Cryptocurrency has been making the news recently, with some stratospheric records being set in one week and breathtaking price plunges occurring the next. More and more people are investing and exploring the world of cryptocurrencies. While mainstream adoption of any given currency is still well behind what their advocates would like to see, there are more ways to spend and use your crypto coins.
Whether you are investing in the next meme-coin hoping for early retirement, looking for long-term growth investment, or using the coins you recently mined to pay for rent, you need to be aware of the tax ramifications. This article will give you an introduction to how cryptocurrencies are treated by the Internal Revenue Service so that you can be more informed on how your latest transaction will affect you.
Cryptocurrency is an Asset – Not Currency
What does this mean? One dollar will always represent one dollar when you use fiat currency, like the US Dollar. You do not have to worry about foreign exchanges fluctuating the dollar value when you want to buy a pack of gum. But for cryptocurrency, it means that any time you dispose of a coin, either by selling it for fiat currency, trading it for another coin, or using it to pay for a good or service, you will have a taxable event that may give rise to a gain or loss. Let’s look at a few examples.
In April, you used your tax refund to buy a single bitcoin when the price was $45,000. That price becomes your basis in that asset, crucial for later. A few months later, you are excited about the new release of Dogecoin and trade your Bitcoin for an appropriate amount of Dogecoin. At the time of that transaction, Bitcoin was priced at $52,000. You now have a taxable event that will give rise to a short-term capital gain. The total amount of the gain is the amount you received, effectively $52,000 less your basis in the coin, or $45,000. The result is a $7,000 gain. Since you held it for less than a year, it is taxed at your regular individual income tax rate, potentially up to 37%, or $2,590.
As we can see from this example, it is vital to track your transactions. If the above scenario had changed, such that you purchased half of a Bitcoin at $45,000 and the other half at $50,000, then the gain when you sold the whole coin at $52,000 would have only been $4,500, significantly reducing your tax bill.
When using cryptocurrency to pay for goods and services, you will need to determine the fair market value of the good or service to determine your profit or loss. If you use Bitcoin to buy a brand new Tesla that usually sells for $60,000, you will use the car’s fair market value less your basis to determine the gain or loss.
But isn’t cryptocurrency anonymous? How will the IRS know?
The secrecy around who owns and uses cryptocurrency is eroding quickly. The IRS has successfully collected information from some of the major crypto exchanges showing who has been using the exchanges via John Doe Summons. This has provided the IRS with a treasure trove of information that they can use to start investigations.
In addition to the information already collected, Congress recently passed a law that will require exchanges and brokers to report the name, address, and phone number of each customer, the gross proceeds from any sale of digital assets, and capital gains or losses. The same bill also requires banks and companies that receive more than $10,000 worth of cryptocurrency to report it separately. These reporting requirements are not yet effective but coming soon.
Finally, the IRS also requires self-reporting on the form 1040 via the first question on the form. Ignoring this question and being caught by the IRS could lead to severe consequences, potentially including criminal charges.
When the IRS combines all of these sources of information, it becomes very likely that they will be able to figure out if someone is not reporting their crypto-assets.
If you have any questions or need help with an IRS examination of your crypto-trading, you can get in touch with an IRS audit lawyer such as our friends at the Law Office of Holland King for assistance.