How Taxes Apply to Cryptocurrency
The IRS has published guidelines on how to treat cryptocurrency for tax purposes. In Notice 2014–21, the IRS indicates that cryptocurrency is property and will be taxed as such. If you are not familiar with the tax system or not sure how it applies to cryptocurrency at an individual level, I will run you through some of the different scenarios most individuals and businesses will face when involved in cryptocurrency transactions and how it affects taxable income in each scenario. Learning taxes can be hard so I will be using simplified numbers in my examples.
The Crypto Investor
I’ll start with one of the more common scenarios: the cryptocurrency investor. The investor buys and sells cryptocurrency, making money off the appreciation in value, much like investing in the stock market or in mutual funds. Maybe the investor is making some profit from arbitrage, trading coins across different exchanges and making a profit off of the different trading prices. The investor’s tax basis is what it cost the investor to purchase the cryptocurrency, including any applicable fees. As an example, the investor sends $1,000 to an exchange and purchases Coin A. The investor pays $50 in fees to acquire a net of 10 Coin A. Though the Coin A only cost $950, the $50 will be included in the basis of the Coin A.
The tax basis of the ten units of Coin A is $1,000. It should be noted that the transfer of money is not a taxable event and neither is this exchange of fiat currency (USD) for cryptocurrency. Some amount of time passes and this initial investment in Coin A has about doubled. The investor sells it all for $2,000. This sale of this property is a taxable event. The $2,000 the investor gets for the Coin A is the proceeds of the transaction while the tax basis was the $1,000 we calculated earlier. Assuming more fees of $50, the gain on this transaction is $950.
Let us say the investor decides to diversify into other coins. The investor hears about Coin B and wants to shift about 10% of holdings into it. Let us say that this transaction happens immediately after the purchase of Coin A. Let us say the investor sends one Coin A to an exchange where Coin B is also traded. Luckily, this is not a taxable event but the exchange of Coin A for Coin B is. If the investor’s $1,000 investment net 10 Coin A, the basis of the one sent to this other exchange will be $100.
Let us assume the investor transfers enough to cover the fees of the transfer and leave the investor with one unit of Coin A on the new exchange. The investor buys 300 Coin B paying three Coin B in fees, netting 297 Coin B. Let us say the dollar value of the 300 Coin B is $100. Subtracting the fees paid of $1 and the tax basis of $100, our investor can report a $2 loss on this transaction.
Some of you may be wondering about the fees used to transfer the money from one exchange to another. Because these fees do not stem directly from investment activity but rather from the movement of funds, they cannot be used to reduce taxable income.
What if Coin A to appreciates before the investor buys Coin B. Let’s say the Coin A hits $2,000 and the investor sends 0.5 Coin A (plus enough for fees to transfer) to get the 300 Coin B. The transfer of Coin A from one exchange to another is still non-taxable. For that 0.5 Coin A the investor can get the 300 Coin B, paying 3 Coin B in fees leaves the investor with 297 Coin B. The basis in 0.5 Coin A is $50, the dollar value of the 297 Coin B is $99, and the applicable fees are $1 in value. The investor must report the $48 gain.
When it comes to reporting these gains to the IRS, you can take a short breath of relief because the only additional form you need is Form 8949. Filling it out is another story. Each taxable event should be reported separately. Each line has 8 columns: a description of the property (the currency given up in the transaction, not received), the date it was acquired, the date it was sold, the proceeds, the basis, a code (that can be ignored here), an adjustment amount (fees) and the gain or loss.
It is important to keep note of the lots of cryptocurrency you buy. By lot, I refer to the amount you bought at a specific price. If you buy 10 Coin C at $100, that is one lot. If you buy another 5 Coin C later at $105, that is a new lot with a different basis. It is important to trace your cryptocurrency to the appropriate lot because you can’t use the basis of one lot in place of the basis of another lot. Furthermore, the character of your gain or loss will be determined by the amount of time you held the cryptocurrency. This refers to long-term or short-term treatment. If held for a year and a day before it’s sold, the transaction will qualify as a long-term capital gain (loss) and be taxed at a lower rate than if the cryptocurrency was held for a year or less.
The Crypto Miner
Looking at another common scenario, we have a miner who has kept the computer on and mining for some time. The miner eventually checks to finds the mining process completed 10,000 times. The miner has a headache in store as the miner must report as income the fair market value (trading value) of the amount of each coin received at the end of each mining process. Assume that the miner receives one coin for each mining process and one coin is mined every hour, on the hour. Let us also assume miner is based in New York. I’ve set up a table to show what the miner daily tracking of coins received could look like.
On this particular day, the miner will report $2,466 in income. It is important to track these values as they will be the basis to the miner when sold for fiat currency or another cryptocurrency. It should be noted that for miners, each lot of cryptocurrency they mine will have a different basis.
The cost of cryptocurrency mining cannot be deducted on a personal tax return. If the miner sets up a business entity to do the mining before starting, not only can the relevant costs like the electricity used be deducted from taxable income but the cost of the computer will be deducted over six years through depreciation. If this business entity is set up as a pass-through entity, the value of the cryptocurrency mined will be included in determining self-employment tax.
