How Is Cryptocurrency Taxed?
Owning cryptocurrencies such as Bitcoin or Ethereum necessitates a comprehensive understanding of how it influences your tax obligations each time you engage in buying, selling, or earning these digital assets.
What Constitutes Cryptocurrency?
Cryptocurrency denotes a decentralized, digital form of storing value and serving as a medium of exchange. It deviates from traditional currencies, such as physical tokens like dollar bills, and operates without centralized governmental supervision.
In lieu of physical representation, cryptocurrency leverages encrypted, distributed ledgers—commonly known as blockchain technology—to document and authenticate all transactions. These blockchain ledgers can be likened to an ever-updated checkbook that meticulously records every transaction within a specific cryptocurrency.
The inaugural cryptocurrency, Bitcoin, was introduced in 2009. Presently, a myriad of others circulate, encompassing examples like Bitcoin Cash, Litecoin, Ripple, and Dogecoin.
What Are the Tax Implications of Cryptocurrency?
The taxation of cryptocurrency is primarily guided by a 2014 IRS ruling, which determined that cryptocurrency should be treated as a capital asset akin to stocks or bonds, rather than as traditional currency like dollars or euros. This decision has significant implications for crypto owners, introducing complexities into the tax landscape.
The IRS’s choice to classify crypto as a capital asset may stem from the prevalent treatment of cryptocurrency as an investment, according to Jeff Hoopes, an associate professor of accounting at the University of North Carolina and research director of the UNC Tax Center. He notes, “I assume [the IRS] decided this because most people hold crypto as an investment, and we tax the appreciation on capital assets held as an investment.”
Capital assets incur taxes when sold at a profit. If you hold your cryptocurrency for over a year and sell it at a gain, you will be subject to capital gains taxes. However, if the holding period is one year or less and you realize a gain, ordinary income taxes apply, which typically have higher tax rates than capital gains.
For instance, if you purchased $20 worth of bitcoin and retained it for three years, resulting in an increased value to $200 upon selling, you would owe capital gains taxes on the $180 gain.
Conversely, if you bought $100 worth of bitcoin and its value decreased to $20 over three years, selling it would result in a capital loss. While capital losses do not incur taxes, you have the option to offset other income, up to $3,000 ($1,500 if married filing separately), to reduce taxable income. The remaining loss can be claimed in subsequent years until fully utilized.
If you receive cryptocurrency as wages, your employer will report the fair market value on your W-2 form. This amount must be reported on your income tax return, and ordinary income taxes are applied to the received cryptocurrency.
Differences Between Capital Gains Tax Rates and Ordinary Income Tax Rates
The Advantage of Crypto in Taxation: When it comes to paying taxes, the positive aspect of cryptocurrencies is that if you’re obliged to settle capital gains taxes, the tax rate tends to be lower compared to your ordinary income tax rate.
In the tax year 2023, capital gains tax rates stand at 0%, 15%, and 20%. These rates are applicable when you sell your cryptocurrency after holding it for more than one year and realize a profit.
Conversely, if you sell your cryptocurrency at a profit but have held it for a year or less, you will be subject to taxation at your ordinary income tax rate, determined by your income level and filing status. For the tax year 2023, ordinary tax rates could reach a maximum of 37%.
Determining My Crypto Tax Liability
Determining Your Tax Obligation in Cryptocurrency:
The amount you owe in taxes related to cryptocurrency is contingent upon whether you sell or earn it.
Upon selling cryptocurrency and realizing a profit on your investment, the tax liability may involve either regular income taxes or capital gains taxes, depending on the duration of your crypto holding. Holding the crypto for a year or less subjects you to the higher, ordinary tax rates.
Earning cryptocurrency through mining, promotions, or as payment for goods or services constitutes regular taxable income, taxed at your standard income tax rate.
Moreover, retaining cryptocurrency acquired through these activities and subsequently spending or selling it for a higher value than when initially received results in short- or long-term capital gains taxes on the profits. The applicable tax rate is determined by the duration of your crypto holding.
What Are My Tax Liabilities on Cryptocurrency?
Determining Your Tax Obligations on Cryptocurrency – Consider the following questions:
- Did you engage in cryptocurrency mining? Cryptocurrency mining involves using computers to solve complex equations and record data on the blockchain. If you received payment in new crypto tokens for this work, you are liable for taxes on the fair market value of the acquired cryptocurrency.
- Have you received crypto as a reward or through an airdrop? If you obtained cryptocurrency as part of a marketing promotion or through an airdrop, it constitutes taxable income.
- Were you compensated for goods or services with cryptocurrency? If someone pays you in crypto for goods or services provided, the entire payment is considered taxable income, analogous to receiving cash. However, unlike cash, your customer may also incur income taxes if the value of the crypto they used exceeds what they paid for it.
- Did you sell cryptocurrency to realize investment gains? Profits from selling crypto at a higher value than the purchase price are subject to taxation, similar to the taxation of gains from stocks or mutual funds.
- Have you converted or exchanged one cryptocurrency for another? When converting or exchanging crypto, such as swapping bitcoin for ethereum, taxes are owed on any gains made in the transaction. For instance, if you bought $400 worth of bitcoin and used it to acquire $1,000 worth of ethereum, taxes would be applicable on the $600 realized profit, even though it involves exchanging one cryptocurrency for another.
While managing these aspects may seem intricate, it is crucial not to take shortcuts when dealing with cryptocurrency taxes. Consider seeking the assistance of a tax professional.
Jon Feldhammer, tax partner at Baker Botts, emphasizes, “Taxpayers are obligated to report their crypto transactions on their tax returns. The IRS is intensifying its scrutiny on this matter.”
