With the dramatic rise and subsequent decline of Bitcoin and other cryptocurrency prices in the past year, you could be ready to reap some impressive gains - or maybe losses.
Almost 10% of Americans bought and sold crypto last year, and we know that many of them were first-time traders who probably know very little about reporting taxes on cryptocurrency. In case you are one of them, chances are you’re also curious about the tax implications of your crypto deals.
We've got information to help you figure out which activities you might have to report to the Internal Revenue Service (IRS) and what you need to do to prepare for your 2023 taxes.
As the name implies, cryptocurrency is a kind of digital asset investors find useful for purchasing goods and commodities. Nevertheless, a large number of investors hold portions of cryptocurrency, similar to shares in stocks.
Some people may be familiar with Bitcoin or Ethereum as they’re the most famous among all cryptocurrencies, but there are thousands of different cryptocurrencies around the world.
One of the main reasons for cryptocurrencies' growing popularity is because of their decentralized nature.
In a decentralized economy, technological advancements allow investors to conduct direct business instead of operating from the inside of a centralized system. Simply put, investors work independently of government agencies like:
Despite referring to cryptocurrency as a virtual currency, the IRS does not consider it a legal tender currency. Instead, it treats it like a commodity -- although some cryptocurrencies may be labeled as securities in the future.
Now, you may be wondering, “what exactly is considered "taxable" by the IRS?”.
In the eyes of the IRS, cryptocurrency possessions are considered "property" as far as taxes are concerned, so you must pay taxes on them, like you would on your other assets, like stocks.
You can owe taxes on crypto in a variety of ways, even when exchanging one token with another. If you take the following actions, you will incur capital and income gains or losses on your ordinary account. Note that retirement accounts are exempt from this rule.
Furthermore, the IRS does not distinguish between spending crypto on consumer goods and selling them. Therefore, such exchanges are also subject to taxes.
Let’s say someone offered you cryptocurrency in exchange for your services — that also needs to be reported for tax purposes.
To sum it up, this is how your taxes will look.
It all sounds confusing, right?
Would you like to know why there is a capital gains tax at all?
You pay taxes for the same reasons you pay other taxes. The IRS levies capital gains tax to generate more funds for the government. Government programs and spending are then supported with this money.
Similar to other assets taxed by the IRS, you may have a short- or long-term gain or loss determined by the length of time you held the cryptocurrency before liquidating it.
Note: if you don't maintain detailed records of your transactions, it can be challenging to determine your short-term or long-term gains and losses during tax season. Don’t bring that upon yourself.
A short-term capital gain is realized after selling an investment you’d held for less than a year. There is also the possibility of being assessed a short-term capital gains tax on the sale of other assets, such as real estate, electronic equipment, or art.
Taxes on these gains are based on ordinary income, which is your individual income tax rate.
Note: When you earn income from working and short-term capital gains from investments, different tax rates could be used to calculate your taxes.
A long-term capital gain is derived from the sale of assets held for more than a year before they are sold. There are three different tax rates for long-term capital gains, each used with a different type of income: 0%, 15%, and 20%.
The majority of taxpayers who declare long-term capital gains pay 15% or less in taxes. Unlike ordinary income tax, long-term tax isn't influenced by your bracket. So rates are more favorable.
You should also learn what's not considered taxable to determine if what you've done this year is subject to taxation or not.
First of all, you won’t owe any taxes just by purchasing virtual currency with U.S. dollars and storing it on the exchange where you acquired it. Moving your coins to your digital wallet won’t mean you’ll owe taxes on them upon your tax return either.
In fact, according to the instructions given on your Form 1040 tax return, you don’t even need to mention it on your form.
In summary, you won’t owe taxes if you only performed the following actions this financial year.
Note that each individual can receive up to $15,000 each year tax-free (that number is higher if you want to gift spouses). The gift should not exceed $15,000 per recipient. If it does, you'll need to submit a gift tax return.
Another thing to keep in mind is that every state imposes its own income tax, and, consequently, capital gains taxes vary from state to state. Several states, including California, apply ordinary income tax rates to both short- and long-term capital gains.
But there may be different tax treatment in other states.
That’s why you should stay updated with your state laws and preferably consult with a crypto-professional CPA before filing your tax returns.
There are dozens of dealers, agents, and trading platforms that facilitate cryptocurrency trading for the general public. However, none of them are required to send tax returns to investors, though some may be programmed to do so.
At the end of the day, it is the individual's responsibility to keep the relevant documents regarding cryptocurrency transactions.
Remember that you need to list your calculations line by line, including the specifics of each transaction in your form. The information you’ll have to provide includes the following, so make sure you keep track of them.
As an investor, you probably do a number of transactions each year.
The IRS needs to be notified about those when you prepare your return, and Form 8949 is where you should begin. Form 8949, Sales and Other Dispositions of Capital Assets, has directions to assist you with calculating and declaring your taxes.
Essentially, it’s where reporting taxes on cryptocurrency really happens.
But before you fill that form, there are more important steps to take, like brushing up on your math skills to calculate how much you owe or establishing what kind of income you owe taxes on.
To figure out how much your gain or loss is, you will have to calculate the difference between the asset's market price when it’s sold and its cost basis.
