Cryptocurrency remained dormant after a short-lived surge in 2017 but like any sleeping giant, it shocked the world by rising again in late 2020 with a single Bitcoin worth just shy of $30,000. This intense change in the course of crypto history prompted many to invest in virtual currency for the first time. As with any coin, there are always two sides. Some were on a path of new discovery. While those who were early to invest and had waited patiently for the right moment were finally cashing in to take advantage of the token’s exploding price for a profit.
As trends have shown, many people have jumped on board the cryptocurrency train in hopes of increasing their bottom line. However, for those unaware of the annual tax reporting requirements, crypto may have the opposite effect on their wallet and legal status. The unprepared user may find themselves coming face-to-face with the International Revenue Service (IRS) and the heavy penalties that follow those who skip reporting on gains. Depending on when you bought and sold your crypto, as well as other factors such as your income, you could be on the hook to pay additional taxes.
Due to the IRS’s increasingly aggressive position on the U.S and international cryptocurrency matters, it’s important for taxpayers to be in compliance now more than ever. The IRS has already positioned itself to pursue global cryptocurrency administration and has joined the global enforcement team of J-5 to impose offshore tax on cryptocurrency in particular.
To combat these challenges, Block Chain Investment Council assists individuals and businesses with tracking crypto taxes—especially across different wallets and exchanges. Our areas of service include:
- Cryptocurrency Income Tax
- Cryptocurrency Capital Gain Tax
- Cryptocurrency on an FBAR
- Cryptocurrency PFIC
- Disclosing Offshore Cryptocurrency on International Informational Returns
- Preparing cryptocurrency tax reports for the current tax year, identifying crypto income; gains, and losses
- Creating or amending crypto tax returns for previous years
- Responding to IRS notices and letters
- Securing a favorable outcome in cryptocurrency tax audits
- Fighting tax bills for unreported crypto
- Planning your most effective cryptocurrency tax strategy, unlocking every deduction, and avoiding legal pitfalls
Although the rules and regulations surrounding cryptocurrency are still being mapped out, the following is a summary of common questions surrounding Crypto Tax Law and how it should be reported to date.
Do You Have To Claim Crypto On Taxes?
Although the name cryptocurrency would suggest otherwise, the IRS sees crypto as property, not income or currency. They actually dubbed cryptocurrency as “the new Swiss bank account” and refuse to acknowledge cryptocurrency as currency.
Due to its categorization as property, the IRS expects you to declare your existing crypto on your tax return when you withdraw it from your account, sell it, or trade it. If you are not doing one of these three things, then you do not have to pay capital gains tax on crypto.
For instance, this past March, the IRS said it will not require crypto investors who simply bought “virtual currency with real currency” in FY2020 to report that transaction on this year’s tax returns. On the other hand, if you were aware that you had either sold or traded cryptocurrency and purposely avoided paying the tax or failed to report the sale on an exchange using a Schedule /Form 8949, then you may be facing a call from the IRS. What people don’t realize is that the majority of crypto exchanges have already tracked and reported their information to the IRS, regardless of their approval. In fact, Coinbase, one of the largest and most common exchanges used across the globe, lost in a hearing against the IRS and is now forced to disclose the names of the majority of its clients.
Can The IRS Track Cryptocurrency?
In short, yes. If you receive a Form 1099-K or Form 1099-B from a crypto exchange, without any doubt, the IRS knows that you have reportable cryptocurrency transactions. We owe this track and trace capability to the “matching” mechanism embedded in the IRS Information Reporting Program (IRP).
Most people, when asked what they know about crypto will tell you one of two answers: It is valuable, and it is untraceable. Many will debate on the first point, being that the value tends to be tempered by market fluctuations. However, the second point is a completely false and dangerous misconception made by the misfortunate. Both the investor and the cryptocurrency invested in are traceable. Although this fact may upset some, the IRS is not likely to loosen its reins as the number of crypto investors increases but on the contrary, they are getting better daily at tracing digital currencies around the world. With support from fellow agencies like INTERPOL and Europol, it’s getting almost impossible for crypto users to slide through the cracks and remain anonymous.
Does Coinbase Report To the IRS?
