Cryptocurrency and taxes explained: What you need to know
Cryptocurrency is not treated the same as other currency when it comes to taxes. Since the government classifies cryptocurrency as an asset, there are some important guidelines.
Part of selling and investing in cryptocurrency involves paying taxes to be compliant with the IRS.
Cryptocurrency may be virtual and decentralized in terms of transactions, but there are instances you owe taxes on it. Taxable events depend on how and when you acquired it.
Here is an overview of how cryptocurrency is taxed and what are considered taxable events with these assets.
Do people have to pay taxes on cryptocurrency?
Yes, people are required to pay taxes on cryptocurrency in certain situations. The IRS classifies cryptocurrency as an asset, which means sales fall under capital gains tax laws like other assets.
Moreover, buying something using cryptocurrency is also taxable because the person disposes of cryptocurrency to make a purchase, which is different from normal currencies.
How is cryptocurrency taxed?
Taxes are due after a sale, trade or disposal of cryptocurrency if there is a gain or even a loss. If you sell or trade the cryptocurrency for a profit, you pay taxes on the gain like other assets. The same is true with non-fungible tokens; a capital gain or loss should be reported for taxes.
Other events prompting you to pay taxes on cryptocurrency include the following:
- using it for payment of goods or services; and
- receiving as payment or reward.
Buying, trading and selling cryptocurrency
Buying cryptocurrency is not a taxable event if there are no additional transactions using the cryptocurrency -- even if the token value increases. Taxes are due only when a person sells, trades or uses cryptocurrency as a method of payment.
If someone bought a cryptocurrency for $800 and later sold it for $1,000, they should report the $200 gain on their taxes. The same is true for a loss. If someone bought that cryptocurrency for $800 but sold it for $600, they can use the $200 loss to offset other gains and taxable income.
A cryptocurrency trade could be a taxable event but is slightly more complicated. If you trade one token for another -- such as a dogecoin for bitcoin -- you are required to report any gains. For example, if someone purchased a dogecoin for $5,000 but traded it for a bitcoin valued at $10,000, they would need to report a $5,000 gain.
Each time a new cryptocurrency token is created, a process called cryptocurrency mining takes place, adding a new block to the blockchain. Cryptocurrency mining, such as bitcoin mining, validates and adds the token to the blockchain for circulation after the miner solves cryptographic puzzles. Cryptocurrency is typically the payment or reward for this process, which is considered taxable income.
You should report this cryptocurrency's value by converting it to U.S. dollars the day you received it as payment. A typical form to report this payment is Form 1099-NEC.
Receiving or using cryptocurrency as payment
For some people and businesses, cryptocurrency is a form of payment, which can be sent through a crypto wallet.
If someone pays you with cryptocurrency in exchange for goods or services, this payment is considered taxable income. The taxable amount is the cryptocurrency's fair market value on the day and time you received payment converted into U.S. currency.
For example, if you use bitcoin to purchase a boat valued at $35,000 but the bitcoin fair market value was $30,000 when purchased, there is a gain of $5,000. However, if the bitcoin was worth $40,000, there would be a $5,000 loss. This loss can be used to offset any other taxable income or offset capital gains during the same year.
Participating in airdrop or fork
When a new project launches with a new cryptocurrency, the platform or exchange may offer its regular customers free tokens to encourage them to adopt it. The act of giving these new tokens as encouragement is called a crypto airdrop. These new, free tokens are considered a taxable event, so they need to be reported.
The hard fork process describes upgrading a blockchain network. When a blockchain is upgraded -- with either new software or rules -- the previous network is then invalidated. Users then need the latest version by upgrading the software or blockchain network.
To encourage users to upgrade, sometimes, there is an airdrop after the hard fork. When this happens, the new cryptocurrency offered in the airdrop is a taxable event.
Capital gains and losses on cryptocurrency
Because cryptocurrency is taxed like property and similar to stocks, you need to report capital gains. The rates vary based on the amount of time you hold the cryptocurrency.
Assets, including cryptocurrency, held for less than a year qualify for the short-term capital gains and losses tax rate. Possession of the asset for more than a year qualifies for the long-term capital gains and losses tax rate.
When determining a capital loss or gain, take the original amount paid, and deduct the selling price when disposing of the cryptocurrency. The difference between the two is a capital gain (profit) or loss.
How are cryptocurrency currency transactions reported?
Depending on how you used the cryptocurrency, there are different relevant IRS forms, including Form 8949, Schedule C, Schedule D and Form 1040.
Most cryptocurrency exchange platforms do not send tax forms, so it's important to keep receipts and confirmations of all transactions with the date. These forms are due each year like standard tax forms.
For more questions, talk to a tax adviser, use a cryptocurrency tax calculator or look at these tax guide answers from the IRS.