How Does the IRS View Cryptocurrency Capital Gains?
The popularity and value of cryptocurrencies has steadily increased over the past several years. That said, IRS enforcement policies have not always kept up with the growing prominence of cryptocurrencies. Back in 2014, the IRS issued a statement that virtual currency is treated as property for federal income tax purposes and the capital gains taxation rules apply. However, between 2013 and 2015 less than a thousand taxpayers filed returns reporting cryptocurrency. Those numbers increased from 2016 to 2018 but remained much lower than what would be expected given the number of users, transactions, and value being transferred.
Over the years, the IRS has stepped up its enforcement on cryptocurrencies. In 2019, it sent more than 10,000 letters to people it believed may have failed to report virtual currency income. 2019 was also the first year that the IRS explicitly asked taxpayers whether they had profited from cryptocurrencies. A question on form Schedule 1 asked whether the taxpayer had, at any time during 2019, received, sold, sent, exchanged, or otherwise acquired a financial interest in any virtual currency. In 2020, the IRS ramped up its effort by moving the question about virtual currency to form 1040, which is used by all individuals filing an annual income tax return. This indicates that the IRS is becoming more serious about enforcing the law on capital gains for cryptocurrency.
The IRS treats virtual currencies, like Bitcoin, as property. This means that they are taxed much the same as stocks or real property. If you buy $1,000 worth of Bitcoin and sell it for $5,000, you received $4,000 of taxable capital gains. This is fairly straightforward and taxpayers can easily calculate their capital gains as long as they have accurate records of their cryptocurrency transactions. Even so, this is not the only type of cryptocurrency transaction that constitutes a taxable event. In general, U.S. taxpayers are required to report all sales, exchanges, and other dispositions of virtual currency. Additionally, this obligation applies whether the account is held in the U.S. or abroad.
What if you use one cryptocurrency to buy another? For example, you could directly exchange Bitcoin for Ether. When you directly exchange one cryptocurrency for another, the IRS treats it as if you liquidated the first cryptocurrency into dollars and then used those dollars to purchase the second cryptocurrency. Let’s say you originally bought $5,000 worth of Bitcoin. Over time, the value of your Bitcoin holdings increases to $8,000. You then exchange all of your Bitcoin for Ether. In this example, the value of your Bitcoin increased by $3,000 before it was used to purchase the Ether. The IRS considers this transaction to be a taxable event, and you would need to pay capital gains taxes on the $3,000 of additional value.
Another significant example of a taxable event is the use of cryptocurrency for retail transactions. Several major retailers have accepted payment in Bitcoin for years. Although these retailers are mainly in the tech industry, the trend is towards more and more mainstream businesses accepting payment in cryptocurrency. In 2018, KFC Canada launched a promotional campaign in which it sold a bucket of fried chicken for $20 and accepted payment in Bitcoin. The chicken was sold in a Bitcoin-themed container that showed the price of the bucket in Bitcoin at the time of the sale. Although this was a limited, promotional offer, this campaign shows that in the future all kinds of businesses, including fast food restaurants, could accept payment in cryptocurrency.
All the same, before engaging in retail cryptocurrency transactions, you should know about the tax implications. Just like when you use one cryptocurrency to buy another, the IRS considers the use of cryptocurrency in retail transactions to be a taxable event. It is as if you liquidated your cryptocurrency into dollars and then used those dollars to purchase the good or service. Any increase in value to your cryptocurrency holdings before the transaction is considered capital gains, and those gains are realized at the time of the retail transaction. As a result, when transacting directly in cryptocurrency, you must maintain accurate records of the transactions, and the value of your cryptocurrency at the time of the transaction. This information is critical for accurately reporting your capital gains to the IRS.
It is worth noting that any losses incurred from trading in cryptocurrency can be used to offset your capital gains. This offset is not limited to gains through cryptocurrency and can be applied to your capital gains in general. For example, let’s say that you own a selection of stocks and cryptocurrencies. The stocks perform very well this year and you decide to cash them out, making $10,000 in profit. Your cryptocurrencies, however, do poorly and lose $15,000 in value. You decide to cash out your cryptocurrencies that year as well and realize a loss of $15,000. You have had a net loss across your capital assets. Thus, you are able to completely offset the capital gains owed for the $10,000 of profit on the stocks.
To properly file your taxes, you need to understand how the IRS views your cryptocurrency transactions. That said, you need to do more than understand the process in order to avoid an unexpected tax liability. To avoid potential tax liability you should be proactive and maintain your own, accurate records of your cryptocurrency transactions. You should keep a record of all cryptocurrency purchases, sales, airdrops, lending interest, retail purchases, and anything else that could constitute a taxable event. Most cryptocurrency exchanges have built-in tax reporting features that will automatically generate a report of your transactions for you. But if you use an exchange that does not provide you with this information, you must be sure to maintain it yourself.
Once you have a full transaction report for the year, you can calculate your tax liability. There are many services or tax calculators that you can use to work out what you owe. You may also want to consult a tax professional, or CPA, who can help you calculate your tax liability. This is an especially good idea if you have a particularly complex tax situation.
Contact the attorneys of Oberheiden P.C. if you have any questions.