What is cryptocurrency?
Basically, cryptocurrency is digital money. It's a virtual currency that can be used to buy products and services. Some people hold cryptos as an investment. (Then again, some say investing in cryptocurrency is actually speculation.) One of the most well-known cryptos is Bitcoin. Other cryptos include Litecoin and Ethereum, but the IRS treats all cryptocurrencies the same way.
If you want to trade crypto, it's important to understand the tax consequences. Let's dive into the details.
How is cryptocurrency taxed?
In general, the IRS taxes cryptocurrency the same way it taxes other property, such as real estate and stocks.
1. Short-term vs. long-term capital gains
First of all, it's important to understand that cryptocurrency is treated similarly to stocks and other capital assets.
- When you buy a cryptocurrency, you should note the date you acquire it and its market value. If you hold the cryptocurrency for a year or less before you sell or use it, the result of that transaction is considered a short-term gain or loss. A great way to keep track of the price is to use a tracker like Empower. With their Cryptocurrency BETA tracker you can stay up to date on the performance of your crypto alongside your other investments.
- If you hold the cryptocurrency for more than a year, it is a long-term capital gain or loss. Then, your cryptos qualify for the more favorable long-term rate. Keep track of your transactions so you know where you stand.
- You can also claim losses. Sell your cryptocurrency at a loss, and you can deduct that loss from your other income, up to $3,000 per year.
2. Taxable cryptocurrency events
It's important to understand which transactions with cryptos are taxed. These include:
- Trading in your cryptocurrency for fiat currency (like U.S. dollars)
- Turning in your crypto and converting it to a different crypto
- Buying goods or services using a cryptocurrency
- Interest received on cryptocurrency transactions, including those made through decentralized finance platforms and crypto lending
With these transactions, you must know the market value of the cryptocurrency in U.S. dollars when you acquire the crypto and when you execute the transaction. The difference between those values is your gain or loss.
For example, let's say you bought a bitcoin when it was worth around $3,500 back in February 2019. Now you want to sell that Bitcoin at $9,500. You've held it for more than a year, so your $6,000 gain is taxed at a lower rate than your usual tax rate. But you're still taxed on the gain.
The same is true if you use cryptocurrency to buy products or services. In that case, you calculate the value of the products and services and the cost of the crypto involved. Then you figure out how much of a gain (or loss) you've managed.
You don't pay tax on cryptocurrency when you acquire it, whether you buy it or receive it as a gift. However, you must know its value, because you will have to pay tax when you sell it for fiat currency or use it to buy something.
More: How to sell cryptocurrency and bitcoin
3. What about taxes when mining cryptocurrency?
Many people ask if Bitcoin is taxable when it's been mined. The answer is yes. Anytime you receive a cryptocurrency as some sort of income, it's taxed as such. So, when you mine crypto — when you receive your token — you have to convert that to its fair market value in U.S. dollars to determine the income you received — and pay tax on it as income.
Tax planning with cryptocurrency
Paying cryptocurrency taxes can be a bit challenging because record-keeping can be a little difficult. Here are some of the issues to be aware of when you're dealing with crypto taxation:
- Exchanges don't always provide tax records. When you use a broker for stocks, they have access to your records. They know how much you paid for the stock and what you sold it for and figure out your cost basis. As of 2023, not all crypto exchanges are required to provide tax documents. They will be for tax year 2023, but for tax year 2022, some will send you documents and others will not. If you receive a 1099 form from your crypto exchange, you can use this to report your transactions but will still need to calculate your cost basis and capital gains/losses.
- The IRS can find cryptocurrency users. Government authorities use subpoenas to gather information from exchanges about who is trading cryptos. Plus, they use data analytics programs. So, even if all the details aren't known, the IRS can track down crypto traders and ask them to report.
Calculate the cost of your cryptos
All this is to say that record keeping is extremely important when you're using cryptocurrency. Record the market value of your cryptos when you acquire them and use that to figure out your cost basis. This can be done using the following formula:
(crypto purchase price + transaction fee) ÷ quantity of cryptocurrency = cost basis of one cryptocurrency unit
Let's say that you bought Litecoin (LTC) when it was worth about $210. You bought $1,000 worth and got 4.76 LTC. Now, let's say the transaction fee is 1.49% when you make your transaction.
($1,000 + ($1,000 x 0.0149)) ÷ 4.76 = $211.88 per LTC
Your cost basis is about $212. It's higher than the cost of the crypto because of the fees. That's your basic starting point when you sell it later. Any change in the cost basis is a gain or loss that needs to be planned for in your taxes accordingly.
How do I actually file my crypto taxes?
The IRS has been ramping up enforcement of crypto taxation. As a result, there have been some recent changes to how cryptocurrency transactions are handled.
First of all, if you look at the latest version of Form 1040, you'll notice that there is a place to report your cryptocurrency gains and losses, as well as your income in the form of cryptocurrency. It is in a different place from previous years, so be sure you don't miss it.
You use Form 8949 to itemize your transactions. Include the dates of purchase and sale, your cost basis, and your gain or loss. Once you've filled out that form, you enter the appropriate information on Schedule D.
You might also receive a Form 1099 from the exchange you use. This provides little information beyond serving to let you know how much income was received from your transactions. It doesn't include your cost basis, nor your gains or losses.
If you don't report your crypto transactions and pay the required tax, you could be audited — and have to pay penalties.
Make sure you report your crypto gains and losses
Any time you make money from anything you own, whether it's a digital asset or not, the IRS expects you to report it on your taxes and pay if you owe. However, because of the nature of cryptocurrency, you need to take extra care to keep good records so your taxes are accurate. Make sure you do your due diligence so you don't have to deal with the IRS later.