Cryptocurrency and Taxes
Cryptocurrency is more popular now than ever. You have probably seen reports of rapid, sometimes massive gains and losses in virtual coins such as Bitcoin, Etherium, and Dogecoin. However, these reports do not address what cryptocurrency is, how one obtains and manages it, or what tax implications are generated when trading in cryptocurrency. With this short primer, you will be better prepared to navigate the ever-evolving world of cryptocurrency and understand potential cryptocurrency taxes.
What is Cryptocurrency?
Each individual piece of cryptocurrency, commonly called a coin, is a unique string of code generated by solving an extremely complex puzzle, a process known as “mining.” These coins enter an online ecosystem called a blockchain, where it is tracked as it moves from owner to owner. The tracking process establishes each coin as a genuine article and gives it value. Cryptocurrency may be traded by direct peer-to-peer interaction, on exchanges such as Coinbase or Binance, and through a brokerage. One’s individual cryptocurrency is held in a secure storage area called a “wallet.” Wallets may be completely virtual or saved on physical devices such as flash drives.
Each method of cryptocurrency ownership offers different benefits and drawbacks. Physical wallets allow for the most autonomy in ownership and are less susceptible to cybertheft, but there is no insurance should the device be damaged or lost as the cryptocurrency would vanish along with the physical wallet. Virtual wallets, while not prone to loss, can be hacked if not secured properly. Additionally, even when properly secured both types of wallets require complex passwords and authentication systems. And losing the login information for a wallet may result in the loss of its contents.
Brokerage ownership of cryptocurrency is more forgiving than wallet ownership. However, brokerage accounts are more likely to have ownership related restrictions which may eliminate businesses and trusts from ownership. Trust exclusions may unduly complicate the inheritance of cryptocurrency associated with one’s estate planning. Additionally, some brokerages may not support the transfer of cryptocurrency to an individual wallet.
Cryptocurrency and Taxes?
Cryptocurrency valuations fluctuate in relation to government-issued currencies. Therefore, it is often used as an investment vehicle, and the IRS generally treats it as such. The exception is when generating cryptocurrency via mining. In this scenario the proceeds of the sale of cryptocurrency would be treated as ordinary income.
Taxes on cryptocurrency are calculated in a manner similar to stocks. The difference between the purchase price, or basis, and sale price is taxed as profit under the capital gains tax. Holding cryptocurrency for less than one-year results in taxes based on short-term capital gains rate. While holding it for more than one year will reduce the tax burden as the gains would be subject to the long-term capital gains tax rate. Additionally, if a transaction results in a loss it may be declared and used to offset other gains.
The primary conceptual difference between cryptocurrency and taxes results from cryptocurrency’s purchasing power. One cannot buy goods with stock as stocks may only be purchased, traded, or sold. In contrast, cryptocurrency may be used to buy goods and services from cars to non-fungible tokens (NFT) . Despite being used to purchase goods and services, the IRS considers this to be a divestment of an asset and imposes a tax liability. Thus, buying one unit of Etherium, a popular cryptocurrency, for $1,000 and later using it to purchase an when the price of Etherium is $2,500 will result in the IRS imposing a tax liability on the $1,500 change in value, despite this profit not actually being paid out to the holder.
Conclusion
Any transaction using cryptocurrency, whether a pure exchange or a purchase, generates a tax liability and the basis and profit must be reported to the IRS. Losses may be declared and used to offset gains; additionally, cryptocurrency may, like stocks, be donated to help offset tax liability. You should anticipate the tax implications of each transaction and plan accordingly. The IRS has stepped up tax enforcement on cryptocurrency, including free (“airdropped”) cryptocurrency given out to promote new coins. Cryptocurrency is still cutting edge, and the crypto space can resemble the Wild West. Before undertaking any cryptocurrency transaction, research and develop a plan. For assistance with cryptocurrency and taxes, or how to incorporate cryptocurrency into your estate plan, please contact our experienced and qualified tax and estate planning professionals at RJS LAW.
Published by Gwendolyn K. Davis
Updated 7-13-22 Zachary K. McDaniel
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