The popularity of cryptocurrency — including Bitcoin, Ethereum and Dogecoin — continues to hold steady, if not grow. But no matter how cool crypto (as it's called for short) may seem, investors must remember that it's not tax-free.
The IRS considers crypto a "digital asset." This asset category was recently broadened to include nonfungible tokens (commonly referred to as "NFTs") and other forms of "tokenized" assets.
For tax purposes, digital assets are treated as property. That means you must recognize a capital gain or loss when you sell crypto in exchange for traditional currency. As holds true for other types of property, the amount of that gain or loss is the difference between the sale price and your adjusted "basis" in the crypto. Generally, your basis is the amount you spent in U.S. dollars to acquire the virtual currency — including fees, commissions and other acquisition costs.
Your gain or loss may be short term or long term, depending on whether you've held the crypto for more than one year. Keep in mind that if you sell crypto at a loss, you're subject to the same deduction limits as other capital losses.
Perhaps the biggest tax surprise involving crypto is that using it to buy goods or services can trigger a capital gain or loss. That's because, unlike a traditional currency purchase, a crypto transaction is treated as an exchange of one property for another. Your gain or loss is the difference between the fair market value (FMV) of the goods or services you acquire and your adjusted basis in the crypto you use to make the purchase.
From the perspective of the seller or service provider, crypto payments must be reported as income based on the FMV of the crypto when the payments are received. (For more about the use of crypto in a commercial setting, see "Using Cryptocurrency for Business Purposes" below.)
If you've bought, sold or used crypto, it's important to understand your reporting obligations for federal tax purposes. Beginning with the 2020 tax year, the general information section of IRS Form 1040, "U.S. Individual Income Tax Return," includes the question: "At any time during [the tax year], did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?"
According to IRS guidance, if you bought crypto with "real" currency during the tax year and had no other crypto transactions during that time, you may answer "no." However, if you sold crypto or used it to buy goods or services during the tax year, you must answer "yes" and report these transactions on Schedule D, "Capital Gains and Losses." You also must report any wages earned in crypto on Form W-2, "Wage and Tax Statement," and other crypto income on Form 1099, "Miscellaneous Information."
Even if you don't conduct transactions using crypto, certain events on blockchain or another digital ledger may generate taxable gain. IRS guidance describes two such events:
According to IRS guidance, a hard fork by itself doesn't trigger taxable income. However, if the new crypto is airdropped or otherwise transferred to owners' accounts — and owners have the ability to immediately dispose of the new crypto — then they must recognize it as ordinary income.
Because crypto's value fluctuates widely and frequently, it's critical to maintain records that show the dates and prices of all relevant purchases and sales. You should also keep thorough records of any applicable transactions, such as purchases or sales of goods or services, including the crypto's FMV on the dates that payments are received.
If you buy crypto on different dates for different prices, it may be possible to identify the units you're selling or otherwise disposing of. This provides an opportunity to minimize capital gains by selecting the units with the highest adjusted basis. If you don't (or can't) specifically identify the units, then you must use the first-in, first-out method — in other words, you're presumed to have disposed of the oldest units, which may increase your tax liability.
Crypto may offer enticing investment opportunities and innovative ways to conduct transactions. However, never lose sight of the fact that it also comes with tax implications. Also bear in mind that the tax rules for crypto may change over time because of new legislation or shifting IRS enforcement priorities. Work with your tax advisor to ensure you handle it properly.
Just like traditional currency, cryptocurrency may be used to pay employees' wages or compensate independent contractors for their services. However, the business involved must track the cryptocurrency's fair market value (FMV) as it's paid and then report the cumulative FMV for the tax year on IRS Form W-2, "Wage and Tax Statement," or Form 1099, "Miscellaneous Information."
The business also may have a taxable gain or loss because of appreciation or decline in the cryptocurrency's FMV while it was held before it was paid to the employee or independent contractor. Assuming the company isn't in the trade or business of buying and selling virtual currencies, the gain and loss will be either a short- or long-term capital gain or loss.
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