The Taxation of Cryptocurrency
Because of cryptocurrency, the words fork and airdrop have new definitions. The IRS has issued minimal guidance to date on the tax consequences of many types of cryptocurrency transactions. Before discussing further, it is important to understand some of the new terms related to cryptocurrency.
A soft fork is like a software upgrade for a currency's blockchain, bringing it new functionality. During a soft fork users agree on new changes to the blockchain itself, so it does not split into a new cryptocurrency. When the change happens, the upgraded blockchain carries on chronologically from the same chain.
A hard fork is like a soft fork in that it is an upgrade, but the users do not agree on the changes being made and/or the changes are significant. When all users cannot agree on the changes, the blockchain cannot continue from the previous chain. In this case, the blockchain splits in two - the original and an updated version that implements the change in an entirely new cryptocurrency.
An airdrop is often used as a marketing tool that involves sending coins or tokens to wallet addresses in order to promote awareness of a new currency.
It is not surprising that the IRS is concerned about potential underreporting of cryptocurrency transactions and is looking to add regulation. There is a relatively new question on page 1 of the Form 1040 asking about a taxpayer’s cryptocurrency activity for the year. All major exchanges that transact in cryptocurrency now report transactions to the IRS and are sending 1099s to customers for tax return reporting. However, even if a 1099 is not received, a transaction may still be taxable. The IRS will likely find out about any cryptocurrency transactions, and they have won cases forcing cryptocurrency platforms such as Coinbase, Kraken and Poloniex to share customer data with the IRS.
One of the more common transactions is the sale of cryptocurrency that is owned by a taxpayer. In the US, cryptocurrency isn't viewed as a currency, rather it is viewed as property per IRS Notice 2014-21. Therefore, when a taxpayer sells or exchanges cryptocurrency, they will pay capital gains tax. A capital gain or loss is the difference in value from when acquired to when it is disposed of. Taxpayers will pay up to 40.8% tax on short term capital gains and between 0% to 23.8% tax on long-term capital gains.
Taxpayer A buys 1 BTC in February 2021 valued at $33,000 and pay a 2% transaction fee. Their cost basis is $33,660.
In October 2021, Taxpayer A sells 1 BTC for $60,000. They need to calculate whether they've made a capital gain or loss. To do this they must subtract their cost base from the sales price.
$60,000 - $33,660 = $26,340.
They've made a capital gain of $26,340 which they'll need to pay capital gains tax on.
As they held the BTC for less than a year, they'll pay the short-term capital gains tax rate, which is based on their regular income tax rate, plus a potential 3.8% net investment income tax.
Capital losses offset any capital gains and up to $3,000 of net loss can be deducted against other taxable income each year. Any net loss above $3,000 each year will carryforward to the following year(s) until utilized.
You may be wondering about the tax treatment of mining, payments received in cryptocurrency, airdrops, forks and other cryptocurrency transactions. The IRS has not specifically addressed many of these transactions, but the following is a summary of tax-free and taxable transactions based upon the IRS guidance to date.
Tax-free cryptocurrency transactions
Not all cryptocurrency transactions are taxed in the US. A US taxpayer will not have to pay tax on cryptocurrency when:
- Buying cryptocurrency with fiat currency.
- Holding cryptocurrency.
- Moving cryptocurrency between the same owner's wallets.
- Gifting cryptocurrency - provided the lifetime gift limit has not been reached.
- Receiving gifts of cryptocurrency are not taxable to the recipient.
- Donating cryptocurrency to charity.
- Creation of an NFT. Minting costs may be able to be added to the cost basis.
- In a soft fork of a cryptocurrency a taxpayer will not pay any tax because there are not any new coins or tokens received as a result of a soft fork.
Taxable cryptocurrency transactions
- Swapping cryptocurrency for another currency or cryptocurrency. If a taxpayer buys cryptocurrency with another cryptocurrency, the IRS views this as two separate transactions. For example, if you buy ETH with BTC, the IRS sees this as selling your BTC and then buying ETH at market value.
- Receiving an airdrop. The IRS has made it clear that receipt of an airdrop is taxed based upon the fair market value of the airdropped cryptocurrency when it is received. The fair market value then becomes the tax basis for capital gains when the currency is sold in the future.
- A hard fork of a cryptocurrency is taxable because of the receipt of new coins or tokens due to the hard fork. The amount of income is the fair market value of the coins or tokens when received.
- Receipt of cryptocurrency through mining is subject to income tax upon receipt. It's important to note that running a cryptocurrency mining business will subject the income to both income tax and self-employment tax which covers Medicare and Social Security contributions.
