Taxes on CryptocurrencyThis year a number of first-time investors might find themselves in a unique tax situation, owing money on an asset that doesn’t yet have fully transparent tax treatment. While the cryptocurrency craze might seem like something limited to techies and hackers, that image is outdated. Many see cryptocurrencies as a way of addressing inequality, solving global problems and allowing the masses to have access to investment platforms. With apps like Coinbase making dipping into the world of cryptocurrencies trivially easy for millions of individuals, we thought it would be worth covering some of the intricacies of paying cryptocurrency taxes this tax season.

Before we dig into the details of cryptocurrency and taxes, we wanted to note that this post is for general educational purposes. While we pride ourselves on providing helpful, detailed information, this post does not constitute official financial or legal counsel and is in no way intended to be a replacement for tax advice from a professional. As such, we suggest that you consult a CPA for individualized device tailored to your specific tax situation.

Do I even have to pay cryptocurrency taxes?

First thing’s first, let’s get this question out of the way. Yes, you absolutely have to pay taxes on cryptocurrency gains and transactions. Regardless of how you make money, you are mandated by law to pay taxes on those earnings. If you care about the future of cryptocurrency, you should pay cryptocurrency taxes to ensure that the government doesn’t see digital assets as a vehicle for tax evasion. Should such a perception be formed, it would guarantee that cryptocurrency markets become restricted, if not outright banned.

In any case, it’s getting harder to avoid paying taxes on cryptocurrencies. In the past, before the days of beginner-friendly, SEC-approved exchanges like Coinbase, you could probably get away hoarding all of your gains in a private wallet, but with wide-spread adoption comes attention. Last November, Coinbase was subpoenaed for user information, as a lot of traders using the platform apparently dodged paying Uncle Sam. But even before the rise of mainstream cryptocurrency platforms, the IRS has been looking into taxing cryptocurrencies despite the lack of clear and consistent classification for what exactly they are. Earlier in 2017, the IRS began working with a contractor who developed software that could probe the Internet for cryptocurrency wallets. So regardless of whether or not you use regulated exchanges, which tie your identity to your digital earnings, the IRS is working on ways to make sure they can find out who you are and what you owe.

How do I pay taxes on my cryptocurrency holdings?

In 2014, the IRS released a guide explaining how to treat cryptocurrencies come tax season. The guide is more than a little outdated, as the cryptocurrency scene has become more complex over the last several years, but in light of there being no further documentation or new stance from the IRS, the information in this guide is still effectively taxpayers’ best guess at what the IRS wants.

The key thing to note is that for the purposes of taxation, the IRS considers cryptocurrency or virtual assets to be property. Even if you use it as money, you’re still subject to the rules and regulations surrounding the taxation of assets, like stocks and real estate. Aside from knowing this, you’ll also need to be aware of what is considered a taxable event for cryptocurrency, as there are specific scenarios under which individuals owe money on their cryptocurrency. These include:

1. Selling cryptocurrencies for fiat currency. This is probably the most straightforward aspect of cryptocurrency taxation to understand. Whenever you sell cryptocurrencies for USD or any other legal tender, the IRS considers it a taxable event. This type of transaction is effectively treated as a capital gain, like the selling of a stock or other property. If the USD value of the currency appreciated from the time of your initial purchase to the time of your sale, you must pay taxes on the amount you gained. You can learn more about capital gains taxes on the IRS’ website.

2. Purchases made with cryptocurrencies. Again, because cryptocurrencies are seen as property, purchases made with cryptocurrencies (e.g., buying retail items with Ethereum at Overstock.com) count as the sale of an asset, and are taxable events. This tax event, like the one above, is a capital gain as the purchase of goods and services with cryptocurrency has you realize the value of your holdings by acquiring an item worth your coins’ equivalent value in USD at the time of your purchase.

