While capital gains tax is typically applicable when you sell an asset, for cryptocurrencies there are a number of scenarios which could create a tax liability even without an outright sale. More importantly, cryptocurrency investors are required t report their gains and losses to the IRS, even if they don’t receive a tax form for their crypto account.
What Is Cryptocurrency?
Cryptocurrency, or crypto for short, is digital money. Cryptocurrency can function as a medium of exchange, a unit of account, or a store of value. Similar to Internal Revenue Service (IRS) rules for other asset classes like stocks, selling or exchanging cryptocurrencies or holding digital currencies as investments generally creates tax liabilities. Holders of cryptocurrency can buy, sell, and trade their cryptocurrency only online. Some people buy cryptocurrency to HODL (“hold on for dear life” in crypto community parlance), hoping to earn long-term investment gains. Others may take advantage of the high volatility of cryptocurrency to generate short-term income, a risky but sometimes profitable venture.
How the IRS Treats Cryptocurrency
If you sell or use cryptocurrency, it’s a taxable event similar to selling a stock. If your cryptocurrency holdings gain value, then the value increase at the time of the purchase or sale is treated by the IRS as a capital gain. But if at the time you use or sell it’s worth less than your initial investment in it, then the decrease in value is treated as a capital loss by the IRS. For all capital assets, even if your transactions are not reported to the IRS by another entity, you’re responsible for keeping track of and reporting any capital gains or losses when you file your annual tax return.
Cryptocurrency Tax Scenarios
Cryptocurrency taxes can be complicated. Here’s a look at five potential scenarios that may create a tax obligation.
Generating Short-Term Capital Gains
Assets held less than one year are generally subject to short-term capital gains taxes. Short-term capital gains are taxed at your ordinary income tax rate—10% to 37%, depending on your total income. For example, let’s say you bought one bitcoin when it was worth $10,000 per coin. If you sold the coin for $20,000 10 months later, then you would have earned a $10,000 profit—or a capital gain of $10,000. If your total income for the year lands you in the 22% tax bracket, then you would pay a capital gains tax of $2,200 on the crypto sale. Your profit after taxes would be $7,800.
Earning Long-Term Capital Gains
Assets held for more than one year are subject to long-term capital gains taxes, which are generally lower than ordinary income tax rates. Long-term capital gains taxes range from 0% to 28%, though most people—depending on their total annual income—pay no more than 15% in taxes on capital gains. If you purchased one bitcoin for $10,000, but held the asset for more than a year, then the capital gain would be taxed at a potentially preferable rate. Let’s say you’re still in the 22% tax bracket based on your income. You sell your one bitcoin for $20,000, and because of your income, you’re taxed at the 15% rate. You would owe $1,500 in taxes on your $10,000 profit. You’d pocket $8,500—that’s a savings of $700 compared to paying the short-term capital gains tax rate, all just for holding the cryptocurrency for longer than one year.
Making Purchases With Cryptocurrency
You can make purchases using cryptocurrency. You can hypothetically buy anything from a sandwich to a car using crypto, depending on if the business accepts crypto as payment. But when your purchase goes through, it’s treated by the IRS as a sale of your crypto, just as if you had sold it on an exchange. Any increase in the value of the crypto between the time you purchased it and the time you use it for a purchase is classified as a capital gain. Any decrease in value is considered a capital loss. You as a taxpayer are responsible for keeping track of your crypto gains and losses for tax purposes. Let’s imagine that you own one ether token that is currently worth $5,000, and for which you initially paid $2,000. If you spend that ether to buy something for $5,000, then $3,000 of that purchase is subject to capital gains taxes.
Mining Cryptocurrency for Profit
You can also generate capital gains by earning cryptocurrency as income. Cryptocurrency miners, who process crypto transactions and mint new crypto, are paid in cryptocurrency. That crypto is considered as taxable income. Crypto miners are obligated to keep track of the value of their crypto to determine if it gains or loses value between the time the crypto is earned and the time it is sold or spent. This tracking is necessary to annually report capital gains or losses to the IRS.
Gifting or Donating Cryptocurrency
The tax implications of gifting or donating cryptocurrency are the same as the tax rules for gifting or donating stock. Gifts of cryptocurrency are not taxable up to an annual dollar limit, which is $16,000 for tax year 2022. You could gift, for example, up to $16,000 of cryptocurrency without either you or the gift’s recipient owing any taxes. If the recipient later sells the crypto, then they will be subject to the same rules for capital gains taxes, with the tax basis for the sale equal to the amount that you originally paid for the crypto. For taxable gifts over the annual exclusion, tax rates range from 18% to 40%, depending on the size of the gift. If you donate cryptocurrency, such as to a charity, the donation is not taxable. You don’t recognize any capital gains or losses on donated cryptocurrency.
The IRS Is Serious About Collecting Taxes on Your Crypto
But even if it’s not reported directly to the IRS by a cryptocurrency exchange, your crypto transactions are taxable. If you don’t report and pay taxes on cryptocurrency that you sell, you could face penalties and consequences. In most cases of tax evasion, remedying the situation only requires you to pay taxes, interest, and penalties—which can be sizable. Anyone convicted of tax evasion is subject to up to $250,000 in fines and five years in prison. Filing a false tax return is subject to a $250,000 fine and three years in prison. Remember, just like other investment assets, you can use cryptocurrency losses to offset gains. If you’re struggling to pay taxes on your cryptocurrency gains, then consider paying for cryptocurrency tax software to help you track your crypto and prepare your tax return. You can also hire a tax professional who is well-versed in cryptocurrency to guide you through the process.
