It’s never too early to start preparing for tax season – especially if you are one of the millions of investors who entered the crypto market over the last year, giving you a new asset class to deal with on your taxes.
In 2014, the U.S. Internal Revenue Service (IRS) decided bitcoin (BTC) and other cryptocurrencies should be treated as “property,” meaning they qualify for capital gains tax similar to traditional assets like stocks and bonds. There are, however, some instances where certain activities involving digital assets are treated as income and therefore subject to income tax.
If your only crypto-related activity in a tax year was purchasing a virtual currency with U.S. dollars, you don’t have to report that to the IRS. Things start becoming taxable when you use crypto as a method of exchange or any event in which you realize or trigger profits. This includes selling your crypto for U.S. dollars, exchanging one cryptocurrency for another — buying Ethereum with Bitcoin, for example — or paying for goods and services with crypto.
In May 2021, the Treasury Department announced that it is taking steps to crack down on cryptocurrency markets and transactions, and said it will require any transfer worth $10,000 or more to be reported to the Internal Revenue Service. In addition, a growing number of Wall Street analysts have sounded the alarm that regulators at the Treasury and the Securities and Exchange Commission could soon take a more active role in cryptocurrency regulation. As the IRS continues to come down heavily on crypto tax compliance, it has become increasingly important to understand just how crypto is taxed.
Cryptocurrency capital gains tax events include:
- Selling cryptocurrency for government-issued currency (U.S. dollar, British pound sterling, Japanese yen, etc.)
- Using cryptocurrency to purchase goods and services
- Trading or swapping one crypto asset for another, either on an exchange or directly peer-to-peer
Cryptocurrency income tax events include:
- Receiving cryptocurrency from an airdrop
- Any crypto interest earnings from decentralized finance (DeFi) lending
- Crypto mining income from block rewards and transaction fees
- Crypto earned from liquidity pools and staking
- Receiving cryptocurrency as a means of payment for carrying out work, including bug bounties
It’s worth noting that any losses incurred from trading can be used to offset your capital gains as well as deduct up to $3,000 off your normal income tax depending on how long you’ve held the assets for (see below). Any additional losses can be carried forward to the next tax year. You do, however, have to show a loss across all assets in a particular class to qualify for a capital gains reduction.
How much tax will you pay?
In the United States, how much capital gains tax you owe for your crypto activity depends on how long you’ve held your assets (holding period) and in which income tax bracket you are. Your holding period begins the day after you purchase the crypto asset or make the cryptocurrency transaction and continues until the day that you trade/sell/send that capital asset. This is where short-term capital gains and long-term capital gains come in.
- Short-term capital gains: Any gains or losses made from a crypto asset held less than a year are taxed at the same rate as whatever income tax bracket you’re in. Any losses can be used to offset income tax by a maximum of $3,000. Any further losses can be carried forward as mentioned above.
- Long-term capital gains: Any gains or losses made from a crypto asset held for longer than a year (more than 366 days) incurs a much lower 0%, 15% or 20% tax depending on individual or combined marital income.
Long-term capital gains tax rates for the 2021 tax year
|Up to $40,400
|$40,401 – $445,850
|Married filing jointly
|Up to $80,800
|$80,801 – $501,600
|Married filing separately
|Up to $40,400
|$40,401 – $250,800
|Head of household
|Up to $54,100
|$54,101 – $473,750
Source: Internal Revenue Service
Losses from exchange hacks or theft
The significant changes to tax law in February 2021 confused many crypto investors who had been subject to scams, hacks or other ways to lose crypto investments. The amended law limits personal casualty losses to a “federally declared disaster.”
Many crypto investors and accountants mistakenly thought this limitation would apply to their crypto investments. However, this is not the case. Crypto investment losses are not “personal casualty losses.” Instead, they are classified as investment losses under tax code 165(c)(ii) because they are “transactions entered into for profit, though not connected with a trade or business.”
As a result, all crypto losses in scams, thefts, or accidents are complete tax losses. These losses can be claimed on form 8949 as $0 proceeds transactions. This means that if you bought one bitcoin for $15,000 and it was stolen through an exchange hack, you would be able to report a loss of $15,000.
Deducting Ponzi Scam Losses
Ponzi scam losses can be treated as itemized deductions and are not subject to the $3,000 capital loss limitation. The amount invested in the scam can be deducted from your taxable income. The key requirement is that someone must have been indicted for the loss to qualify as a Ponzi deduction.
How to Prepare for Tax Season
Now that you know how your crypto assets are taxed, here’s what you need to do in order to prepare for and file your taxes:
- Keep a record of all your cryptocurrency activity: The IRS requires all crypto users to keep an accurate record of all cryptocurrency purchases and sales, including airdrops, lending interest and all other activities mentioned above under capital gains and income tax events. Most leading crypto exchanges and platforms have built-in tax reporting features that automatically generate reports for you. However, there are also third-party services that offer to do all the leg work for you.
- Calculate your gains and losses: Once you have your full transaction report, you can use a number of services or tax calculators to work out what you owe or do it manually depending on how many trades you’ve made in the year. The amount is found by finding the difference between the price at which you sold and the cost basis (the original price you paid).
- Fill in Form 8949 and add it to Form Schedule D: Form 8949 is the specific tax form for reporting crypto capital gains and losses. The Schedule D form is the main tax form for reporting overall capital gains and losses. Any cryptocurrency earned as an income needs to be added to Schedule 1 Form 1040, and self-employed earnings from crypto need to be added to Schedule C.
Crypto investors should keep in mind that the taxation of crypto is not as simple as it may seem. Due to its price volatility, it is hard to determine the fair market value of the crypto on sale, purchase transactions, and overall cryptocurrency investment.
It’s also challenging to determine the right accounting approach to use when it comes to crypto taxation. Strategies like Highest In, First Out (HIFO) and Last In, First Out (LIFO) can help reduce the amount of income tax and crypto gains tax.