properly accounted for.
Don’t ignore the IRS. The safe route is to start reporting your cryptocurrency activity and stay in the good graces of the taxman. Better to report today than get audited later.