Yes, Coinbase reports to the IRS. This past year, Coinbase provided its US customers with the IRS Form 1099-MISC in exchange for rewards and/or fees through Coinbase.com, Coinbase Pro, and Coinbase Prime. Customers that were not from the US did not receive forms from Coinbase and were expected to manage their own local tax obligations.
Coinbase has already stated that for the 2021 tax year, they will not be providing users with the IRS 1099-K form. They will only be expected to report the 1099-MISC for those who received $600 or more in cryptocurrency from Coinbase Earn, USDC Rewards, and/or Staking in 2020.
Does Kraken Report To The IRS?
Yes, Kraken also reports to the IRS. Along with others, the popular U.S. crypto exchange called Kraken has been ordered to provide the IRS with information regarding user accounts that have made transactions equal to $20,000.
What Happens If You Don’t Report Cryptocurrency?
Filing a false return or failure to file and pay taxes can lead to the following:
- Tax Evasion Penalties
- Criminal Charges Of Tax Evasion
Even if you don’t receive notice directly from the platform you choose to invest with, there are reporting requirements that you are responsible for.
How Is Crypto Taxed Like Stocks?
For tax purposes, the IRS ruled in 2014 that Bitcoin and other digital currencies are capital assets, not currency. This means that crypto “currencies” get taxed like stocks whenever sold for a profit. It’s helpful to remember that since the IRS treats cryptocurrency as a property you can expect to see similar tax rules that also apply to stocks.
For instance, if the value of the property or stock goes up and you sell, you’ll likely be expected to pay a capital-gains tax. However, if the sale happens during the same year you purchased that property or stock, then you’ll only be expected to pay a short-term capital gain on your proceeds.
The same goes for purchasing goods/services with cryptocurrency. If the amount of crypto you spent has gained value over what you paid for it then you will incur a capital gains tax.
EXAMPLE: If you buy $30 of Ethereum and the value rises to $300 and you use that $300 to buy groceries, you will then owe capital gains to the IRS on the $270 profit you realized. Spending or selling crypto is the same in the eyes of the IRS.
Do I Pay Tax When I Purchase Cryptocurrency?
No, as previously stated, the IRS treats cryptocurrency like property. When a person purchases a property, they do not pay tax because the purchase price of the property is not a taxable event, therefore, the purchase of crypto is not a taxable event.
What Is The Relationship Between Cost Basis, Purchase Date And The Value Of Cryptocurrency And Why Is It Important?
- Cost basis is the amount you spend to acquire an asset, including the purchase price, transaction fees, brokerage commissions and any other relevant cost.
- The purchase date is important because it represents the cost basis of your property. When you sell or trade your cryptocurrency, this “basis” will serve as the acquisition price that will help determine your taxable gains and thus, what you owe to the IRS.
Simple Cost Basis Formula = (Purchase Price + Fees) / Quantity
- EXAMPLE: If you invested $150 into Bitcoin on April 1, 2020, for $6,537 with a 1.49% transaction fee. Your cost basis would be your total purchase price of $152.24 ($150 + 1.49%*150) divided by 0.023 ($150/$6,537) — or $6,619 per BTC.
How Does Your Accounting Method Affect Cost Basis?
- First in First Out (FIFO) – The cost basis for a sale is the cost basis of the earliest crypto that you acquired.
- Last in First Out (LIFO) – The cost basis for a sale is the cost basis of the last crypto that you acquired.
- Highest in First Out (HIFO) – The cost basis for a sale is the cost basis of the most expensive crypto that you acquired.
- Actual Cost Basis – Each cryptocurrency is tracked and any sale is the sale of a specific coin.
- EXAMPLE: While using the FIFO method you acquire one Bitcoin in 2018 and two Bitcoins in 2019. If you sell two Bitcoins in 2020, you would use the cost basis for the 2018 purchase and one of the 2019 purchases.
How Is Cost Basis Affected By Crypto-To-Crypto Transactions?
For cash-to-crypto transactions, the cost basis is straightforward. However, when dealing with crypto-to-crypto things can get a bit more complex and will require an extra step in the process.
- EXAMPLE: If you sold one Bitcoin to obtain the equivalent in Litecoin the cost basis would be the fair market value of the Bitcoin at the time of sale in U.S. dollars (plus fees). So …. $6,500 plus a 1.49% transaction fee of $96.85 divided by 144—or, $45.88 per LTC.
