The past decade of investing in cryptocurrency has been the equivalent of a modern-day gold rush for casual and sophisticated investors alike. Those who’ve followed the journey of Bitcoin (“BTC”) remember when someone spent a whole 2 BTC on a pizza back in 2011. Today, 2 BTC in 2021 can buy a luxury automobile demonstrating the total returns diligent crypto investors have generated.
Nowadays, BTC is not the only player, and an explosion of cryptocurrencies has entered the market. Each cryptocurrency provides promising solutions using blockchain technology. More cryptocurrencies with various yield farming techniques lead to more complex tax issues.
Many CleverProfits clients are savvy business owners with higher risk tolerance that have invested some of their excess business profit into cryptocurrency. A lot of our clients just buy and hold, but a few risk seekers have turned into complete “degenerates” entering previously uncharted territory with sophisticated yield farming strategies for maximum returns.
Unfortunately, dealing with crypto tax is a massive headache for any investor who has put money into this. Our goal is to help educate you on the fundamental tax issues around basic crypto investing strategies surrounding buying, selling, creating, mining, and exchanging cryptocurrency.
In this guide, we will explain:
- How property taxation rules work in the United States and why cryptocurrency is treated like property
- How to identify the character of your crypto sales and exchanges, mining rewards, and staking rewards on your tax return
- How to track your cryptocurrency purchases, sales, and exchanges for easier reporting on your taxes
This article will not dive into tax considerations for specific advanced crypto investing strategies.
Fundamental rules of property taxation
Cryptocurrency is treated as property by the Internal Revenue Service (“IRS”). When you buy a piece or all of a cryptocurrency, you buy property much like you would buy a share of stock. It just happens to be an intangible piece of code instead of a stock certificate that you own the rights to.
Tax basis
Let’s say you’re feeling lucky and you decide to buy 1 BTC for $40,000. Your tax basis in that 1 BTC is $40,000. That means in the future, when you have a recognition event, you will be able to offset your proceeds by your tax basis of $40,000. If you sell your 1 BTC tomorrow for $60,000, you can offset the proceeds on that by your tax basis of $40,000 and recognize a gain of $20,000 on your tax return.
| Gross Proceeds on Sale of 1 BTC | $60,000 |
| Less: Tax Basis in 1 BTC | ($40,000) |
| Taxable Gain on Recognition Event | $20,000 |
Calculating a taxable gain when selling Bitcoin
This makes fundamental sense under the tax rules because you should only pay taxes on your appreciation, not the gross proceeds.
Recognition event
Now, what constitutes a recognition event that would trigger a taxable gain? Under the tax rules, a recognition event occurs when you sell or exchange your property. This could happen under a few different scenarios:
- if you sell your 1 BTC for dollars, you have a taxable event
- if you trade your 1 BTC for 10 ETH, you have a taxable event
- if you trade your 10 ETH for 1 Bored Ape NFT, you have a taxable event
- if you pay for a pizza with 1 BTC, you have a taxable event
- consuming 0.1 ETH in gas or transaction fees is a taxable event
These recognition events can add up quickly even though you never exchanged that final 1 NFT for real US dollars. This creates taxable gain even though you have not received any cash to pay the tax – called “phantom income”. For this reason, crypto investors have to be extra vigilant when they are selling or exchanging their crypto. Even if all of your crypto is still sitting in your Coinbase account, you are creating a recognition event if you trade one for another.
TIP: One goal as a crypto investor should be to avoid creating recognition events to shelter it from taxation and preserve your capital.
Character of gain
The last piece of the puzzle is what type of tax gain you will have. The importance of the character of your gain cannot be understated. Savvy investors know that long-term capital gains are the most favorable in the tax code with a maximum 23.8% federal tax rate. This lower tax rate is much more favorable when compared to the 40.8% highest marginal tax rate on ordinary income. To the extent possible, we want to maximize long-term capital gains.
Short-term capital gains are still taxed at your marginal tax rate so they aren’t that favorable for investors except to absorb other capital losses. Net capital losses cannot be deducted beyond $3,000 per year, and any excess must be carried forward to future years.
For the character of your crypto gain to be capital, it must be a capital asset to you. This is an easy requirement since most people purchasing crypto buy it as an investment. However, if you are day trading full time, the gain could be ordinary in nature. It depends on how you approach buying and selling crypto.
In order to classify your sale or exchange as long-term capital gain, you must hold your property for at least 366 days before selling or exchanging it. Note that if you trigger a recognition event on an exchange, your new property resets the holding period back to day 1.
