Top 6 Tax Considerations in Cryptocurrency Trading
Taxes are rarely top of mind when investors consider entering the world of cryptocurrency and Bitcoin. However, it is becoming increasingly apparent that crypto tax compliance should be prioritized. Why? Because the IRS is laser-focused on cryptocurrency.
One thing is certain: The Internal Revenue Service is concerned about one thing and one thing only: collecting as much tax as possible. With crypto trading reaching new levels in recent years, the IRS wants its rightful share.
Over the past seven years, the IRS has implemented a series of new guidelines for taxing cryptocurrency earnings, which has caught many U.S. investors off-guard. Accordingly, investors are making strategic plans to avoid unforeseen tax ramifications.
What are some of the most common myths, or misconceptions, about cryptocurrency trading and taxes?
Myth: Cryptocurrency exchanges are completely anonymous.
While some transactions are not traded under an individual’s real name, every transaction can be tracked back to the wallet address, making it possible to discover illegal activity and identify the person behind the wallet.
Myth: The IRS cannot track down earnings from cryptocurrency trades.
Because crypto has the perception of anonymity, many people believe they can make a profit and avoid paying taxes. The truth is most cryptocurrency exchanges gather enough information from investors to report transactions to the IRS.
Myth: Flipping one coin into another is not a taxable event.
According to the IRS, flipping one coin out and exchanging it for another is no different than selling one stock and buying another. Both are reportable transactions with the potential for tax exposure. Remember, any increase in value from flipping coins will be looked upon as income by the IRS, even if the crypto is not liquidated and withdrawn. Additionally, the IRS has specifically stated that rules pertaining to like/kind exchanges do not apply to virtual currency transactions and any capital gains and losses must be reported.
Below, we have outlined the six most common tax considerations that cryptocurrency traders should know about in order to prepare for potential tax liability.
Accumulation of DeFi governance and incentive tokens
Defi developers often distribute incentive tokens or governance tokens as a way of decentralizing the network more rapidly. As members of the developers’ community, recipients of these tokens are assigned some of the governing responsibility for the protocol.
Similarly, staking contracts allow stakeholders to determine some of the dynamic parameters of the exchange and decide how they might impact the focus of the project’s development.
When an individual starts collecting a large quantity of incentive or governance tokens, their taxable current market value could add up into the millions. Owners of such tokens should be aware of the complex tax issues that may arise with such assets. While it may be hard to say whether these tokens are taxed as gifts or transfers, a tax professional should be able to weigh them in relation to an individual’s unique tax circumstances and offer sound advice.
Reconstructing trades for IRS reporting
What happens when individuals make thousands of trades on multiple exchanges within a single tax year? How is it possible to comply with IRS requirements and properly report them to the IRS?
Since 2014, the IRS has implemented specific rules that apply to virtual currencies, which are considered by the IRS to be property. These rules require taxpayers to report virtual currency transactions as U.S. Dollars on tax returns, meaning a fair market value must be established at the time of each transaction. Several bookkeeping methods can be used to accommodate the precise recordkeeping that the IRS requires.
What happens when the taxpayer does not have the proper documentation for reporting trades to the IRS?
Many taxpayers are concerned about improper reporting of cryptocurrency trading in prior tax years and are unsure how to reconstruct these trades to avoid an IRS audit. While it is certainly not easy, it is possible to rebuild crypto trading histories and file an amended tax return. Through the Voluntary Disclosure Program, it is possible to update a return from prior tax years to avoid penalties from the IRS.
Will the IRS know if these transactions are not properly recorded and filed?
Through its Virtual Currency Compliance Campaign, as well as increased use of data analytics, the IRS aims to help taxpayers fully understand their obligations under the US Tax Code.
One recent change to the Form 1040 is a line, formerly on Schedule 1, which asked taxpayers: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” If the answer is Yes, the IRS will expect to find these transactions recorded in the tax return.
- Taxpayers must check the “Yes” box even if they received cryptocurrency for free, exchanged it for goods or services, or swapped it out for other property, including digital assets (as per the “general tax principles applicable to all transactions in property”)
- The IRS requires all U.S. taxpayers to accurately report virtual currency transactions or be subject to future criminal and civil enforcement actions.
- Further information about these requirements can be found at www.irs.gov and in Notice 2014-21 which describes the general tax principles for property transactions, which also apply to transactions involving virtual currency.
- Cryptocurrency trading impacts tax returns when a capital gain or capital loss was be incurred in the tax year. Any captured gains must be reported, and taxes must be paid.
IRS sends letters to taxpayers owing back taxes for cryptocurrency transactions.