If you don’t intend to use reputable price indexes, then you need to keep a record of your transactions to guarantee that you have the right cost basis on file. Otherwise, you may have to short through historical data to find the fair market value for different cryptocurrencies at different times.
What Do Initial Coin Offerings (ICOs) Have To Do With Cost Basis Accounting Methods?
ICOs were initially designed to finance the early stages of blockchain projects using crowdfunding because cost basis can also be complicated by the lack of liquidity. Investors would receive tokens or vouchers that in turn, they would utilize to pay for future services being developed by the issuing firm. Today these utility tokens have been replaced by ‘tokenized securities’. Dealing with the cost basis for issuers comes with less certainty than when dealing with ICO investors. According to the IRS, any “issuance of ‘utility tokens’ for cash, crypto or other property, will be treated as the sale of property in which the issuer has a zero-cost basis”.
How Does Cost Basis Affect Airdrops & Forks?
If you are not paying to acquire a new cryptocurrency, your cost basis of a hard fork or airdrop is zero. You would only pay a tax on the entire amount when you sell it. An immediate tax obligation is formed for the current year when a hard fork or airdrop takes palace. In simpler terms, tax is owed on the cost basis or fair market value during the time of acquisition of the new cryptocurrency in that current tax year. Your only requirement is to maintain technical control over the asset.
Fortunately, lawmakers have pushed for better solutions since most crypto holders do not have an option when it comes to being on the receiving end of a hard fork or airdrop. Currently, if a crypto holder does not sell their crypto at the right time, they may not realize a single cash gain!
How To Determine Cost Basis Across Multiple Wallets & Crypto Exchanges?
If you use multiple wallets or exchanges, you will not be able to rely on the exchange alone to report your cost basis figures accurately. To stay on top of things, you keep track of how you originally acquired the cryptocurrencies that you’ve imported into your account. Most exchanges will not know this information, although they may be able to prepare a cost basis report where possible.
Keep in mind that exchange cost basis calculations do not work if you have:
- Bought or sold digital assets from elsewhere.
- Sent or received digital assets from elsewhere.
- Stored digital assets on an external device.
- Participated in an initial coin offering.
- Used different accounting methods than the exchange.
It is helpful to merge your transactions across all your exchanges and wallets onto a single data set to determine the cost basis. In addition, it is important to house every exchange transaction you have made on a CSV or other commonly shared file format. The goal is to be able to determine when each transaction occurred. Then you can determine the cost basis for each transaction based on your accounting method.
The bottom line is to remember that if you are going to use multiple exchanges, you must also aggregate transactions to guarantee your cash basis calculations are correct.
What Happens When You Sell Cryptocurrency?
Unlike purchasing, selling cryptocurrency is a taxable event. At the most fundamental level, you are hopefully selling for a profit, or a Capital Gain at which point you will owe money to the IRS.
Do You Pay Taxes On Crypto If You Haven’t Sold?
Even if you have not sold or if you have incurred a loss, also known as a capital loss, you will still need to disclose your crypto activity on your tax return. Fortunately, if either of these two events occurs, you will not be responsible for paying tax on your cryptocurrency. Furthermore, if you do incur a capital loss, it will offset any gains that you made and decrease the amount of tax you might owe.
How Exactly Is Crypto Tax Calculated?
- You must pay tax on your cryptocurrency profits the year in which you sold.
- This tax as mentioned previously will be based on the capital gains and losses from your digital asset holdings.
- The federal tax rate on cryptocurrency capital gains ranges from 0% to 37%.
For tax purposes, it is important to note the accounting method used for calculating gains, total profit made, and how long you held the coins before selling, better known as the holding period.
Total profits = the sale price of your crypto x how much of the coin you sold
- EXAMPLE: Kevin purchased $35,000 of Cryptocurrency on February 1, 2018, and sold it on December 14, 2018, for $30,000. When Kevin sold the Crypto for $45,000, he made $10,000 — and the IRS wants to tax Kevin on his $10,000 profit.
Here’s how it works:
- Short-Term Capital Gain
- The $10,000 Kevin made from the sale of his crypto is considered a short-term capital gain since he bought and sold his crypto in the same year and held it for less than 12 months.
- With this type of gain, Kevin will be taxed at the same rate as his regular income.
