Apps like Robinhood and Coinbase have made it incredibly easy to trade in and out of virtual currencies. But what are the tax implications of such transactions?
Surveys show that between 13-20% of Americans own or trade cryptocurrencies. The most widely held and traded cryptocurrencies are Bitcoin and Ethereum, of course there are many others, actually there are over 9,000 different types of cryptocurrencies.
According to Coinbase, the typical holding time for Bitcoin is 89 days and 74 days for Ethereum. That means that retail investors are regularly trading these currencies and may not fully understand the tax consequences.
With so many people trading cryptocurrencies and using it for daily transactions, the IRS has taken notice. This article discusses some of the tax implications and common questions of trading cryptocurrencies. For example, do you have to pay tax when you exchange one cryptocurrency for another? What if you buy a Tesla or a cup of coffee using Bitcoin?
Whether or not you should be invested in crypto and virtual currencies is the subject of a different article and discussed here. For tax purposes, we will consider cryptocurrency and virtual currencies as the same thing.
Is income from cryptocurrency taxable?
Unlike stocks that pay dividends or bonds that pay interest, virtual currency does not generate any income. Virtual currency is only taxable when it is traded, exchanged, mined, or received either as a compensation, rent, or other forms of income.
Despite its name, the IRS does not consider cryptocurrency as an actual currency, but as property which is taxed as a capital asset. Stocks, bonds, and real estate are examples of capital assets. The only exception is if the virtual currency is held as inventory and held mainly for the sale to customers in a trade or a business.
As a capital asset, taxpayers are able to offset gains from virtual currency against losses in other capital assets, and can use up to $3,000 of capital losses per year against ordinary income.
How to answer “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” on the form 1040
Beginning in 2020, the IRS started asking taxpayers if you received, sold, exchanged, or disposed of any virtual currencies during the year. Don’t take this question lightly. The 1040 instructions are clear on when you should check “yes” to this question. Check “yes” if a transaction involving virtual currency includes, but is not limited to:
- The receipt of virtual currency as payment for goods or services provided;
- The receipt or transfer of virtual currency for free (without providing any consideration) that does not qualify as a bona fide gift;
- The receipt of new virtual currency as a result of mining and staking activities (NEW for 2021);
- The receipt of virtual currency as a result of a hard fork;
- An exchange of virtual currency for property, goods, or services;
- An exchange/trade of virtual currency for another virtual currency;
- A sale of virtual currency; and
- Any other disposition of a financial interest in virtual currency
I suspect this list will continue to grow as virtual currencies become more widely used.
If your only transaction during the year was to buy virtual currency with real currency (US dollars), then you can answer “no” on the 1040 question.
How is cryptocurrency reported to the IRS?
The fact that the IRS has put the yes or no question on the front page of the 1040 means that the IRS takes the taxation of cryptocurrency very seriously and so should you. Trading apps like Coinbase and Robinhood must report your trading activity to the IRS. You may receive either a 1099-K, 1099-MISC, 1099-B, or you may not receive a 1099 at all. Regardless of whether or not you receive a 1099, you must still report your virtual currency transactions. Watch our video to learn more about the various types of 1099s.
Do I owe tax if I exchange one virtual currency for another?
Yes, the exchange of one virtual currency with another is essentially the sale of one asset to purchase another. If you bought $1,000 worth of Bitcoin and later exchanged it for Ethereum or another virtual currency when the fair market value of your Bitcoin was $1,200, you will owe capital gains tax on the $200 rise in value.
The tax rate will depend on your holding period. If your holding period was less than a year, then you will owe ordinary income tax on the $200; if your holding period was a year or longer, you will owe long-term capital gains rates which are more favorable than ordinary income tax rates.
Transferring virtual currency from one wallet or broker to another is not taxable because you have not actually sold or exchanged the virtual currency.
Can I do a 1031 exchange with Virtual or Cryptocurrencies?
Unfortunately no. You cannot do a 1031 exchange with virtual or cryptocurrencies. According to a letter by the Chief Counsel of the IRS, exchanges of virtual currencies does not qualify as a like-kind exchange under 1031 of the Code.
Do I owe tax if someone gives me virtual currency?
