Cryptocurrencies have gone mainstream. You can now invest in them and use them to buy and sell many products and services. However, crypto transactions have important federal tax implications that may not be well understood by everyone. Here's an update on what you need to know about the federal tax issues if you exchange or receive Bitcoin, Ethereum or other cryptocurrencies.
Cryptocurrency is also known as virtual currency or digital assets. It's usually issued and controlled by software developers and accepted as payment by willing parties.
Cryptocurrency can be transferred, stored, held for investment or traded electronically. Unlike familiar conventional currencies, cryptocurrencies aren't issued by government-controlled central banks, so they're largely unregulated.
The IRS has taken the position that crypto assets are classified as "property" for federal income tax purposes. That means you're supposed to recognize and report taxable gain or loss every time you exchange crypto for goods, services, U.S. dollars or another cryptocurrency. If you fail to report crypto transactions on your tax return and get audited, you could face interest and penalties — and even criminal prosecution in extreme cases. (See "Crypto Recordkeeping," below.)
The IRS is serious about enforcing compliance with the applicable tax rules. In fact, the 2022 version of IRS Form 1040 asks you to check a "yes" or "no" box about the issue. It states: At any time during the year, "did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?"
The instructions to Form 1040 clarify that digital assets are any digital representations of value that are recorded on a cryptographically secured distributed ledger or any similar technology. For example, digital assets include cryptocurrencies, stablecoins and non-fungible tokens (NFTs). The "Yes" box on your federal income tax return should be checked if you:
You have a financial interest in a digital asset if you're the owner of record of the asset, have an ownership stake in an account that holds one or more assets, or you own a wallet that holds assets.
The following actions or transactions, alone, generally don't require you to check the "Yes" box:
Finally, the instructions warn that you can't leave the question about digital assets unanswered. You must answer either "Yes" or "No."
To arrive at the federal income tax results of a crypto transaction, the first step is to calculate the fair market value (FMV), measured in U.S. dollars, of the crypto on the date you receive it or pay it. The values of the most-popular cryptocurrencies are listed on exchanges.
When you exchange cryptocurrency for other property, including U.S. dollars or a different cryptocurrency, you must recognize taxable gain or loss. You'll have a taxable gain if the FMV of the property you receive exceeds your tax basis in the crypto that you exchanged. You'll have a loss for tax purposes if the FMV of the property you receive is less than your tax basis in the crypto. If you held cryptocurrency for investment purposes for more than one year, any gain will qualify as lower-taxed long-term capital gain.
If you use cryptocurrency to pay employee wages, the FMV of the crypto counts as wages, subject to federal income tax withholding and federal payroll taxes. Like any other wages paid to employees, you must report them on Form W-2.
If you use cryptocurrency to pay an independent contractor for performing services for your business, the FMV of the crypto is subject to self-employment tax for the contractor. You're required to report the payment on Form 1099-NEC, "Nonemployee Compensation," if payments to that contractor during the year amount to $600 or more.
You may also have a tax gain or loss due to appreciation or decline in the value of the cryptocurrency during the time you held it before paying it out to cover business expenses, including wages or services from an independent contractor. Because you're not in the trade or business of buying and selling crypto, the gain or loss will be a capital gain or capital loss. Whether it's short-term or long-term depends on how long you held the crypto.
For example, in August 2023, Amy used two Bitcoin to buy tax-deductible supplies for her sole proprietorship. On the date of the purchase, the Bitcoin were valued at $30,000 each. So, she has a business deduction of $60,000. That amount would be deducted as an expense on her 2023 Form 1040. But there's another piece to this puzzle: the tax gain or loss from holding the Bitcoin and spending them.
Let's suppose Amy bought the Bitcoin in July 2022 for only $21,000 each. So, she had an $18,000 taxable gain from appreciation in the value of the Bitcoin while she held them ($60,000 minus $42,000). The $18,000 gain is a long-term capital gain, because she held the Bitcoin for more than one year. She would report the gain on her 2023 Form 1040.
If you receive cryptocurrency for goods or services, you must determine the FMV on the transaction date to convert the deal into U.S. dollars. Then you can calculate your taxable income or gain.
For example, Barry sells a vintage auto that he bought and restored. His tax basis in the auto is $50,000. Barry accepts three Bitcoin as payment for the vehicle. On the date of sale, Bitcoin are worth $30,000 each. To report this transaction on Form 1040, he would convert the three Bitcoin into U.S. dollars ($30,000 times 3 equals $90,000). So, his taxable gain on the sale is $40,000 ($90,000 minus $50,000).
How would a self-employed person report crypto payments? Let's say Cecilia is an IT professional who operates as a single-member limited liability company (LLC) that's treated as a sole proprietorship for tax purposes. She accepts four Bitcoin as payment for a major project. On the date of receipt, Bitcoin are worth $30,000. She must recognize $120,000 of taxable income for services rendered ($30,000 times 4). Because Cecilia is self-employed, the $120,000 is also subject to self-employment tax.
Many taxpayers may be unaware of all the federal tax implications of cryptocurrency transactions. But the IRS doesn't usually accept ignorance as an excuse for failure to comply with tax rules. Contact your tax advisor for help determining the implications of your transactions.
Detailed records are essential for compliance with the federal tax rules related to cryptocurrency. Your records for crypto should note:
With this information, your tax professional can determine the federal income tax consequences of your crypto transactions. There may be state income tax consequences, too. You may even have to file a federal gift tax return if you gave crypto to a loved one. You may have to file federal payroll tax returns if you paid employees with crypto, and you may have to file a Form 1099 if your business paid an independent contractor with crypto.
Get in touch today and find out how we can help you meet your objectives.