- When dealing with a short-term sale of property (i.e. exclusions, exemptions, and limitations permitting) there is no special tax credit or treatment.
- Long-Term Capital Gain
- Let’s suppose Kevin sells his crypto on December 14, 2019, instead of 2018. This type of sale is now considered to be a long-term capital gain because more than 12-months have passed since the initial purchase was made.
- Long-term capital gains receive a preferred tax rate compared to short-term gains. The tax rate for long-term capital gains is 15%. However, if a person falls into the top tax bracket their rate jumps to 20%. **
**Please note, it is important to keep up with the regulations the year in which you sell your crypto because long-term capital gains rules change constantly.
EXAMPLE: (Short-Term vs. Long-Term Capital Gains): Sara and Kevin each earn $800,000 a year and are both in the top tax bracket. If Kevin and Sara each purchased cryptocurrency for $30,000 and each sold it for $100,000, here is how the different situations tax situations will play out:
- Kevin (Short Term Gain) would have a $70,000 dollars gain that will be taxed as an ordinary income tax rate, and his net effective tax rate would be somewhere between 35 to 40%. (about $25,000).
- Sara (Long Term Gain) has a $70,000 gain that will be taxed at 20%.(about $14,000). If she was not in the top tax bracket she would only be taxed at %15 (about $10,500).
What Are The Tax Rules For Exchanging Cryptocurrency?
When dealing with exchanges, things can get rather complicated quickly. To assist with explaining this transaction we will use a simple example below.
- EXAMPLE: Laura purchased Dogecoin for $10,000 and it is now worth $20,000. Sergio purchased Cosmos for $5,000 and it is now worth $17,000.
- Laura has decided to Exchange her Dogecoin for Sergio’s Cosmos. Laura’s basis is $10,000 and she is receiving Sergio’s crypto for $17,000 at current market value. This means that Laura has a gain of $7,000 of which she must pay tax on.
- If Laura decides to sell her crypto in the future, her new basis will be $17,000 instead of her initial investment of $10,000 because she paid tax on the full value.
- EXAMPLE: Using the initial purchase scenario above, Sergio has a basis of $5,000 in Cosmos. If Laura trades Sergio her crypto, which is now worth $20,000, Sergio will have to report tax on a gain of $15,000.
- In the future, if he wants to sell cryptocurrency, his new basis will be $20,000.
It is important to keep in mind that when you exchange property for another piece of property, or crypto in exchange for crypto, you are receiving it at the current market value. If the property you receive has a higher value than the one you have, you most likely will need to pay a capital gain tax on the gain.
Income Tax & Cryptocurrency
If you receive $400,000 in cryptocurrency as a result of employment instead of a check or cash, you will owe income tax similarly to what you would owe if you had received the amount as “regular” currency. The value of your cryptocurrency would be determined by looking at the day it is received. The IRS would then expect you to pay income tax on this amount along with any potential social security tax, NIIT, etc. The IRS has no intention of letting you or your employer circumvent tax rules simply because you received a cash equivalent instead of actual cash. From their perspective, you did work and as a result of said work you were paid, and they are now due their cut.
How Is Tax For Exchanging Cryptocurrency Calculated?
Tax on an exchange can be calculated by subtracting the cost of the purchase of the property/crypto from the market value of the property/crypto you received. This number will bring you to your gain amount on which you will pay tax to the IRS.
What Happens If You Receive Cryptocurrency As A Gift?
When cryptocurrency has been gifted to you, assume the standard tax rule states you have also received the carryover basis. This basis will now serve as the basis for your cryptocurrency.
EXAMPLE: Your grandfather bought cryptocurrency years back for $20,000. He held onto the amount, and it is now worth $400,000. He gives you this crypto as a gift to put towards the purchase of a new home. The sellers of the home will not accept crypto directly, so you decide to sell it first.
Since the fair market value on the day you received the gift was $400,000, should you receive the amount tax-free? No; because you received the crypto as a gift, you have to take it at the value your grandfather purchased it for, which was $20,000. This also means you have a gain on the exchange or a carry-over basis of $380,000.
You Received Cryptocurrency As An Inheritance (Step-Up)
Now let’s say you had a family member pass away and instead of gifting you their cryptocurrency, they left it for you in their will. The rules that govern estate tax state that you will receive the market value of the property on the date your family member passed. This is also known as stepped-Up Basis.