Cryptocurrency as Wages
Employers can pay their employees in cryptocurrency. The employee will report the cryptocurrency they receive as income and the employer is obligated to withhold the appropriate amount for taxes. For these examples, assume the employee’s tax rate to be 25%. The key in determining how the wages should be taxed depends on the structure of the payment. If the eployee is receiving a wage valued in USD, for example a weekly salary of $2,000 that is payed in Coin D, it would be taxed just as any other wages would be. Start as though the payment was made in USD, withhold the appropriate taxes, convert the remainder into Coin D, and transfer to the employee. Assume that Coin D is trading at $15 when the employee is paid.
Note that with a set rate in USD, the tax withholding will be the same on a weekly basis.
Paying a set rate in cryptocurrency is a little trickier. If the arrangement is such that the employee will receive the value of 133.333 Coin D, the employer would have to determine that value in USD to determine the appropriate tax withholding. If Coin D is trading at $15, 133.333 Coin D is worth $2,000. The employer would be required to withhold $500 from the employee’s wages.
If the arrangement is such that the employee is to receive a set number of Coin D, because the employee does not receive their gross wages, the taxes must be calculated, treating the payment as the net wages to the employee. In this example, let’s say the employee is guaranteed 100 Coin D weekly. The current trading value is still $15.
To calculate the gross pay, you multiply the net pay by one minus the tax rate.
The difference between the gross pay and net pay will be the withholding the employer is required to send in on the employee’s behalf.
When the employee sells the Coin D for fiat currency or another cryptocurrency, the basis reported will be the net payment received by the employee.
Receipt of Cryptocurrency for Goods and Services
If a business accepts cryptocurrency as a form of payment, it is required to include the fair market value of the cryptocurrency received, when it is received, in income. Let us say a business accepts 10 Coin E for a widget. If Coin E is trading at $6 when the sale is made, the merchant will include $60 in revenue.
As with any other sale, the cost of the widget and any other relevant costs in processing the transaction will be deductible.
A business might agree to accept installment payments in cryptocurrency. If the business has a service contract where payments are to be made in cryptocurrency. If 25 Coin F are paid on four dates, the 15th of February, May, August, and November, the value of those coins will be included in revenues for the company.
This payment system is somewhat risky as cryptocurrency is extremely volatile. Individuals and businesses are both required to make tax estimated payments throughout the year. These estimated payments are supposed to come close to your total tax liability for the year. If you’re estimates are too low, you could get hit with an underpayment penalty.
When the coins are sold for fiat currency or another cryptocurrency, the basis will be the amount included in revenues. In the service contract example, the basis will be different for each of the four lots of Coin F.
I want to also touch on the topic of forking. On August 1, 2017, Bitcoin hard-forked and Bitcoin Cash came out as a result. Similar to a stock split, whoever had Bitcoin as of a certain time now had the rights to an equal amount of Bitcoin Cash. The IRS has not released their position on how this event should be treated. The issue is further complicated by the fact that Bitcoin Cash was not being traded immediately so a value at the date of receipt is not based on the real actions of a marketplace. By nature of hard-forks, not every recipient of the other currency will receive it well. Bitcoin has experienced several hard-forks since inception and few received major market acceptance. Are taxes owed on each of these forks? It is still up in the air so pay attention to news from the IRS to see what their policy will be on hard-forks.
CryptoKitties and Collectable Treatment
One of the applications built on the Ethereum block-chain is a collectable known as CryptoKitties. Some people buy and collect them much like someone would do with Beanie Babies or Baseball cards. The IRS taxes the gain on the sale of collectables at a higher rate of 28%.
With how easy it is to acquire cryptocurrency, it shouldn’t be a surprise that some minors have taken to investing in cryptocurrency. The Kiddie Tax (Topic Number 553) applies when unearned income is over a threshold amount, the child meets certain age requirements, at least one of the child’s parents is alive, the child is required to file a tax return, and the child is not married.
Valuing your Crypto Transactions
The key is keeping up with the value of the cryptocurrency in USD when you make the transactions. Don’t panic if you haven’t been keeping a good record. While you may not be able to find the exact price of the coins you bought when you bought them, you can at least find approximators. There are websites such as coinmarketcap.com that will report open, close, high, and low prices of each coin, each day. With this information you can calculate the range of value your cryptocurrency could have been in at the time of your transactions. Most Tax CPA’s would probably suggest using the high and low values to create conservative estimates. For tax purposes, this means the highest gains and the lowest fees.
Do the Research and the Work or Hire an Expert
To the people with cryptocurrency transactions, you must search through your transaction histories for this information and report your gains to the IRS. While some of you may relish the challenge to trace through your transactions on your own, others may not have the time or patience to do so. This is also a new field that has tons of CPA’s scratching their heads; it is important to find someone that knows what they are doing. There are firms that specialize in cryptocurrency tax services and a professional’s help in the beginning tends to prevent a huge headache in the end.