Cryptocurrency: What It Is and How It Affects Taxes

The concepts behind cryptocurrency have been around for a long time, but they weren’t realized until Bitcoin was introduced in 2009. Since then, hundreds of cryptocurrencies (or crypto) have emerged to capitalize on the Bitcoin trend, and a handful of them have managed to stick. In fact, cryptocurrencies have developed to the point where they have significant tax ramifications for many.

Let’s take a look at how cryptocurrencies are regulated, tax-wise, and how taxpayers can offset the tax burdens associated with their crypto.

What Is Cryptocurrency and How Is It Acquired?

Cryptocurrency is a unit of exchange disconnected from fiat currencies like the U.S. dollar. When first introduced, it was billed as a potential alternative to government-controlled currencies, as cryptocurrencies are not centrally managed. Further, cryptocurrencies are less affected by inflation, making it a potential hedge during uncertain economic times.

The challenge with crypto is that its value is dictated by the market, like any other asset. As such, crypto can experience volatile swings in value. Those value spikes and dips can have tax implications.

Cryptocurrencies are also less accessible than traditional fiat currencies. It can be bought or traded for, but new cryptocurrency units (typically called coins) must be “mined” for. This is done using blockchain technology, which has applications beyond cryptocurrencies. Blockchains are encrypted databases that function like a transaction record. When someone attempts a transaction using the cryptocurrency, the request is sent out to a network of “miners” who receive the transaction data in its encrypted form – these are the blocks. The miners use extensive computing power to solve mathematical problems attached to each block. Once this is done, the miner’s work is verified and, if the math works out, the transaction is added to the block, the miner receives a certain amount of crypto for the effort, and the cycle repeats again.

However people acquire or trade crypto, taxes are inevitably involved.

Cryptocurrency Is Treated Like Property for Tax Purposes

Regarding taxes, there is a major difference between cryptocurrency and fiat money. The value of the U.S. dollar, Euro, or other fiat currency is dictated by that currency’s face value. A dollar is worth a dollar, in other words.

Crypto, though, does not have a face value that dictates the currency’s worth. Instead, it is considered a capital asset for tax purposes, meaning that it is considered property. Here’s what that means for crypto investors:

• Crypto earned through mining is taxable – When miners acquire crypto through blockchaining, that crypto is subject to income taxes. Therefore, it must be reported as income for tax purposes, using the fair market value at time of acquisition. This could be more than what the crypto is worth at tax time.
• Crypto trading is also subject to taxes – If crypto is traded or sold for a gain, that gain is taxable. For example, if an investor buys $1,000 worth of Bitcoin and later sells it for $2,000, the resulting $1,000 gain is taxed.
• Purchasing items or services with crypto is also a taxable event – If goods or services are purchased using crypto, taxes may be applied. Specifically, if the acquired goods and services are worth more than the fair market value of the crypto at time of purchase, the resulting gain is taxable. For instance, if someone buys $10,000 worth of Bitcoin and then trades it for a $20,000 car, the IRS considers this a $10,000 taxable gain.

Also, if someone is paid using crypto, it is taxed as standard income and must be reported.

The situation can get complicated when a cryptocurrency undergoes a “hard fork” or when new crypto is distributed as part of an “airdrop.” Occasionally, there are major changes to a particular crypto’s blockchain – such as the size of blocks or the method of decryption. When these changes occur, there’s effectively a split between the old and new versions of the cryptocurrency. In some cases, this can result in an entirely new cryptocurrency.

Airdrops are frequently associated with hard forks. During an airdrop, new crypto tokens or coins are distributed to select people – typically active members in the crypto community. This is almost always done for promotional reasons, to drive adoption of the new crypto. People who receive cryptocurrency in this way must report it for tax purposes. Timing is important, though, as receipt of the crypto is not official until the receiver has dominion, or control, over the currency. For instance, if someone has crypto stored in a wallet available through a crypto exchange, they likely do not have dominion over the currency, and therefore do not have receipt of it for tax purposes.

How Cryptocurrency Holders Can Minimize Their Tax Burden

The most effective way to reduce crypto taxes is to treat the currency like a long-term capital gains asset. This can be difficult, as crypto is subject to major swings in market value. By holding onto the crypto for a year following acquisition, though, it may be subjected to long-term capital gains tax instead of short-term gains.

Long-term capital gains are taxed up to 20 percent, depending on the taxpayer’s income. In most cases, the tax rate is below 15 percent for long-term assets. Short-term capital gains taxes are treated as standard taxable income and can therefore be taxed up to 37 percent. Again, it depends on the taxpayer’s income bracket.

When crypto is disposed of as an asset, any gains must be reported on Form 8949 (Sales and Other Dispositions of Capital Assets) and on Schedule D (Form 1040 – Capital Gains and Losses).

Also, any losses sustained as a result of trading or selling crypto can be deducted from your taxes.

Cryptocurrency Is a Complicated Tax Subject, So Speak with an Expert if You’re Invested In It

Crypto has been around for less than 15 years, so the tax rules are still being ironed out. Crypto investors are also faced with tracking their assets for tax preparation purposes. The regulations in this area can be difficult to pin down, even though there could be thousands at stake.

Given these crypto challenges, investors are encouraged to speak with their tax preparation professional. By doing so, investors can maximize their crypto tax savings.