Crypto taxes can be a headache, whether you’re trading, mining, collecting NFTs, or diving into DeFi. Many people don’t realize the tax burden they’re creating with their crypto activity. But the IRS has been cracking down on cryptocurrency taxes for many years, so it’s important to understand how to report virtual currencies.
If crypto taxes are making you feel completely lost, you came to the right place! While we recommend working with a tax professional for specific advice, this guide will help you understand how cryptocurrency taxes work and how to report crypto on your tax return.
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How Should I Answer the IRS Crypto Question?
The IRS crypto question is the first question on your tax return, right beneath name and address. It asks: “At any time during [year], did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?”
If the answer is yes, you must answer truthfully or risk penalties or even criminal tax charges. You must also attach a full crypto tax report to your return showing all of your trades.
The IRS has clarified that if all you did was purchase cryptocurrency with USD, you do not need to check “yes.” Otherwise, almost any involvement with crypto requires a “yes.”
How Is Cryptocurrency Taxed? The Basics
Crypto taxes are similar to taxes on stocks; it’s treated as property, not currency, for tax purposes. Unfortunately, that means most transactions with cryptocurrency create what we call a taxable event. A taxable event is something that triggers a reporting requirement.
If you’re wondering what the cryptocurrency tax rate is, it’s not a clear-cut answer. There are varying tax rates depending on each situation.
Generally, two types of tax apply to cryptocurrency (including Bitcoin, altcoins, NFTs, and sometimes utility tokens): capital gains tax and income tax. There are different taxable events for each of these.
Crypto Capital Gains Tax
Capital gains are profits made from buying and selling property like stocks, real estate, and crypto. For many taxpayers, the majority of crypto taxes come from this category. In simple terms, what you made minus what you initially paid is a capital gain.
For example, if you bought BTC for $5,000 and sold it for $20,000, then you have a capital gain of $15,000.
If you paid more for the cryptocurrency than you sold it for, then you have a capital loss.
Capital gains taxable events include:
- Selling crypto for USD/fiat
- Exchanging one type of crypto for another
- Paying for goods and services with crypto
The tax rate for capital gains depends on how long you held the asset. For short-term gains (assets held less than 1 year), the tax rate is the same as your income tax rate. For long-term gains, the tax rate is 0%, 15%, or 20%, depending on the amount.*
*A higher tax rate has been proposed for long-term capital gains, but it has not been passed as of the time of publication.
We’ll go through examples of each taxable event below.
Do you pay tax when you cash out crypto?
Yes, cashing out your crypto—selling it for USD or any other type of government-issued currency—is taxable. This creates a capital gain.
Is converting crypto a taxable event?
Swapping one type of crypto for another (for example, trading ETH for ADA) is a taxable event. It’s as if you sold the first coin for USD (triggering a capital gain) and then used USD to buy the second coin. This includes converting to a stablecoin like USDC.
When it comes to crypto taxes, one of the most common mistakes we see is failing to account for taxes from these trades.
Is paying with crypto taxable?
Yes, using crypto to pay for something is a taxable event that creates a capital gain. This is true whether you’re buying physical goods, services, NFTs, or anything else.
What about NFTs?
The IRS has not released any specific guidance on NFTs. But generally speaking, the same tax principles that apply to trading cryptocurrency also apply to trading NFTs. For more information on specific scenarios, read our NFT taxes blog or contact our crypto tax lawyers!
What about DeFi?
Decentralized finance, or DeFi, creates a wide range of complicated tax questions. Although earning interest on DeFi loans might seem like a simple scenario, it actually depends on how things are structured on whichever DeFi platform(s) you’re using.
For example, getting protocol tokens/placeholder tokens in exchange for ETH can be considered a taxable crypto-to-crypto swap.
If you have complicated DeFi activity, we highly recommend hiring a tax professional to ensure you’re reporting crypto taxes correctly.
How to Figure Out Cost Basis for Crypto Capital Gains: FIFO, LIFO, HIFO, and Specific ID
When you sell or dispose of crypto, it’s not always obvious which coin (or fraction of a coin) was used. So how can you tell how much you initially paid for it?
