Cryptocurrencies have been increasing in popularity, and we are seeing more and more questions about how they are taxed. In this blog post, we will take a brief look at the current state of cryptocurrency taxation in the United States. We will answer some common questions about how taxes work for digital currency transactions and provide some tips on how to stay compliant with the tax law.
Cryptocurrency is a type of digital asset that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. There are currently more than a thousand known cryptocurrencies. Although they might have different names, all cryptocurrencies have one common trait – they act as a medium of exchange on the market. Cryptocurrencies are often traded on decentralized exchanges and can also be used to purchase goods and services.
What do you need to know about cryptocurrency to file your tax return?
A question about cryptocurrency transactions recently was included by the IRS in the income tax return forms. Cryptocurrency wallets (i.e., the special software used to store the cryptocurrency balance) do not contain any information about their owner, this technology is by design anonymous, and it is important to maintain the full record of your transactions with these assets. Unreported transactions with cryptocurrency (other than the purchase of cryptocurrency for cash) can result in penalties and interest due to the IRS, in addition to the income taxes on these transactions. Taxpayers who did not disclose reportable transactions may also become subject to criminal prosecution. This could lead to charges of tax evasion and filing a false tax return with consequences as severe as a prison term of up to five years and a fine of up to $250,000. Therefore, to avoid fines and penalty payments, you need to check the “Yes” box under the question about cryptocurrency included in your income tax form if during the tax year you:
• Received or made a cryptocurrency payment from/to your customer, vendor, business partner, or your friend
• Mined or staked cryptocurrency
• Traded, converted, or sold cryptocurrency
• Burnt, donated, gave away cryptocurrency
• Sent your cryptocurrency to a wrong wallet address
• Received cryptocurrency via airdrop or as a result of a hard fork.
If you only purchased cryptocurrency during the year in exchange for United States Dollars (or any other government-issued currency), you should check the “No” box for this question. You should also answer “No” if the only other transaction with cryptocurrency you’ve made was a transfer of cryptocurrency from a wallet, address, or account belonging to you, to another wallet, address, or account that also belongs to you, then the transfer is a non-taxable event, even if you receive an information return from an exchange or platform as a result of the transfer.
The correct answer to this question in your income tax return and accurate disclosure of the related transactions is critical. The IRS treats cryptocurrency as property for federal tax purposes and this means that general tax principles applicable to property transactions must be applied to cryptocurrency transactions. For example, gain or loss from the sale or exchange of cryptocurrency generally is treated as capital gain or loss. This capital gain or loss must be recognized as short-term capital gain or loss if you sold cryptocurrency held for less than a year after its purchase and long-term capital gain and losses if you held the cryptocurrency for more than one year before selling or exchanging it. This one-year holding period begins on the day after you acquired the cryptocurrency and ends on the day you sell or exchange the cryptocurrency. At the same time, cryptocurrency received for goods and services is treated as ordinary income and may also be subject to state and local income taxes, sales taxes, payroll taxes, and other taxes.
In an on-chain transaction, you receive the cryptocurrency on the date and at the time the transaction is recorded on the distributed ledger. It means that generally, you will need to recognize income when payment is received and you can transfer, sell, exchange, or otherwise dispose of it, which is generally the date and time the transaction is recorded on the distributed ledger. This is true even if the payment is made in the period or after the period when the income was earned.
To accurately determine the costs of cryptocurrency sold, exchanged, or otherwise disposed of, you need to either be able to identify specific unit(s) of cryptocurrency used in the transaction or calculate costs of cryptocurrency disposed of using First-In First-Out (FIFO) approach. Often this information can be found on your cryptocurrency exchange website page in the “Tax Documents” section.
We understand that the cryptocurrency question can be difficult to answer, and we want you to feel confident that your taxes were calculated accurately to maximize your tax refund amount. That’s why our team of experienced CPAs is here to help you through every step of the process. If you have any questions or need assistance with anything related to the tax reporting of cryptocurrency transactions, please do not hesitate to reach out to us. Our team at Murtha & Murtha CPAs is more than happy to help you navigate this new and exciting world of digital currency.