If you are like many people, you may be involved in cryptocurrency trading, such as Bitcoin. If this is the case, don't assume that you have found a Shangri-La that means any money you earn is not sought after by the IRS to be taxed. In fact, the opposite is true, since the IRS has for several years been on an all-out offensive to track down those who may have unreported cryptocurrency transactions. If you are curious about how your involvement in cryptocurrency will impact your taxes, here is everything you need to know.
Crypto Transactions are Not Anonymous
When you first started to dabble in cryptocurrency, you may have thought these financial transactions were virtually impossible for the IRS to track. However, that's not the case now. In fact, when blockchain, the technology behind cryptocurrency, became mainstream about a decade ago, most people thought these transactions flew under the IRS radar. But to their surprise, blockchain is an open ledger to the IRS, meaning it can see all of its activities. As a result, the IRS has in the past two years mailed out letters to over 100,000 taxpayers it believes may have failed to report cryptocurrency transactions.
Cryptocurrency is Taxed Like Stocks
To simplify how the IRS views cryptocurrency in relation to your taxes, think of Bitcoin as you would any investments you have made in stocks. Though Bitcoin is called currency, it is viewed by the IRS as property, and is taxed as such. For federal tax purposes, you won't have to worry about paying taxes on your virtual currency until it is exchanged or sold. Also, if you purchase your virtual currency with US dollars, this is not viewed by the IRS as a "taxable event," so no taxes are due in these cases.
Capital Gains
For investors, capital gains taxes are always something that seems to make people gnash their teeth and pull out their hair in frustration. If this sounds like you, it’s important that you pay particularly close attention to how capital gains taxes will impact your cryptocurrency transactions. Based on IRS guidelines, if you have had your cryptocurrency for one year or less, profits on a sale would be considered to be a short-term capital gain and thus taxed as ordinary income. However, if you've held it for more than one year, it would be a long-term capital gain that will afford you a lower tax rate, which could mean saving thousands of dollars in what you may owe the IRS.
Keep Very Accurate Records
While it is important to keep very detailed and accurate records about anything related to your taxes, it is absolutely critical you do so regarding your cryptocurrency transactions. In fact, if you are trading cryptocurrency, experts recommend that you download transaction logs from each platform on which you trade cryptocurrency on a regular basis. By doing so, you will be prepared should the IRS decide it's time for an audit of your taxes. If you don’t have any records of your cryptocurrency transactions for the period in question, it is likely the IRS will just decide everything is taxable, which could have you paying thousands of dollars unnecessarily to the federal government.
A Double Whammy at Tax Time
While most people choose to trade cryptocurrency just as they do stocks, others decide to do this and also to use it for everyday transactions, such as buying a cup of coffee or other items. Though this sounds easy enough, it can end up creating a double whammy for you at tax time. For example, if you buy $10 of Bitcoin one day and it is worth $14 the next day, that's great. However, if you take your newfound wealth and buy something, the IRS will view this as you making two separate transactions; those being buying the item plus selling your Bitcoin. Since you incurred a $4 capital gain, the IRS will be free to tax you on that $4 capital gain. As you can see, should you do this over and over each time you use Bitcoin to buy something, the tax headaches can add up very quickly.
IRS Pushing Hard for Regulations
Though the IRS first published official guidelines concerning cryptocurrency and taxes in 2014, it is continuing to put pressure on virtual currency exchanges to become more transparent regarding user data. In fact, federal regulations now state that all US-based digital currency exchanges must report certain user transaction data to the IRS. Also, with more pressure from the federal government on virtual currency exchanges to release even more information, experts believe it is only a matter of time before you will see a decentralized financial infrastructure, meaning it will become even easier for the IRS to gain access to your data regarding cryptocurrency transactions.
States Also Want a Piece of the Action
If you think it is only the federal government that wants a piece of the action regarding the money you've made investing in cryptocurrency, think again. In most cases, state governments will also want their fair share of tax payments from you on these transactions. To calculate whatever gains or losses you may have incurred along the way, you will need to use Form 8949 and report the results on Schedule D. Since the rules that pertain to how cryptocurrency is taxed are still relatively new and subject to change, never try to find all the answers on your own. Though select tax software can help you make some sense of various records, always rely on an experienced CPA who has an in-depth knowledge of cryptocurrency and taxes.
While it can be exciting and of course quite profitable to invest in cryptocurrency, you also see it can take what may have been a somewhat straightforward tax season to which you've become accustomed, and turn it upside down in a hurry. If you have started investing in cryptocurrency and now wonder how it may impact your taxes, schedule a time to seek out advice from a CPA you know and trust.