You can use a cryptocurrency tax accounting software to pull in your transaction history and automatically determine your cost basis, sales proceeds, and holding period. Depending on the software you choose, multiple accounting methods may be offered.
The IRS guidance generally advises taxpayers to use FIFO (first in, first out). FIFO means crypto is sold in the same order you bought it.
Specific ID can also be used in some cases. This allows you to lower capital gains by identifying the specific coin that was used in a transaction, but it requires special accounting (ask our crypto tax attorneys for more information). NFTs, by nature, require specific ID accounting.
It is possible to use specific ID for some transactions while using FIFO for everything else.
You may have also heard of LIFO (last in, first out) or HIFO (highest in, first out). Even though these accounting methods may be offered in your crypto tax software, the IRS is unlikely to support LIFO or HIFO unless you have enough documentation to specifically ID your coins.
Crypto Income Tax
Not all cryptocurrency profits are earned by trading and earning capital gains, so there’s a whole other category of crypto taxes to consider! You might be earning coins in a game, or you might simply have random coins show up in your wallet. These types of profits are taxed as ordinary income (the same category that wages from a traditional job would fall into).
For cryptocurrency that’s taxed as ordinary income, you need to find the fair market value of the coins (in USD) when you received them and count that amount toward your gross income.
If you then sell, exchange, or spend the coins, you’ll have a capital gain tax event. The fair market value at time of receipt—the same amount you reported as income—would be your cost basis for any future transactions.
Crypto income taxable events include:
- Receiving mining or staking rewards
- Receiving crypto as payment for goods and services
- Receiving an airdrop
- Receiving crypto in play-to-earn games
Let’s go through some examples of each taxable event.
Are crypto mining rewards taxed?
Yes, mined crypto is considered ordinary income. Typically, mining is considered a business, which means that you can deduct business expenses.
Are crypto staking rewards taxable?
Yes, staking rewards are taxed as ordinary income. Unlike mining, staking isn’t necessarily seen as a business; the rewards are typically considered passive income.
If I get paid in crypto, will I be taxed?
When you receive payment in cryptocurrency, that’s considered ordinary income. This is true whether you’re being paid for original NFTs, physical goods, services, or anything else. It also applies if your employer pays you in crypto.
If I receive a crypto or NFT airdrop, will I be taxed?
The IRS has specified that airdropped tokens are taxed as ordinary income. Although they have only released guidance for cryptocurrencies (such as BTC and ETH), the conservative approach would be to treat airdrops of NFTs or utility tokens the same way.
Each airdrop should be reported; the coins may not be worth much individually, but they can add up! Ask our attorneys about refusing worthless airdrops for tax purposes.
Sometimes, the fair market value at time of receipt isn’t obvious; what if there was no market for the token yet? Our crypto taxes team can help determine an acceptable value using the information available. Keep in mind that claiming a value of $0 might not hold water with the IRS.
Do I have to pay crypto taxes for play-to-earn games like Axie Infinity?
If the rewards received from play-to-earn crypto/NFT games have value, then they’re considered ordinary income.
As these types of games become more popular, we’ve seen increasingly complicated situations arise. For example, in Axie Infinity, Managers and Scholars can work together and share rewards. These setups can create unexpected tax burdens and we recommend speaking to a tax professional before getting started.
Which Crypto Transactions Are Not Taxable?
It may seem like crypto taxes apply to everything, but there are a few things you can do without creating a taxable event. The following types of transactions do not create a tax burden (but you may still need to report them):
- Purchasing crypto with USD/fiat
- Holding crypto, even if the value increases
- Transferring crypto between your own wallets and exchanges
- Giving or receiving crypto as a gift (within limits)
- Donating crypto to a qualified nonprofit
Here are some examples of each event.
Do I have to pay tax when I buy crypto?
Simply buying crypto with USD or another government-issued currency is not taxable. It also doesn’t require you to check “yes” to the crypto question on your tax return (assuming you had no other reportable activity).
My crypto has gone up in value; will I have to pay tax?
