When cryptocurrency first hit the scene about a dozen years ago, it came with a few compelling qualities that made it attractive to at least a small number of people.
First and foremost is that it’s decentralized. It’s not issued by a bank or subject to the control of the central bank, the way fiat currencies like the U.S. dollar or the euro are. Second, transactions are fast and simple. That’s because they move between individuals, not institutions. And third, crypto transactions are cheaper, because there is no middleman collecting a fee.
Cryptocurrency and Taxes
But there was another quality to cryptocurrencies that seemed particularly…intriguing. Since cryptocurrency isn’t regulated and doesn’t pass through the usual bureaucratic chain, it just might be the perfect payment system to avoid income taxes.
At least that was the thinking at the time, and there was some merit to it. After all, cryptos were a mere bug on the wall of the financial universe. They were barely drawing any attention from the tax authorities, especially the IRS.
But that was a long time ago, at least in terms of modern investing, and much has changed. Cryptos have grown in popularity and value, and they’ve gone mainstream. Prices for Bitcoin are now tracked and reported regularly by the major financial media.
More important, cryptocurrency is no longer being ignored by the IRS. That being the case, you’ll need to be aware of the impact of taxes on your cryptocurrency transactions.
Even though IRS treatment of cryptos is still evolving, it should now be obvious that the Tax Man is actively tracking crypto activity. The best strategy for crypto investors is to become educated, and be ready to play by the rules.
But what are those rules?
As I said, the IRS is still developing strategies for handling crypto transactions. But before we get into the questions, I need to advise you that I’m a certified financial planner, not a CPA or tax attorney. That means I’m not an expert on taxes, so you’ll want to consult a tax professional with any questions specific to your personal circumstances.
With that said, I’m going to do my best to spell out what we do know about IRS treatment of crypto transactions, at least up to this point.
Let’s cover seven common cryptocurrency questions.
7 Common Cryptocurrency Tax Questions
1. Are my cryptocurrency transactions taxable, and do I need to report them to the IRS?
I’ll get right to the point—absolutely! The IRS has even gotten serious about targeting undeclared crypto earnings. They initiated a program—Operation Hidden Treasure—to track down crypto activity. And they are warning taxpayers that crypto transactions are not anonymous.
If your crypto trading is taking place on an IRS-compliant broker, like Robinhood, you’ll receive a 1099-B from the broker reporting your crypto activities.
But let’s say you’re using an exchange, one that is not IRS compliant and doesn’t provide a 1099-B. You should know that you are not relieved of the tax liability. You’ll need to keep your own records of crypto transactions and report them to the IRS.
Just as you would with the profits on the sale of securities, like stocks and bonds, you’ll need to report and pay tax on any gains on the sale of cryptocurrency. They’ll need to be reported on your tax return. You can report them on Schedule D, Capital Gains and Losses, when you file your individual income tax return.
I’ll get into how much you’ll owe on your crypto capital gains in Question #3 below.
2. Do I have to pay tax on increases in the value of my cryptocurrency if I don’t sell it?
Nope, no taxes are due because no gains are realized or recognized—for tax purposes, at least—until the asset has been sold. All that has happened is an increase in the market value of your crypto, which is not taxable.
3. How much tax will I owe on a gain?
The answer to this question will depend on whether the gain is the result of a short-term capital gain, or a long-term capital gain. Short-term capital gains are gains on the sale of securities or other assets that occur in one year or less. Long-term capital gains are those that occur in more than one year.
That’s an important fact to be aware of, because the tax rates for short-term gains are much higher than they are for long-term gains.
Long-term capital gains have a maximum rate of 20%, and that’s only if your income is greater than $441,450 if you’re single, or $496,600 if you’re married, filing jointly. But if your income is less than $80,000 per year, you may owe zero capital gains tax (amounts over $80,000, but less than the threshold above, are generally taxed at 15%).
Short-term capital gains are subject to your ordinary income tax rate. Depending on your income, that can be anywhere from 10% to as much as 37%.
That doesn’t necessarily mean short-term capital gains are a bad situation. You’re paying tax on a profit. You’ll pay tax based on your highest marginal tax rate. I would have to pay 37% based on my tax bracket. But I’d rather take the profit and pay the tax than take a loss.
4. What is the tax treatment if I am lending online cryptocurrency?
The income you earn from lending cryptocurrency is treated like interest for tax purposes. This is similar to the interest you can earn on high-yield savings accounts. It will be entered on your income tax return, and taxable at ordinary income tax rates.
5. Can I reinvest my cryptocurrency gains to defer capital gains taxes?
The IRS does have provisions for like-kind exchanges that enable you to defer capital gains. A 1035 exchange applies to life insurance policies and annuities, while a 1031 exchange can be used for real estate. Basically, either exchange enables you to replace one asset with a comparable asset and defer taxes until the second asset has been sold.
But this is not the case with cryptos. You’ll need to pay tax on any gains you earn, regardless of what you do with the proceeds.
6. Will the IRS know about my cryptocurrency activities?
Big Brother is always watching! Even if you’re trading crypto on a non-IRS-compliant exchange, the IRS will still know you’ve invested money in that exchange when you transfer money from your U.S. bank account to the exchange.
Large or frequent transfers can tip them off that you’ve been very active with crypto investing. Cryptocurrency isn’t nearly as anonymous as it was when it first came out. As it’s grown in popularity, the IRS and other government agencies are increasingly tracking the activity.
7. What if I exchange my cryptocurrency for another one – do I still owe tax?
This can happen if you exchange, say, Bitcoin for Dogecoin or Ethereum, or for one of several different stablecoins.