EXAMPLE: Using example 9 for reference, if the value of the cryptocurrency you received is $400,000 and you choose to sell this crypto for $400,000, you will not pay any tax.
Are There Any Ways To Defer Crypto Taxes?
Yes! A 1031 exchange is a way to defer crypto taxes. We will use the short example below to show you how:
EXAMPLE: You have a rental property that you purchased for $200,000 that is now worth $2,000,000.
To avoid paying a tax from the sale of the property, you decide to shift the investment into a new rental property. In order to do this, you execute a 1031 exchange (which has very specific timing rules and holding requirements), and absent any boot (usually cash or mortgage payoff in addition to the property) you receive a new property while maintaining the same basis ($200,000) and it is not considered a sale so that you do not have to pay Capital gains tax at the time.
Unfortunately, at this time1031 rules do not apply to cryptocurrency for exchanges for coins in 2018 and subsequent years.
Are There Rules For Reporting Foreign Cryptocurrency?
Yes, and this is where things can get most complicated. Due to the lack of direction from the U.S. Government, many find themselves faced with the penalties associated with non-compliance of required foreign disclosure activities. In order to assist you in navigating these waters we’ve provided the basics:
Who is FBAR /FinCEN?
Now enforced by the IRS, FBAR represents the Report of Foreign Bank and Financial Accounts Form and was created by FinCEN. A person is required to report to FBAR if they have more than $10,000 on any given day of the year in foreign accounts (not limited to bank accounts). Failing to report to FBAR can result in numerous penalties, including anything from a warning letter all the way up to a 100% penalty in a multi-year audit.
How Exactly Do You Report To Fbar/Fincen And The Irs When Dealing With Overseas Cryptocurrency?
FinCEN and the IRS have not yet created clear guidelines for overseas cryptocurrency reporting which has proven to be problematic for most users with overseas crypto. Most assume that they do not need to report cryptocurrency on FBAR since crypto is treated as property and the FBAR is used to report foreign accounts. However, FBAR Rules are Contradictory and confusing.
EXAMPLE: Let’s assume you have a safety deposit box in the bank. According to most blogs, this box would not be considered an account along with the precious metals and stones inside. On the other hand, if you refer to the IRS manual you will find the following clarification regarding Safety Deposit Boxes:
- “A reportable account may exist where the financial institution providing the safety deposit box has access to the contents and can dispose of the contents upon instruction from, or prearrangement with, the person.”
- “Precious metals, precious stones, or jewels held directly by the person.31 USC 5314 defines ‘foreign financial agency’ as ‘a person acting for a person as a financial institution, bailee, depository trustee, or agent, or acting in a similar way related to money, credit, securities, gold, or a transaction in money, credit, securities, or gold.’ Therefore, a reportable account relationship may exist where a foreign agency holds precious metals on deposit or provides insurance or other services as an agent of the person owning the precious metals.”
Most would agree that the information above is conflicting. This is because even though the FBAR is being enforced by the IRS (and they have their own internal Revenue manual), the form was created by FinCEN, which has its own enforcement standards.
What Is The Purpose Of Foreign Reporting?
Both the IRS and FinCEN seek to promote transparency. Normally, you will see courts err on the side of the U.S. government instead of entertaining arguments from people seeking to avoid reporting and/or maintain anonymity.
If you are not just holding crypto on your own personal wallet on your personal computer, you will find there is more to consider when looking into reporting. For instance:
- Is there virtual currency and regular currency in the same account?
- Have you exchanged the currency for cash and left it in the trading account?
- How much cryptocurrency do you actually have in the foreign account?
- In addition to FBAR, you may also have other reporting requirements under FATCA, Form 3520, Form 3520-A, and Form 8621 (amongst others).
So, Are You Out Of Compliance?
Block Chain Investment Council is one of the leading law firms in the field of cryptocurrency tax law. We strive to provide clear and proactive guidance to our clients so we can help you avoid the complexities of crypto taxes while you focus on your next investment!
If you are looking for effective crypto tax solutions that help to maximize your digital gains while avoiding non-compliance, then there is no better organization for your needs than Block Chain Investment Council.