by Pam Krueger and Jeffrey George, CFA, CEPA
Originally published in TechCrunch on March 14, 2022.
Maybe you’re one of the millions of Americans who jumped on the Bitcoin bandwagon in 2021. Or perhaps you’ve become an active crypto trader. Or maybe digital currency bonuses have become part of your compensation package at work. You might have even used some of it to buy something or pay someone else for their services.
While you’re buying, selling, earning or spending crypto, have you given a lot of thought about the tax implications? Perhaps you’ve been thinking, Crypto currencies aren’t physical currencies. They aren’t even regulated by the U.S. government. That means I don’t have to pay taxes on profits I make from trading crypto, right?
Even though the IRS’s rules around crypto are still sketchy in many areas, they’ve made it clear that cybercurrency is treated as an investable asset for tax filing purposes.
Gains and losses
In terms of calculating taxable gains and losses, crypto transactions are treated exactly the same way as those involving stocks, bonds or mutual funds.
If you sell crypto for more than you paid for it, the profit will be taxed as a short-term capital gain if you held the crypto for less than a year. Generally, people try to avoid short-term capital gains because they’re taxed as ordinary income.
If you make a profit selling crypto you’ve owned for more than a year, it will be taxed as a much more preferable long-term capital gain. The tax rate will either be 0%, 15% or 20% depending on your income.
If you sell crypto for less than what you paid for it, you can take a capital loss which can reduce your taxable income or offset capital gains from the sale of other assets.
Seems relatively simple, right? But what if you made numerous trades of Bitcoin, Ethereum, or other cryptos throughout the year, profiting from some transactions and losing money on others?
Will your crypto exchange help you accurately calculate how much you’ll owe Uncle Sam?
The answer is: It depends.
Fuzzy tax support
Since crypto exchanges aren’t regulated by the SEC, they’re not legally required to offer the same level of tax reporting that discount brokerages and custodians must provide to stock, bond and mutual fund investors.
While some U.S.-based crypto exchanges offer basic summaries of taxable proceeds from crypto-related trading activities, many do not.
And, to the best of our knowledge, none currently generate IRS Forms 1099-B and 8949, which brokerage companies and custodians deliver to consumers to help them report income and capital gains and losses from the sales of investable assets.
While the basic taxable summaries some crypto exchanges provide may be helpful, their numbers could potentially increase your tax burden.
Why? Without getting into arcane details, let’s just say that the often-creative yet perfectly legal methods some exchanges use to pair purchases and sales to minimize profits may inadvertently result in a higher percentage of these profits being characterized as short-term capital gains.
If you don’t trust your exchange to provide accurate tax summaries, you can download a spreadsheet listing all of your raw transactions. You can then manually calculate gains and losses yourself or hand it off to your accountant.
Another option is to use an online crypto-tax resource to generate these IRS-ready reports for you.
Crypto’s unique tax-management challenges
Many investors and financial advisors use a strategy called tax-loss harvesting to reduce capital gains taxes. The idea is that you sell one security at a loss to offset profits from the sale of another.
This strategy poses unique problems for traders who are constantly buying and selling a particular crypto over the course of the year. Why? Because these activities may run afoul of the IRS’s rules regarding wash sales.
What is a wash sale? To keep it simple, if you want to claim a capital loss from the sale of any investable asset, whether it’s a stock, mutual fund, or crypto, you must wait 31 days before purchasing that same asset again. If you purchase it before 30 days have passed, the IRS considers this a “wash sale” and won’t allow you to claim the loss.
So, if you buy and sell Bitcoin every month, you probably won’t be able to claim losses from transactions that didn’t pan out.
The lesson here? If you’re going to trade crypto frequently, your options for using capital losses to offset capital gains may be limited.
Other crypto-taxable situations
Profits from trading aren’t the only crypto-related activities the IRS requires you to report.
If you receive crypto as payment for a service provided, you’ll have to report this income on your tax return. The actual amount is based on the price of the crypto on the day you received it. Even if you don’t sell it immediately you still have to report this income.
What if you use a bit of your Bitcoin to buy a new outfit or iPhone from a leading-edge online retailer? Since you’re selling Bitcoin to purchase something, you’ll need to report the purchase and selling price for that particular transaction to the IRS as well.
Proceeds from sales on foreign exchanges should be reported, too
Many U.S. investors use foreign crypto exchanges to buy and sell crypto. Since these exchanges don’t have to comply with IRS tax reporting rules, the level of tax-related information they provide may be very limited.
That doesn’t mean you’re off the hook. While the IRS hasn’t yet established clear guidelines for reporting of proceeds from overseas crypto transactions, the agency has hinted that it will soon require these transactions to be reported on Form 8938, Statement of Specified Foreign Financial Assets.
What happens if you don’t report these taxes?
Don’t think that just because the IRS’s rules around crypto are still evolving doesn’t mean that you’ll be able to claim ignorance as an excuse for non-compliance.
After all, we know that the IRS has no problem penalizing people who underreported taxable income in previous years.
And we’re already seeing the U.S. government becoming more aggressive about regulating the crypto industry.
For example, starting in 2023, U.S.-based crypto exchanges will have to generate 1099-B reports for traders and pass this information on to the IRS. And businesses that participate in crypto-related transactions of $10,000 or more will have to report them to the IRS.
The IRS is also stepping up its efforts to uncover and prosecute crypto-related tax-dodging and cybercrimes.
In 2021 the agency subpoenaed dozens of crypto exchanges to identify crypto-tax scofflaws.
And in February, the IRS-Criminal Investigations Cyber Crimes Unit arrested two people who were trying to launder $3.6 billion in crypto stolen from Bitfinex, a virtual currency exchange, in 2016.
We’re likely to see many more of these kinds of cases in the future. Try not to be one of them.
Don’t gamble on noncompliance
The cost of failing to report—or incorrect reporting—proceeds from crypto-related activities could be extremely high if the IRS gets you in its crosshairs.
That’s why, if you don’t feel you have enough knowledge to figure out your reportable crypto income on your own, you should meet with an accountant or tax preparer who has experience working with those who own and trade crypto and other digital assets.
Pam Krueger is the founder and CEO of Wealthramp, an SEC-registered advisor matching platform that connects people with vetted fee-only financial advisers, and the creator and host of the investor-education television series MoneyTrack.
Jeffrey George is a fee-only financial adviser and founder of TAO Financial, a registered investment adviser offering advisory services in Florida, Texas, and other jurisdictions where registered or exempted. He is an advisor on the Wealthramp network.