In recent years, the IRS has been sending letters to taxpayers who have crypto transactions dating back to 2014, informing them that an amended return must be filed. Accordingly, the IRS has collected the names of more than 10,000 American taxpayers who own or have owned digital currencies, and whose previous tax-year’s transactions were inaccurately reported.
What happens when one receives such a letter from the IRS?
Individuals who have received one of these letters will have many questions about how to comply, especially if some or all of their transactions were conducted on foreign exchanges.
Three different versions of the letters were issued to taxpayers:
- Letter 6173 – You may have received this letter if you “have or had one or more accounts containing virtual currency and may not have met your U.S. tax filing and reporting requirements for [virtual currency] transactions.”
- Letter 6174 – You may have received this letter if you “have or had one or more accounts containing virtual currency but may not know the requirements for reporting transactions involving virtual currency.”
- Letter 6174-A – You may have received this letter if “have or had one or more accounts containing virtual currency but may not have properly reported your transactions involving virtual currency.”
What are the IRS parameters on Form 1099-K?
Anyone who has traded a significant amount of cryptocurrency on the major exchanges should expect to receive a Form 1099-K from the IRS, but only if their gross payments exceeded $20,000 USD or they engaged in 200+ transactions. However, if only one exchange was used the taxpayer will receive a 1099-B form and may add that information to Form 8949 when filing a tax return.
For the average investor this will not be too complicated, but those who have traded on multiple exchanges will find this reporting process far more challenging.
Tax professionals have appealed to the IRS saying that a $20,000 threshold is too high, saying most taxpayers have either used multiple exchanges and will not hit $20,000 on any of them, or they have done fewer than 200 transactions on a single exchange. Either way, however, taxpayers must find a way to report these transactions for tax purposes.
What are the three crucial factors that U.S. taxpayers should know about cryptocurrency tax filings?
Before one can file accurate tax returns for cryptocurrency transactions, three questions must be answered.
- What was the fair market value of the virtual currency at the time of the transaction?
- What was the basis, or the amount paid, when the asset was acquired?
- How long was the holding period, or the length of time the asset was held. before it was sold?
Long-term capital gains vs. ordinary income
In determining how to classify taxable gains from cryptocurrency trading, here is the guideline: If the holding period was less than a year it will be considered ordinary income, but If the asset was held for longer than one year, it will be considered a long-term capital gain.
It is important to correctly ascertain which category such a transaction falls into, as the tax treatment is quite dramatic. While the tax rates on ordinary income can be as high as 37%, long-term capital gains are subject to rates of 0%, 15%, or 20%.
How to prove the fair market value of digital assets to the IRS.
Proving fair market value in cryptocurrency trading can be complicated outside of on-chain transactions, but the IRS will need this information to determine the correct tax rate.
If the digital assets are received through a peer-to-peer transaction, or another transaction that did not take place on an exchange, the fair market value is determined as of the time and date that it was recorded on the distributed ledger.
When the transaction was off-chain or otherwise unregulated, the IRS will accept as fair market value the “value as determined by a cryptocurrency or blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates its value at an exact date and time.” If an explorer value is not used, the taxpayer must provide alternative evidence that establishes its value has been accurately represented. One way of doing this is to make it equal to the fair market value of the property or services exchanged for the cryptocurrency at the time of the transaction.
More resources from the IRS
The IRS issued IRS Notice 2014-21 as guidance for individuals and businesses on the tax treatment of transactions using virtual currencies.
The IRS also published Frequently Asked Questions on Virtual Currency Transactions for individuals who hold cryptocurrency as a capital asset and are not engaged in the trade or business of selling cryptocurrency.
For more information about how to correctly report cryptocurrency assets to the IRS, file amended returns for prior tax years, and remain compliant with the U.S. Tax Code, consult with the cryptocurrency tax compliance specialists at the Dilendorf Law Firm.
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- IRS Private Letter Ruling on Taxation of Hard Forks and Airdrops
- Understanding the Tax Basics of Virtual Currency
- Virtual Currency: IRS Issues Additional Guidance on Tax Treatment and Reminds Taxpayers of Reporting Obligations
- Publication 525, Taxable and Nontaxable Income, for more information on miscellaneous income from exchanges involving property or services
- Publication 526, Charitable Contributions, for more information on charitable contribution deductions,
- Publication 544, Sales and Other Dispositions of Assets, for more information about capital assets and the character of gain or loss
- Publication 551, Basis of Assets, for more information on computation of basis
- Publication 561, Determining the Value of Donated Property, for more information on the appraisal of donated property worth more than $5,000
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Max Dilendorf, Esq.
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