A property's cost basis is how much it cost at the time it was acquired, which also applies to all and any transactions, commissions, or utility fees.
So, the math looks something like this.
Simply put, you’ll need to monitor how the value of different assets has increased or decreased since you received them to measure your gain or loss on each transaction.
Here’s an example to make this easier to digest. Imagine you obtained $300 worth of Bitcoin and sold it for $800. In that case, you’d have a capital gain of $500. You would instead suffer a capital loss if the value of your Bitcoin dropped during that time.
When your losses are greater than your gains, you can subtract up to $3,000 from your taxable income (this applies to individual taxpayers).
Crypto tax software will come in handy for those of you who aren't professional accountants. It’ll give you the opportunity to hone in on your trading and not spend hours trying to figure out your crypto taxes.
Crypto tax software is designed to eliminate your after-trading worries by working out your crypto tax debts quickly and easily. This software is primarily built to deal with real-world difficulties that taxpayers face when managing their financial information.
Crypto Tax Software offers a technology-driven solution to handle tax reporting on digital assets, and that’s why it makes the tax reporting procedure incredibly efficient and straightforward.
Some of them may offer:
The following is a list of common income events for crypto users.
The capital gains/losses tax will apply to all other transactions, whether you trade assets for cash or exchange them for goods (like a car) or services (like a spa).
Crypto gains and losses are disclosed on Form 8949. You will need to provide specific details about your crypto trades in order to complete this form. You read about these details in this blog post, but we’ll provide them here again for easy access.
Having listed all your transactions on Form 8949, add them up and then copy the information onto the relevant parts of Schedule D. On Schedule D, you’ll deduct your cost basis from the sum of your gains to determine your overall capital gain or loss.
You should repeat this process for each taxable crypto transaction you had during the year.
Note: When you purchase and sell your cryptocurrency, the length of time you owned it influences how much tax you owe. So, make sure you list accurate and precise dates on your form.
In addition, if you earn revenue from cryptocurrency holdings, you must also report it. Although, you will report that income elsewhere on your tax form.
It is mandatory for taxpayers to fill out a question on Form 1040 to indicate whether any virtual currency transactions took place in the previous year. That one simple question can completely change how the IRS handles your taxes.
Getting your tax filed and paid by the due date can help you dodge a penalty. In case you can't do so, a payment plan or extension of time may be available to you.
Whether it's an honest mistake or not, you could get slapped with penalties for not filing crypto taxes.
There are two types of penalties the IRS can impose:
The IRS issues a letter or statement if you are liable for the Failure to File Penalty. In general, the Failure to File Penalty is determined by two things.
The IRS’s failure to file a penalty is 5% of your unpaid taxes for each month, or a partial month your tax return is late. However, it’s capped at 25% of your unpaid taxes.
You will also be penalized if you fail to pay the entire tax bill on time. If you fail to pay your tax bill, you will be penalized 0.5% of your overdue taxes every month you fail to pay.
The fine for late payments is capped at 25% of your unpaid taxes, similar to the failure to file a late payment.
Although, it may be possible to avoid or reduce some penalties if you were honest and showed a valid reason as to why you were unable to pay your taxes on time.
Note: April 18 was the deadline to report your 2021 taxes or apply for an extension. The filing would be due on Oct. 17, 2022, if you applied for an extension.
If you’re thinking of not submitting your crypto tax report because you’re unable to pay the taxes, don’t.
You shouldn't avoid filing a tax return just because you can't pay your bill, as it won't help you escape penalties either.
You must report your taxes even if you cannot manage to pay them. In fact, you find out more about your losses by disclosing them. You can actually use these losses to avoid paying taxes on Bitcoin and other currencies.
But what if they are still too expensive once your losses have been deducted as part of your taxable income?
Well, there is still hope. Here are three methods you can use to avoid facing penalties.
An IRS installment plan allows you to pay your tax liability over a period of up to six years. There are still penalties, but they are reduced.
With this arrangement, you can settle your tax debt with the IRS for a lower amount than you owe. Not everyone’s qualified for this option, though. You can use IRS’ pre-qualifier tool to learn whether you can use this option or not.
While your file is in CNC status, the IRS cannot seize your assets or income to get money from you. However, the IRS will still charge a penalty and interest on your tax debt and may also apply future tax refunds to it.
Did you know that getting your tax return audited by a professional CPA can be really helpful? It doesn't matter whether you filed your own return or hired a non-CPA to prepare it; a tax return review can do you a lot of good.
If you run a business, then you may already have an accountant who should deal with tax liabilities. But handling only one basis of accounting saves them the time they would have spent tracking updates both under GAAP and taxation rules.
A third-party crypto consultant can take that burden off your accountant's shoulders and provide you with specified tips about your report.
Many people are stunned by the fact that there is so much detail involved and that your income is not the only thing you factor into a fiat transaction.
You may want to seek the advice of a financial advisor when managing short-term or long-term investments.
Let us know what you need, and we're here to help. We've built a team of professional CPAs and tax lawyers who have expertise in the following areas.
Schedule a call, and we’ll help with reporting taxes on cryptocurrency and guide you to your next course of action.