If your crypto has gone up in value but you’re still holding onto it, that is not a taxable event. When you sell, trade, swap, or otherwise dispose of the crypto, then you’ll have a taxable event.
Is transferring crypto from one exchange or wallet to another a taxable event?
No, moving your crypto between wallets or exchanges that you own is not taxable. As long as the virtual currency remains in your possession, this is simply a transfer and not a transaction. However, the movements of your crypto need to be tracked so that you can have an accurate cost basis.
If I give someone cryptocurrency as a gift, is that taxable?
When you send crypto as a gift to family and friends, that’s often not taxable (to you or to them), as long as you don’t exceed annual or lifetime limits. The gift also must be no-strings-attached and you must completely give up control of the cryptocurrency.
Currently, the lifetime gift tax exclusion limit is $11.7 million. For 2021, the annual limit is $15,000 per recipient. And the best part? Amounts less than the annual limit don’t count toward your lifetime limit!
However, there’s still some reporting to do for your crypto taxes. If you’re gifting cryptocurrency, you should write the recipient a gift letter containing the original acquisition date and cost basis; the recipient will inherit them. You may also need to file a gift tax return.
How is it taxed if I donate crypto to charity?
Donating cryptocurrency to a qualified nonprofit needs to be reported, but it won’t create an extra tax burden—as long as you don’t convert the crypto to cash first. Even if you donate crypto that’s increased in value, this transaction doesn’t create a capital gain. The donation can also serve as a tax write-off, helping to lower your bill.
What If I Lost Money on Crypto?
You need to report your crypto losses to the IRS—and doing so could actually save you money, for two reasons.
One: Your exchange may be sending information about your transactions to the IRS, but that information is often incomplete and doesn’t include any losses. This can make the IRS think you owe much more than you actually do. Correcting that mistake can be more expensive and troublesome than reporting properly to begin with.
Two: Capital losses offset capital gains, lowering the amount of crypto taxes owed. They can also be used to offset regular income and can even be carried forward to offset future gains! Give us a call to learn more.
How Does the IRS Track Cryptocurrency?
The easiest way for the IRS to track cryptocurrency is to receive information directly from exchanges.
Late in 2021, President Biden signed the Infrastructure and Investment Jobs Act, which has a very significant impact on cryptocurrency tax enforcement. A provision in the law will require crypto exchanges to file Form 1099-B reporting users’ trades to the IRS.
Additionally, if you undergo an IRS audit, it’s typically very easy for the IRS to uncover any unreported crypto activity. At some point, you probably put cash from your bank account onto a crypto exchange or sent proceeds from the exchange to your bank account; those activities will appear in your records and lead the IRS to your crypto trades.
And if you thought your account on a foreign crypto exchange or decentralized exchange could be kept under wraps, you might have a problem during an audit; typically, a centralized exchange like Coinbase, which does report to the IRS, is used as a bridge. Again, this appears in your records and leads the IRS straight to the unreported accounts.
What Are the Penalties for Not Reporting Crypto Taxes?
If you have unreported crypto, you could face substantial fines or even a prison sentence.
Accuracy-related penalties apply if you underpay tax—for example, by leaving the activity from a decentralized exchange off your tax return. The accuracy-related penalty is 20% of the unpaid tax, plus interest. It can be assessed due to negligence or substantial understatement of income tax.
Tax fraud—a willful attempt to cheat the Tax Man—carries more serious penalties.
The IRS can assess civil tax fraud penalties equaling 75% of the unpaid tax attributable to fraud. (That’s on top of the actual tax owed!) In addition, you can also face criminal charges, which are handled by the Department of Justice. Criminal penalties include up to $100,000 in fines and up to 5 years in prison. Penalties are assessed per violation, which typically means per tax year.
There is no statute of limitations for tax fraud, meaning the IRS and Department of Justice could target you years after the fact.
Hopefully, you’re feeling more confident about the basics of cryptocurrency taxes! If you have additional questions or need help preparing your crypto tax return, reach out to Gordon Law Group—we’d be happy to help!