Let’s say you buy Bitcoin for $10,000, and it rises to $50,000. You then exchange your Bitcoin for an equivalent amount of Ethereum. Unfortunately, that is a taxable event.
Even though the crypto universe views it as an exchange between two cryptos, the IRS will see it as selling one crypto for another.
You’ll need to recognize a taxable gain in your Bitcoin of $40,000, which is the $50,000 sale price, less your $10,000 initial investment. Whether you sell the Bitcoin for U.S. dollars or for another crypto, you’ll need to declare the gain on the Bitcoin sale.
Miscellaneous Crypto Tax Questions
While I was addressing the questions above, I thought of a few more that might be helpful in handling your crypto trades for tax purposes.
What is the order of cryptocurrency sales of multiple crypto purchases?
For example, let’s say you bought Bitcoin when was $3,000, then again when it was $50,000. The price goes to $60,000, and you decide to sell. Is the gain based on the $3,000 purchase or the $50,000 purchase?
For tax purposes, gains are recognized on a first-in, first-out (FIFO) basis. That means the gain would first need to be recognized on the $3,000 purchase, which would of course result in a much larger capital gain, at $57,000 ($60,000 − $3,000).
The sale of the $50,000 purchase at $60,000 would result in a $10,000 capital gain. But the gain on the $3,000 purchase would need to be recognized first.
Do the tax rules for crypto exchanges change if the exchange is for a stablecoin?
Stablecoin is a type of crypto where the value is tied to the dollar, or some other recognized world currency. That’s why these coins are referred to as stable.
The same rules apply on the exchange of any crypto for stablecoin as they do for exchanging for another crypto. You’ll need to recognize the gain on the sale of the crypto at the time of the exchange for the stablecoin.
Once again, it doesn’t matter if your crypto is sold for cash or exchanged for another crypto. The gain on the crypto you’ve disposed of will be taxable.
Is there any difference between buying and selling crypto with a broker like Robinhood, that doesn’t have its own digital wallet, and through a crypto exchange that does?
Whether you sell crypto through a broker or an exchange—even one based outside the U.S.—doesn’t change the tax consequences of the transaction. All the rules stated above will apply.
The main difference is that a broker like Robinhood, which is US-based and therefore US tax compliant, will issue a 1099-B, while the noncompliant crypto exchange will require that you maintain records and report your transactions from those records.
If you buy Bitcoin on one exchange, then buy it again on another exchange, does the wash-sale rule come into effect if you’re trying to sell one at a loss to lock in a short-term capital loss, then buy it again on another exchange before the 30-day window has passed?
It won’t matter because wash-sale rules don’t apply to cryptocurrency, since it’s considered property and not a financial security.
Speaking of the wash-sale rule…
The Wash-Sale Rule: The Crypto Trader’s Best Friend
Up to this point I’ve been covering the tax consequences of cryptocurrency transactions. But there is a huge tax savings available with cryptocurrency that you can’t get anywhere else. And the benefit is incredible. I had to do deeper research to make sure it’s true.
The tax savings is called the wash-sale rule. Basically, if you buy a security and it drops in value, you can sell it at a loss. But you can’t buy the same or an equivalent security within 30 days of the sale of the original security (or within 30 days before the sale). If you do the capital loss will be disallowed.
But as it turns out, wash-sale rules don’t apply to cryptocurrency. Because the IRS classifies cryptocurrency as property, rather than as a financial security, wash-sale rules don’t apply, or at least this is the current interpretation.
(NOTE: IRS notice 2014-21 doesn’t specifically exempt crypto from wash-sale rules. Instead, it defines crypto as property, which is widely interpreted to be excluded from wash-sale rules.)
How does that benefit cryptocurrency investing?
Bitcoin has taken a dive in recent months. Let’s say you bought $50,000 worth of Bitcoin back in March that is now worth $30,000. You can sell it today, and lock in a $20,000 capital loss.
That capital loss can be used to reduce future capital gains. Under IRS regulations, you can deduct capital losses against capital gains.
If you use the $30,000 proceeds from the sale of Bitcoin to purchase other cryptocurrency, up to $20,000 in gains on those investments will be shielded from taxes.
The volatility of cryptocurrency creates opportunities. At any point, one crypto is going down while another is going up. If you sense it’s time to get out of one and into another, this wash-sale loophole is a big deal. It’s a way of creating tax-free gains from your losses.
Capital Loss Carryforward
Even if there are no crypto capital gains to apply the capital losses to, you can still get a benefit from those losses.
If losses for the year exceed gains, you can still deduct up to $3,000 in capital losses for that year. When the losses exceed $3,000, you can carry them forward into subsequent tax years, and deduct them against income earned in those years.
If there are no capital gains in future years, you can continue to deduct $3,000 in capital losses each year, until your capital losses have been fully written off on multiple tax returns.
Tracking Your Cryptocurrency Trades
You need to come up with a strategy to track your trading activity, especially if you’re a frequent trader. Personally, I haven’t received a 1099 from anyplace where I’ve traded cryptos, so tracking and reporting still seems to be something of a gray zone.
You’ll need to use specialized software to help you track your transactions, especially if you’re trading on a noncompliant exchange that doesn’t issue Form 1099-B.
A Final Word of Advice on Cryptos and Taxes…
The last piece of advice I want to give is that you should consult a professional tax advisor if you have any questions, and especially if you’re an active trader.
I’m trying to make the discussion of cryptos and taxes simple, but it is potentially complicated. The IRS is still working out exactly how to treat crypto transactions, and new rulings are coming out all the time.
Tax professionals are the best people to consult about the latest rules. Yes, it will cost you some money to consult a tax professional. But that’s only a tiny fraction of the thousands of dollars in taxes and penalties the IRS may impose on you if you make a mistake.