Depends. If you receive virtual currency from someone to settle up a dinner bill, similar to a Venmo, Paypal, or Cash App and you do not sell/exchange that virtual currency, then you do not owe taxes, yet.
However, if you subsequently sell or exchange that virtual currency to purchase a cup of coffee, settle-up with someone else, or exchange it for another virtual currency, and the value of the virtual currency has risen since you received it, then you will owe capital gains tax on the difference.
If you receive virtual currency as a gift, you will not owe taxes until you sell, exchange, or dispose of it. How much tax you owe is determined by your basis. In most cases, if you received the virtual currency as a gift, you will inherit the cost basis of the donor’s basis. The receipt of virtual currency as a gift becomes more complicated because of estate tax rules and taxation.
Can I get a tax deduction for donating my virtual currency?
Yes, similar to donating stock, you can donate virtual currency and claim a non-cash charitable deduction on the fair market value of the virtual currency on the date of the donation as long as you held the virtual currency for more than a year. If you held the donated virtual currency for one year or less, then your deduction is the lesser of your basis in the virtual currency or the fair market value of the virtual currency on the date of the donation.
How do I report virtual currency on my tax return?
How you report a virtual currency transaction depends on the nature of the transaction, regardless of whether or not you receive a transaction report such as a 1099 from a broker. Here are the most common ones:
Report on Form 8949 and Schedule D if you bought, sold, or transferred any virtual currency. This includes using virtual currency to purchase goods or services or exchanging for another virtual currency.
Report on Schedule C if you received virtual currency as compensation as an independent contractor. Note that even if you do not sell the virtual currency received as compensation, you will owe self-employment tax. By the way, the IRS wants US dollars for the payment of self-employment tax and does not accept virtual currency, at least not yet.
Report on Schedule E if you received virtual currency from rental real estate, royalties, partnerships and S-Corporations estates, trusts, and residual interests in REMIC. The passive activity loss rules will still apply.
Do I owe tax if I sell a product/service in exchange for cryptocurrency?
If someone pays you in virtual currency for goods or services, you must report the fair market value of the virtual currency as income on the date that the virtual currency was received. This is no different than if you received US dollars for selling goods or services.
If you subsequently sell/exchange the virtual currency to pay for anything such as business expenses, then you will owe capital gains tax if the fair market value of the virtual currency on the date of sale/exchange is higher than when the virtual currency was received.
If you use the virtual currency to pay wages, then you will owe payroll taxes based on the fair market value of the virtual currency on the date the wages were paid. Payroll taxes are payable only in US dollars.
If you sold goods and services subject to sales tax and you collected the entire sale in virtual currency, then you must remit the sales tax collected to your local taxing agency (usually the state the sale was made). This too must be paid in US dollars.
Do I owe tax if I mine virtual currency?
Yes. If you successfully mine virtual currency, you have to report income (its fair market value) on the date you actually receive the virtual currency.
What if I don’t report my virtual currency transactions on my taxes?
The IRS is significantly ramping up its enforcement of virtual currency taxation. It has pressured Coinbase and Robinhood, the most widely used trading app by retail investors, to report customer transaction information to the IRS. If you have transacted in virtual currency and have not reported on your tax return, the IRS may send you one or more of these notices:
In this letter, the IRS is saying they know you transacted in virtual currency, but you did not report it on your taxes and they want you to provide them with detailed information within a specified timeframe. This is a serious letter that requires a response and should not be ignored.
This is a less threatening letter than 6173. In this letter, the IRS is saying that they have information that you may have an account with virtual currency and have not reported it. You do not need to respond to the letter. It is only asking you to amend your tax returns for those years to report the virtual currency transactions. It only requires a response if you do have such an account and you did not report it on your tax return.
This is very similar to letter 6174 except that 6174-A has the following sentence at the end: “You do not need to respond to this letter. Note, however, we may send other correspondence about potential enforcement activity in the future.”
You will receive this letter if you reported your virtual currency transaction on your tax return, but what you reported does not match the information received by the IRS.
For example, if you reported you sold $5,000 of Bitcoin, but your broker (let’s assume Coinbase) reported to the IRS that you sold $10,000. The IRS will want to know why the difference.
The IRS has tons of resources on the taxation of crypto and virtual currencies.
Publication 544, Sales and Other Dispositions of Assets
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