February 16, 2022
Cryptocurrency is the word on everyone’s lips. Most popularly discussed are Bitcoin and Ethereum, but there are thousands of other cryptocurrencies in use around the world.
These digital assets can be used as an alternative payment method to buy goods and services. Most commonly, however, people are using cryptocurrency as means of investing, much as they would shares of stock.
Whether you accept cryptocurrency as a payment, pay with it, invest in it, mine it, trade it, or even receive a small amount of it as a gift, as we approach tax season, it is important to understand the tax implications of cryptocurrency.
How Are Cryptocurrency Transactions Taxed?
While cryptocurrency is widely referred to as a virtual currency, it is not actually considered currency by the IRS. Instead, according to IRS Notice 2014-21, the IRS considers cryptocurrency as property; thus, it must be taxed as such.
Since cryptocurrency is treated as property, this means that any capital gains and losses resulting from cryptocurrency transactions must be reported on Schedule D and Form 8949.
In addition, cryptocurrency can be contributed to charity. The donor will receive a charitable contribution deduction equal to the fair market value on the date of contribution. Any appreciation will not be taxable to the donor, a double benefit. Consult with the charity because not all charities may be able to receive and sell cryptocurrency. There is more detail on this topic further in the newsletter.
Understanding Different Types of Cryptocurrency Transactions
Determining how to report cryptocurrency transactions on your tax return depends on two variables: 1) how you came to own the cryptocurrency; 2) how you used the cryptocurrency.
If You Received Cryptocurrency as a Payment
If you received cryptocurrency as a payment for goods and/or services, this is considered taxable income - just as if you were paid with cash or check. When it comes to tax reporting, the dollar value of your cryptocurrency transaction is the fair market value of the cryptocurrency on the day that you received it.
If You Mined Cryptocurrency
Cryptocurrency mining involves solving extremely complex mathematical equations in order to validate cryptocurrency and add it to the blockchain. If you mine cryptocurrency, it is also considered taxable income, and it will be taxed on the fair market value of the cryptocurrency on the day you received it - just like self-employment income.
Bear in mind that you will need to report this income even if you do not receive a 1099 form.
If You Exchange Cryptocurrencies
If you exchanged one type of cryptocurrency for another, this is a taxable event; more specifically, it is a capital transaction. This means your cryptocurrency transaction will have resulted in a capital gain or a capital loss - just as if you had sold shares of stock.
For example, suppose you have $500 worth of Bitcoin and you exchange it for $500 worth of Ethereum. If your Bitcoin was worth $100 on the day you purchased it, this means you have realized a capital gain of $400 in making the exchange. This must be reported on your tax return.
If You Sold or Spent Cryptocurrency
Whether you own cryptocurrency because you received it, bought it, or mined it, remember that selling it or spending it is also a capital transaction.
For example, consider the following the scenario:
- You receive $500 worth of Bitcoin as payment for services on March 1.
- On October 1, the fair market value of your Bitcoin is now $1,000.
- You sell your Bitcoin for $1,000 on October 1.
- On your tax return, you must report:
- $500 of income for the Bitcoin you received on March 1.
- $500 in capital gains that you realized on October 1.
Based on this example, it can seem that reporting cryptocurrency transactions is pretty straightforward - but not all transactions are this cut and dry.
Imagine, instead, that you bought $500 worth of Bitcoin, added it to a cryptocurrency debit card, and then spent it over the course of several months on many little transactions, like coffee, dinner, shopping, etc. When cryptocurrency is treated as a cash alternative, tracking capital gains and losses for each transaction throughout the year can be a complex web to untangle during tax season.
If You Donated Cryptocurrency
Conversely, if you donated cryptocurrency, you may be able to take advantage of a tax deduction. This will vary depending on how long you owned the cryptocurrency:
- If you owned the cryptocurrency for more than one year, the tax deduction will be the fair market value of the cryptocurrency on the day you donated it.
- If you owned the cryptocurrency for one year or less, the tax deduction is the lower of your cost basis or the fair market value on the day you donated it.
If the contribution of cryptocurrency is valued at more than $500, Form 8283 will need to be completed. If the donation is valued at more than $5,000, you will also need to furnish an appraisal from a qualified appraiser. Form 8283 must be signed by the charity and appraiser and included with your tax return.
How to Report Cryptocurrency Transactions on Your Tax Return
With so many different types of cryptocurrency transactions, it can be overwhelming to consider how you can accurately track them all and properly report them on your tax return.
In most cases, you can simply download a transaction report from your crypto exchange platform, which will detail each time you bought, sold, or exchanged cryptocurrency. This is simple if all your cryptocurrency transactions took place on one exchange. If, however, you have cryptocurrency transactions that took place across several different exchanges, you will need to download a report from each exchange and then enter the correct information from each report on your tax return.
The IRS Is Looking Out for Cryptocurrency Transactions
There is a trend of non-compliance when it comes to reporting cryptocurrency transactions on tax returns. In fact, it’s estimated that only a fraction of people who buy, sell, and/or trade cryptocurrency report it properly. The IRS is increasing enforcement of reporting cryptocurrency transactions. There is a question on Form 1040 that asks if you received, sold, or exchanged any virtual currency. This will assist the IRS with regard to the enforcement of reporting cryptocurrency transactions. Therefore, taxpayers should comply with all the reporting requirements regarding cryptocurrency transactions.
Cryptocurrency can present complex issues. In the context of tax returns, it becomes even more complicated. For help understanding how to report cryptocurrency transactions on your 2021 tax return, contact Perlson LLP professionals at (516) 541-0022.
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