3. Buying one cryptocurrency for another. This is probably one of the most contentious aspects of cryptocurrency taxation. Since in all other circumstances the selling of a cryptocurrency is seen as the realization of a capital gain, many tax experts have suggested that selling one currency for another (e.g., buying Ethereum with Litecoin) counts as a taxable event. While the IRS has officially said nothing about this, as of the 2019 filing season, the newly passed tax bill quietly removed a loophole (known as a like-kind property exchange) that cryptocurrency traders have been using to defer paying tax on cryptocurrency gains in previous years. What this means for the current (2018) tax season is unknown, but many tax experts have suggested that the like-kind distinction never at any time applied to cryptocurrencies, given how wildly different each one is in function. However, because there is currently nothing legally preventing you from using this distinction this tax season, cryptocurrency traders can technically file using like-kind capital gain tax deferment, but understand that it is not recommended and might complicate your return. Make sure you consult your accountant before you decide how you’re going to report your cryptocurrency gains this tax season.

4. Wages earned in cryptocurrencies. If you earn income through any cryptocurrency, your employer has to report its fair market value in USD at the time you received it and include the amount in documentation disclosing your income for the year.

5. Special cases: Mining & Forks. Cryptocurrency mining and hard forks also count as taxable events. If you’re a trader who doesn’t know what either of these things are, it’s probably because they likely don’t apply to you. Mining cryptocurrency earns miners coins, so it’s essentially a form of self-employment, and coins earned through mining must be reported as income. Hard forks and airdrops, which are similar to one another, are a bit more challenging to figure out, especially in the absence of comment from the IRS. There are some suggestions to simply treat forks and airdrops like income, but that may not be the best option for everyone. Because the situation surrounding hard forks can differ based on variables like what exchange you’re on or when you had access to the forked currency, it might make sense to consult an accountant if you have a sizable portion of forked coins or airdrops in your cryptocurrency portfolio.

This list isn’t all-inclusive, and there may be additional special cases that count as taxable events; however, the list above includes the most common taxable events that the average cryptocurrency trader will likely encounter. This will be especially true for traders whose activity was limited to exchanges like the ones mentioned above.

How do I calculate what I owe in taxes?

Like with other assets, when it comes to trading cryptocurrency, you’ll need to know what is known as the cost basis of your holdings. The cost basis is the original value of an asset at the time of purchase which is subtracted from the value at which you sold your asset when calculating your capital gains. In this regard, trading cryptocurrency is like trading stocks, and thus, it’s extremely important that you’re aware of the cost basis of each individual transaction. This can be difficult because most exchanges, don’t provide any tax documentation to users who aren’t institutional investors or individuals with large gains. For example, Coinbase only provides a 1099-K to users who’ve made at least $20,000 tied to at least 200 transactions. Other traders can still generate reports of their own assuming they’re on an exchange that has APIs and other reporting tools, but this isn’t a guarantee. Furthermore, your tax situation can get more complicated if you’ve made multiple transactions on different exchanges, each with their own reporting tools. This is why it’s critical that you keep good records of your sales.

Aside from knowing the cost basis of all your transactions, you’ll need to decide on a cost basis reporting method. Your cost basis reporting method can be thought of as the order in which you sold different portions of your assets. Different reporting methods lead to different capital gains calculations. For example, imagine that over the course of two years, you make a series of transactions adding up to 2 Bitcoin and one day you decide to sell 0.5 Bitcoin. You could choose to tie the cost basis of this sell to the first 0.5 Bitcoin you purchased, which would usually be taxed at a lower rate since these are older holdings, or you could tie the cost basis to the last 0.5 Bitcoin you bought. Doing the former would be considered reporting on a first in, first out (FIFO) basis because your oldest holdings are reported and taxed first, while the latter would be regarded as last in, first out (LIFO). You might also be able to choose to specify which portion of your holdings you want to be taxed first as well (referred to as “specific identification”).

Which of these should you choose? The recommended advice is that using FIFO is the best way to avoid underreporting your tax liability, but you can speak to an accountant for information specific to your current situation. While most should be able to help you, there are groups of emerging accountants who specialize in managing digital assets and cryptocurrency. Alternatively, software and applications can assist you in determining your cost basis exist, as well. Often these programs can be used in junction with other tax preparation services to make things even easier for you. For more tax preparation advice, follow our tax preparation blog.