The first major use of cryptocurrency was through a dark-web marketplace called Silk Road that allowed people to buy and sell illicit drugs anonymously with Bitcoin. The marketplace operated for less than three years – generating $1.2 billion in profits – before it was seized and shut down by the FBI in October of 2013.
Though applied for a malevolent purpose, the fact that Silk Road only dealt in Bitcoin was a significant first. It demonstrated the power of decentralized currency – and that it has value. After Silk Road was taken down and its profits were realized, cryptocurrency became a target for taxation.
In March of 2014, the IRS issued their first cryptocurrency guidelines.
A Little Background
Cryptocurrency, otherwise known as digital currency or global decentralized money, is an open accounting system. This means that every transaction and investment in it is visible to the public and is accessible to anyone with a phone and the internet. Cryptocurrency essentially makes everyone their own bank because anyone with a crypto wallet and digital currency in it can receive and make transactions within seconds, worldwide, without a third-party in the mix. And all these personal banks share the same currency throughout the world: Bitcoin in the United States has the same value of Bitcoin in Japan.
This network of individual banks operates in such a way that the value of the currency in them cannot be manipulated by a central authority. Cryptocurrency does not rely on third-party entities such as governments, credit card companies or banks to process money transactions (which normally include additional fees).
It’s still subject to taxes, though. The government might not be able to control that you have crypto and what you use your Bitcoin or Ether for, but they can still claim a percentage of your gains.
Regulations can’t keep pace with innovation, so even though Bitcoin (the first cryptocurrency) was launched in 2009, it didn’t start being taxed until 2014. However, the IRS’s initial (vague) guidelines left many questions unanswered as the crypto market continued to grow more complex. In 2019, the IRS issued additional detailed guidance to help people better understand their reporting obligations. So now we are not challenged by a lack of rules, but by a great many that are being imposed on an even more complicated, constantly evolving system.
No More Secrets…
In the online world of cryptocurrency you are anonymous, but the IRS can still see where your money is going (e.g., from your bank account to crypto exchange platforms like Kraken or Coinbase). Because crypto is so volatile, the IRS relies on your voluntary reporting to find out how much you have gained (or lost) from your investment. However, if they suspect you of tax fraud there is on-chain technology that enables them to view records of your transactions on the blockchain, which is visible to everyone. Sometimes, the Internal Revenue Service will issue summons to platform requesting the turnover of transaction history to check compliance. See our post regarding the Coinbase and our update on United States Operation Hidden Treasure.
So with all these relatively new rules implemented on a novel decentralized digital system of money, how do you know which transactions are taxable and which ones are not? What if you’re behind on your crypto taxes and don’t know what you owe to the IRS?
Digital Currency is Property
Cryptocurrency, though being a digital currency, is not regarded by the IRS as currency at all, but rather as an investment of tangible US dollars. As “property”, cryptocurrency is subject to capital gains tax when withdrawn.
In the eyes of the IRS, buying crypto is equivalent to investing money in real estate. The initial purchase of crypto is non-taxable, but it is a good idea to write down the date and time you bought it and the amount of USD you invested. This will help gauge your gains and/or offset future losses on your tax returns (more on that later). Not every cryptocurrency transaction is taxable, though, so let’s start on a positive note by going over the things that aren’t.
Non-Taxable Cryptocurrency Events
- The Purchase and Holding of Cryptocurrency: Since the IRS regards crypto as property, the purchase of digital currency is treated as an investment. You gain nothing from investing if you don’t cash out on your funds, so no taxable event is triggered.
- Donating to Nonprofits or Charities: Donations of any kind to a tax-exempt 501(c)(3) charitable organization are non-taxable and can be used to offset your other capital gains.
- Transferring Cryptocurrency Between Wallets: As long as you have not exchanged one digital currency for another before moving it between wallets, the transfer from Wallet 1 to Wallet 2 is not taxable. To the tax authorities, it’s like moving a five dollar bill from an old wallet to a new one. You gain nothing other than a different location that holds the same fair market value of funds.
- Gifting Cryptocurrency: As of 2022, gifts of up to $16,000 (according to the fair market value of the cryptocurrency at the time) are non-taxable. If a gift exceeds that amount, you’ll need to file a gift tax return. Note that a transfer that is not made in exchange for goods or services (such as giving someone money after losing a bet) may count as a gift even though you didn’t intend it as one.
Taxable Cryptocurrency Events
- Converting One Cryptocurrency to Another: Let’s say you’re using your Bitcoin to buy Ether. Before you purchase Ether, you first have to sell the Bitcoin, which will be subject to capital gains tax. When you purchase the Ether after selling your Bitcoin, you are starting a new investment, and will not owe taxes on the Ether until you withdraw your funds (assuming there is a gain).
- Selling Cryptocurrency For Cash: Like any other investment in property, if you take out more money than you put in, you have to pay capital gains tax on the difference. If you sell your crypto for fiat currency and it is now worth less than you initially paid for it, you can use that loss to offset any other gains (digital currency or otherwise). This is the main reason why it is important to keep track of the amount you paid to purchase your cryptocurrency (and when). Good record keeping can help you save money!
- Using Cryptocurrency to Make a Payment: Because the IRS regards crypto as property, the purchase of anything with it (including a coffee at Starbucks) is subject to short- or long-term capital gains tax. For example, if you put $1 into crypto that is worth $4 on the day you bought a $4 White Chocolate Mocha at Starbucks, you owe capital gains tax on the $3 you gained from your “cashed-out” investment. It might be simpler to just use spare change for that purchase.
- Being Paid for a Service in Cryptocurrency: This is a taxation double-whammy: Getting paid in cryptocurrency subjects you to income tax on the fair market value of that crypto, and when you withdraw those digital funds, you pay capital gains tax on the increase in value.
- Mining Cryptocurrency: If you are mining crypto as a hobby it will be taxed as self-employment income (determined on the basis of the fair market value of the mined coins at the time of receipt). If you are mining crypto as a business, the tax rate is higher and you’ll still have to pay the self-employment tax – you are, however, eligible to deduct necessary business expenses such as the purchase of equipment, electricity costs, repairs and rented space.
- Staking cryptocurrency: Staking cryptocurrency is only offered by some cryptocurrencies like Ether and Polkadot. Staking means that you have committed to hold a certain amount of money in a cryptocurrency for a specified amount of time, and you are rewarded in additional tokens by the exchange platform. This enables you to generate passive income just like interest is generated from holding money in a bank. But since your interest has accumulated from an investment in property and not from cash holdings, you have to pay capital gains tax on the cryptocurrency tokens you receive as a reward for your staking.
- Airdrops: Crypto traders love airdrops because they’re essentially free money. Just imagine opening your wallet and seeing some extra money there that was sent to you. This usually happens when a startup crypto company is promoting itself or thanking you for being one of its investors. But this deposit doesn’t count as a gift – the tax authorities view airdrops as income. A company handing out rewards in cryptocurrency is treated like an employer rewarding a good employee with a bonus, which is taxable.
For more tax planning when it comes to cryptocurrency please see our prior blog post regarding tax planning for miners and stakers or listen to our podcast on cryptocurrency and taxation.
Tax Attorneys for Crypto Investors
Understanding the cryptocurrency tax guidelines is just the beginning of smartly managing these investments. Please see our practice area on Cryptocurrency for more information and contact our office to learn more about how we can help you manage your cryptocurrency to minimize your tax liability.