Cryptocurrency and Taxes

With tax day just a month away, it's a good time to take a look at how cryptocurrencies are taxed. There are similarities to how other assets and property are taxed, but there are also differences. Furthermore, the taxation of cryptocurrencies is different than many people expect. Here's a brief rundown on how cryptocurrencies are taxed.

When Do You Pay Tax on Cryptocurrency?

Believe it or not, digital assets and cryptocurrencies don't work like typical currencies. They are instead considered property and are taxed as such. Even something as simple as spending cryptocurrency to buy something can cause you to pay taxes on that cryptocurrency. Here are some common digital asset situations that create a tax liability.

Selling or Exchanging Digital Assets

If you purchased a digital asset or cryptocurrency and then sell or exchange that digital asset for a profit, then that profit is considered a gain and you must pay taxes on the gains. 

Gifting Digital Assets and Cryptocurrencies

If you gift more than $15,000 in digital assets to an individual, then the gains of the portion of the gift that is greater than $15,000 is taxable.

Spending Cryptocurrency

This is the one that really catches a lot of people by surprise. When you spend cryptocurrency, you must pay taxes on any gains. For example, you bought bitcoin at $20,000. You decide to spend some of your bitcoin to buy a new iPhone when bitcoin is valued at $40,000. The bitcoin is considered to be sold at that price when you use it to purchase something else. In this example, it would be a 100% gain, so 50% of whatever is spent is considered a taxable gain. If you spend iPhone is $800 in bitcoin to purchase the iPhone, then $400 of the purchase is taxable.

Swapping Digital Assets and Cryptocurrencies

This is another one that surprises many people. Similar to the example above, if you exchange one digital asset or cryptocurrency for another digital asset or cryptocurrency, you are considered to be selling the digital asset and then using the proceeds to purchase the other digital asset. If there are any profits or gains from the sale, then those are taxable. For example, you exchange 1 bitcoin for 14 ether. If you have a 20% gain in that bitcoin, then 20% of the value of the exchange is taxable.

It's important to note that in any of the transactions above, whether selling, gifting, or exchanging digital assets, only the capital gains are taxed, not the full amount of the digital assets. To know how much is taxable, one would subtract the price that was paid (including fees) from the proceeds that are received, the value exchanged, or the amount gifted.

Additional Income Tax Events

Additional income tax events may include (but many not be limited to):

• Receiving an airdrop
• Interest earning in DeFi lending
• Cryptocurrency earned from liquidity pools and interest-bearing accounts
• Receiving cryptocurrencies as income instead of fiat currency

What About Mining and Staking?

Unfortunately, this is currently still a gray area. The IRS has not provided clarity on whether mining or staking cryptocurrencies is taxable. However, there's an ongoing case against the IRS regarding when staking rewards should be taxed. The debate surrounds whether staking rewards should be taxed when they're earned or when they're sold. The plaintiffs in the case argue that newly created property, such as furniture or other manufactured goods, is usually taxable only at the point of sale, and that digital assets should be treated the same. The IRS did refund the taxes the plaintiffs had paid, but didn't provide clarity for future matters, so it's unclear which direction it will go. Until there is more clarity, it is best to discuss these particular situations with your tax professional.

Ordinary Income Tax vs. Capital Gains Tax

The good news is that the same rules that apply to traditional investments regarding capital gains also applies to digital assets. If you sell the digital asset less than 12 months after purchasing it, then ordinary income tax is assessed on any gains. If you have held the digital asset for more than 12 months then long-term capital gains tax is owed on any gains. Capital gains tax rates are 0%, 15%, or 20% depending on your filing status and income level.

Deduction of Losses

Capital losses from selling digital assets that have declined in value may be deducted from capital gains to reduce capital gains taxes. Also, as with traditional assets, up to $3,000 in capital losses may be deducted from ordinary income to reduce income tax liability per year. Additional losses beyond the $3,000 could be carried over into the next tax year.

No Wash Sale Rule

Currently, the wash sale rule that applies to traditional securities investments, does not apply to digital assets. The wash sale rule states that if you sell an asset at a loss you cannot deduct the losses if you have purchase the same or significantly similar assets with a 61 day window that is 30 days before or 30 days after the sale. If that happens you don't completely lose the deduction, as the amount of the loss is added to the cost basis. With digital assets, you don't have to worry about the wash sale rule. You can sell a digital asset at a loss and then repurchase the digital asset at the same price to take advantage of the loss deduction against other capital gains. An important note here is that this is only how it is right now. There will be new regulation coming that may change this and the wash sale rule may apply to digital assets in the future, and that could also be made to take affect retroactively. As always, confer with your tax professional before making any decisions that may affect your tax liability.

Preparing Your Digital Assets Transactions for Taxes

Figuring out digital asset holdings, transactions, gains, and losses can be a very difficult task. One way to use use a spreadsheet to track every digital asset holding you have and the transactions with each that includes how much you paid, the amount of the asset, the value of the asset, and any fees paid. For anyone that has a number of different digital assets located in different exchanges or wallets and a multitude of transactions, this can be a very daunting task. Fortunately, there are a number of services that are available to make the process either easier or completely automated and headache-free.

If you need assistance, as always, it's recommended to consult your tax professional to see what they use and recommend, or what they can do to help you with the process. If you don't have a tax professional, Escient Financial can provide tax preparation, including for digital assets, for ongoing financial planning clients. Feel free to...