If you buy, trade, or earn from crypto in any way, it is important that at least you acquaint yourself with how these activities are likely to impact your tax obligations.
In many jurisdictions now, including the U.S., revenue agencies are more than developing a keen interest in the value that investors generate from cryptocurrencies. They are setting up systems that will help them determine what you should report when you file your tax returns.
How the revenue authorities tax your crypto-related activities is based on how they have chosen to treat cryptocurrencies and other assets created on the blockchain.
Cryptocurrencies are not currencies
It is almost indisputable that when Satoshi Nakamoto launched Bitcoin, he intended it to be a digital currency. One that is used as a store of value, unit of account, and a medium of exchange. This is how those who embraced cryptocurrencies continue to see them.
However, revenue authorities have chosen to see cryptocurrencies as something else. The Internal Revenue Service, in particular, has opted to treat cryptocurrencies as property for taxation purposes.
If the IRS treated Bitcoin as just another currency, you wouldn’t have to worry about paying taxes when converting your value in crypto into fiat and vice versa. It wouldn’t also matter to the tax collector if you paid for goods and services using a cryptocurrency.
Initially, the IRS, like many other revenue authorities around the world, ignored Bitcoin and other cryptocurrencies. It seemed to them to be something existing in the virtual world’s less-visited part and had little to do with the real world mainstream financial system.
However, as more value was generated, more people got involved, and they moved the value between crypto and the fiat financial system, the revenue agency had to find a way to tax the activities involved.
Cryptocurrencies are property
In April 2014, the IRS released a special notice classifying bitcoin and other cryptocurrencies as property for taxation purposes. This meant that they were going to be treated the way stocks and real estate are treated.
When you sell stocks you’ve been holding, what is taxed is the difference between the cost at which you acquired them and the price at which you dispose of them (the fair market value).
If the fair market value of crypto assets is higher than the acquisition cost, the difference is taxed. For example, if you bought a bitcoin on Sept. 10, 2020, for $10,000 and sold it on Jan. 9, 2021, for $40,000, the difference will be $30,000. You will be expected to pay the percentage of the difference to the tax collector.
On the other hand, if the fair market value is lower than the acquisition cost, then the difference is considered a capital loss, and you could qualify for tax-deduction when this turns out to be the case after disposing of the asset. That means if you bought a bitcoin at $10,000 and sold it at $$8,000, then you are not expected to pay but declare a loss that can be deducted from other taxes you may be expected to pay.
This is a very simplified description of how cryptocurrencies are taxed. There are more complex activities in the space than buying, holding, and selling.
For example, some people don’t buy the cryptocurrencies they sell, but they “mine” them, in short they have powerful computers that solve the cryptographic maths confirming transactions and are rewarded with new coins as a result. There are also those involved in things like yield farming. All these calls for a nuanced approach to crypto taxation.
The taxation of events emanating from mining, peer-to-peer lending, yield farming, and airdrops is the focus of our next post.
For now, let’s look at two fundamental concepts you need to know to understand how you are likely to be taxed or how you are expected to file your returns.
This is the difference between the cost you incurred to acquire the property and what you get when you dispose of it. In the first example above, we have a capital gain of $30,000. In the second example, we have a capital loss of $2,000.
The concept also applies when you use the cryptocurrency you were holding to make purchases. For example, if you bought a car using bitcoin, the capital gains or loss is the difference in the bitcoin price when you acquired them and the market price when you used them to buy the car.
A taxable event
This is a transaction that involves you disposing of a property like bitcoin and, as a result making a capital gain or a loss.
When you sell cryptocurrency on an exchange for fiat, that qualifies as a taxable event. If the selling price is more than the acquisition cost, you are supposed to report gains.
Also, buying or selling one cryptocurrency for another is considered a taxable event. The difference in the value in dollars can be a capital gain or loss. If you used bitcoins to buy a car, that could also qualify as a taxable event.
There are, however, transactions that are not taxable events. For example, when you move your cryptos from one wallet to another or move them into a wallet on a trading platform.
Time determines tax paid on gains
The amount of tax you pay on your capital gains also depends on how long you’ve held the property. If you acquired a bitcoin and then disposed of it within a year, your capital gains are going to be taxed under your marginal tax bracket.
On the other hand, if you’ve held the property for more than a year, then your capital gains will be taxed under a different regime, which often charges a lower percentage.
In a second article, we will look at how complex cryptocurrency transactions such as mining, lending, airdrops, and yield farming are likely to be treated for taxation.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Constantin Kogan is Managing Director at Wave Financial Group and a Partner at BitBull Capital. He has been a cryptocurrency investor since 2012. He has over 10 years of experience in corporate leadership, technology and finance. He contributes to the digital asset space as well as the sharing and value economies.
About Wave Financial
Wave Financial LLC (Wave) is a Los Angeles and London based investment management company that provides institutional digital asset fund products. Led by a team of highly experienced financial services professionals, Wave provides investable funds via their diverse investment strategies applied to digital assets and tokenized real assets. Wave also offers managed accounts for HNWIs and family offices seeking tailored digital asset exposure, bespoke treasury management services, and early-stage venture capital and strategic consultation to the digital asset ecosystem.
Wave is regulated as a California Registered Investment Advisor (CRD#: 305726).
Important Disclosures and Other Information: Nothing in this material should be interpreted as an offer or recommendation to buy, sell or hold any security or other financial product. Past performance is no guarantee of future results. Wave Financial LLC is a registered investment adviser, registered with the state of California (CRD#: 305726). Registration with the state authority does not imply a certain level of skill or training. Additional information including important disclosures about Wave Financial LLC also is available on the SEC’s website at www.adviserinfo.sec.gov. Or, learn more information about Wave Financial atwww.wavegp.com.
The ecosystem landscape included in this post is intended to provide generalized guidance; nothing in this analysis is intended as tax advice, investment advice, a recommendation or an introduction to particular funding or capital resource.