- Staking cryptocurrency. The term staking is sometimes used interchangeably to refer to both DeFi lending and proof-of-stake or proof-of-work. From a tax perspective, this matters because there may be different tax implications. The IRS hasn't released any official guidance on staking rewards and how they're taxed.
- Proof-of-stake is a process that involves committing crypto assets to support a blockchain network and confirm transactions in return for some reward. The IRS’s concession recently in Jarrett v. United States could indicate that the treatment of staking rewards in certain cases is not taxable upon receipt, but more guidance is needed.
- DeFi Lending is lending cryptocurrency for a specific return. Cryptocurrency earned as additional tokens should likely be taxed as ordinary income. Earnings from tokens that increase in value should likely be taxed as capital gains. This tax treatment is based on the current tax law and guidance received to date. Further guidance is needed from the IRS to confirm the tax treatment.
- Spending cryptocurrency is subject to capital gains tax since it is considered a disposal of an asset.
Additional complex transactions such as wrapped tokens and minting interest-bearing tokens have not been addressed in any IRS guidance. If cryptocurrency is held on exchanges outside of the US, there may be some additional foreign reporting forms filed with the IRS each year.
The IRS does not let taxpayers claim lost or stolen cryptocurrency as a capital loss. Prior to the Tax Cuts and Jobs Act (TCJA), cryptocurrency investors could claim theft and casualty losses as a capital loss. Since the TCJA came into effect, casualty and theft losses are no longer tax deductible. Due to this change, if taxpayers lose cryptocurrency due to a hack, scam or the loss of private keys there is no deduction allowed. Losses that occurred prior to 2017 may be deductible if taxpayers can prove ownership of the assets and can provide a declaration or receipt that specifies how much was lost in the hack.
Tax planning for cryptocurrency
- Gifting cryptocurrency under $16,000: Taxpayers can gift up to $16,000 USD in 2022 per person tax-free, without filing a gift tax return. This is known as the annual gift tax exclusion. This can help taxpayers take advantage of lower income tax rates in a taxpayers’ household to pay less tax overall. If taxpayers gift over this amount, provided they are under the lifetime gift tax exemption of $12.06 million in 2022 (increased each year for inflation), taxpayers won't need to pay gift tax. However, taxpayers will need to file a gift tax return, Form 709.
- Capital Gains Tax Free Allowance: If taxpayers earn less than $41,675 total income in 2022, including cryptocurrency income, they'll pay no capital gains tax on long-term gains.
- Long-term Capital Gains Tax Rate: If a taxpayer keeps cryptocurrency for more than a year, they'll pay a lower long-term capital gains tax rate of between 0% to 23.8% depending on how much they earn.
- Unrealized Losses and Wash Sales: Harvest (or sell) cryptocurrency with unrealized losses to offset capital gains. The wash sale rule prevents investors from selling a stock at a loss, then repurchasing a “substantially identical” asset in the 30 days before or after the sale. As of the date of this article, there is no cryptocurrency wash sale rule in place. Since the IRS considers digital currency to be property rather than a security, a taxpayer could technically sell cryptocurrency at a loss and repurchase the same cryptocurrency without having to observe any waiting period in-between, allowing a capital loss to be recognized.
- Donate cryptocurrency to a charity: Cryptocurrency donations are recognized as noncash contributions at fair value at the time of donation.
- Cost Basis Methods: The right accounting method is the one that enables a taxpayer to pay the least or the most accurate tax on their cryptocurrency.
- First In First Out (FIFO): the first asset bought is the first asset sold.
- Last In First Out (LIFO): the last asset bought is the first asset sold.
- Highest In First Out (HIFO): the most expensive asset bought is sold first.
- Specific Identification (Spec ID): pick the asset sold, provided it can be identified with records.
Keep records of cryptocurrency transactions
The IRS requires taxpayers to keep sufficient records to support positions taken on their tax return. As a minimum, the following records of cryptocurrency transactions should be kept:
- The date of transactions.
- The fair market value of cryptocurrency in USD the day it is acquired.
- The fair market value of cryptocurrency in USD the day it is disposed.
- The capital gain or loss made from each transaction.
- What the transaction was, and the parties involved.
- Receipts of purchase and sale.
- Records of transfers and transactions from all cryptocurrency wallets and exchanges.
Cryptocurrency is complex and ever-changing, and we have we have numerous tax professionals that are ready to help you navigate the tax rules. Please feel free to reach out to HHM CPAs should you need any assistance.