Mining and staking rewards
Mining and staking rewards are a little different because they are generated from work you are doing with your computer or existing crypto you’ve pledged. The IRS treats mining and staking rewards as ordinary income. This means you will have an ordinary income recognition event every time you receive a reward taxed at your marginal rate.
For example, let’s say you mine a block and receive 0.0001 BTC worth $0.40. You will recognize $0.40 on your tax return and have a tax basis in the 0.0001 BTC of $0.40 – the exact amount that you recognized into ordinary income.
One important thing to note is that these rewards are also treated as self-employment income and subject to self-employment tax. Self-employment tax is the federal government’s way of forcing you to contribute to social security and medicare. Some investors opt to treat their rewards as part of an S-corporation, but we don’t always recommend this because you don’t want to lock up appreciated property in an S-corporation.
Receiving crypto for services
A new trend for businesses is to pay their workers or consultants with cryptocurrency in lieu of actual currency. The tax rules are very clear on the tax treatment for the receipt of crypto (or any property for that matter) in exchange for services. You must recognize ordinary income (and self-employment income) for the fair value of the crypto you received on the day you received it. The long-term capital gain holding period for that property starts on the day you receive it. Your tax basis in the crypto is the amount of income you reported on your tax return.
For example, if your client pays you 5,000 in stablecoin like USDC, that’s easy to calculate because the value of 1 USDC is equal to $1 US dollar on any given day. You’d recognize $5,000 of self-employment income on your tax return. In another example, if you receive 1 ETH in lieu of USD, you need to calculate the value of the ETH you received and report it on your tax return as self-employment income.
Your tax basis in the ETH you received is equal to the amount of income you reported. If you sell or exchange the ETH in the future, you’ll recognize gain or loss on the difference between the new value and your original tax basis. It’ll be long-term capital gain if you hold it for at least 366 days.
One trap business owners fell into was opting to receive crypto instead of USD for services in 2021. The entire crypto market was inflated and they were required to report income on their return for the inflated value. If they held the crypto and didn’t divest in time before the crash, they incurred a lot of unrealized capital losses.
Once they created a recognition event, it would trigger a significant capital loss that could not be offset against ordinary income from the receipt – a disaster tax problem. This is because net capital losses can’t be claimed on your tax return beyond $3,000 annually. When exchanging services for high risk assets, you must be aware of possible bad tax consequences.
Consistent tracking
Let’s say you decide to buy another 1 BTC for $50,000 on May 1, 20×1, and 1 BTC for $60,000 on June 1, 20×1. You sell one BTC. How do you know which is taxed?
The IRS lets you choose to specify exactly which one you sold. This requires you to keep highly diligent records on all of your crypto purchases, sales, and exchanges so you can keep tabs on what is being traded and when.
You can also go with a simpler first-in, first-out (“FIFO”) method. Some investors prefer using the last-in, first-out (“LIFO”) method because their tax basis is higher for later purchases, and they realize their gain will be lower that way. One alternative method if you do a lot of volume trading is the highest-in, first-out (“HIFO”) method which will ensure you use the highest tax basis for crypto sold or exchanged.
Whichever method you choose, you must track it and it must be consistent every year.
Wash sale rules
Cryptocurrency is not subject to the traditional 30-day wash sale rules that stocks are. In case you’re curious, some savvy investors wanted to force recognition events to trigger capital losses on their investments. They would recognize the loss on their tax return, and simply use the proceeds to buy back their shares.
The US government got smart and installed wash sale rules that prevent you from reporting a loss if you buy back the same property within 30 days. Fortunately, this rule does not apply to crypto. A good strategy if you have accumulated a lot of losses closer to the end of the year is to sell your currency and buy it back to use the losses on your return against other capital gain income.
Note that selling your crypto and buying it back will reset the long-term holding period. Another consideration is that net capital losses are still limited to $3,000 per year. The excess is carried forward to future years until consumed.
Use software
The best way to go about keeping tabs on all of your crypto purchases, sales, and exchanges is to use software to track everything. The #1 tool we have seen used in crypto communities is https://cointracking.info (we don’t get a commission for referring you.)
You can plug in your exchanges and wallets using APIs or importing CSV data into your account, and CoinTracking will calculate your balances and your tax gain at the end of the year. You can provide these reports to your CPA or EA, who will use them to prepare your income tax returns and calculate your tax liability on crypto gains on Form 8949 and Schedule D of your personal tax return.
This is way too confusing…
It gets even worse when we start diving into advanced crypto investing strategies, NFT sales, and more. If you need help navigating the crypto tax rules, CleverProfits helps our CFO clients navigate their taxes fluidly and efficiently. Schedule a consultation with an advisor today.
