capital gains tax

How Is Cryptocurrency Taxed? Here's What You Need to Know

If you think the lack of government oversight means that cryptocurrency is not taxed, you're in for a big surprise.

Cryptocurrency has headlined many news articles, served as the subject of social media posts, and gained significant traction in mainstream culture. Bitcoin, the first digital currency, has grown exponentially in recent years, with a total market capitalization growing from a modest $10 billion in July 2016 to over $1.1 trillion earlier this year.

If you've held on to your Bitcoin since then, you've obviously learned how to increase your net worth and now have a sizable unrealized capital gain in your portfolio. But what happens if you choose to convert this erstwhile investment into an actual currency used to buy goods and services?

You're going to feel a tax pinch. But do you know how much you'll owe Uncle Sam? To answer that question, you need to understand what cryptocurrency is and how your tax liability is determined every time you buy it, sell it, or mine it.

What is Cryptocurrency?

Cryptocurrency is a type of virtual currency that uses blockchain cryptography to secure transactions. It also has no central bank overseeing the supply of currency available in the market.

Unlike centralized electronic money or traditional paper money systems, called fiat currencies, cryptocurrencies rely on distributed digital ledgers to secure and verify transactions. (Well-known fiat currencies include dollars or euros.)

This blockchain technology anonymously logs all transactions ever recorded and acts like a continuously-updated checkbook universally accessible by all.

There are many different types of cryptocurrency, but Bitcoin is the best-known, closely followed by coins including Ethereum and even Dogecoin.

There are also ways to receive cryptocurrency beyond simply buying it on an exchange. For example, some cryptocurrencies use "mining" as a process to solve complicated equations to record data on the blockchain. To incentivize miners to participate, they may receive payment in new crypto tokens. You can also receive cryptocurrency through a marketing promotion on an exchange or through an "airdrop."

How Cryptocurrency is Treated for Tax Purposes

Many people are quick to point out how cryptocurrency is not backed by any government and, thus, subject to less regulation than fiat currencies like the dollar or euro. This lack of oversight has led many to believe that cryptocurrency  investors are participating in elusive and anonymous transactions that allowed them to avoid paying taxes. However, this belief is absolutely false. In the United States, crypto exchanges must report user activity on gains and losses to the Internal Revenue Service (IRS), and cryptocurrency is taxed in much the same way as traditional stocks or similar assets.

Cryptocurrency is considered "property" for federal income tax purposes, meaning the IRS treats it as a capital asset. This means the crypto taxes you pay are the same as the taxes you might owe when realizing a gain or loss on the sale or exchange of a capital asset.

For instance, when you purchase a capital asset – be it a stock, bond, exchange-traded fund, house, Bitcoin, or any other investment – you initiate a basis equal to your cost to acquire it. When it comes time to sell your capital asset, you simply compare your net sales proceeds to your original basis to determine whether you have a capital loss or a capital gain. If the proceeds exceed your original cost basis, you realize a capital gain. When reversed, you've locked in a capital loss.

Calculating Taxes When You Buy and Sell Cryptocurrency

When you buy and sell cryptocurrency, comparing your net proceeds to your cost basis isn't the only step in figuring how much you owe in crypto taxes. You also need to consider the length of time you held the asset, as this determines the type of capital gain or loss you recognize. Depending on how long you hold your cryptocurrency, your gains or losses will be considered "short-term" or "long-term." That distinction will play a big role in how much you have to pay in crypto taxes.

  1. Short-Term Capital Gains and Losses. When you buy and sell an asset within a 365-day period, you recognize either a short-term capital gain if it sold for more than what you paid for it or a short-term capital loss if it sold for less than what you paid for it. Short-term gains and losses are subject to the same tax rates you pay on ordinary income, such as wages, salaries, commissions, and other earned income. The IRS has seven tax brackets for ordinary income ranging from 10% to 37% in 2021.
  2. Long-Term Capital Gains and Losses. If you buy an asset and sell it after one year, the resulting difference between your net sales proceeds and your cost basis is a long-term capital gain or loss. Typically, you'll pay less tax on a long-term gain than on a short-term gain because the rates are generally lower. Currently, there are three tax rates for long-term capital gains – 0%, 15%, and 20%. The rate you pay depends on your income.

You can also offset capital gains with capital losses. However, the offset must first apply to gains and losses of the same type. For example, short-term losses first lower your short-term gains, while long-term losses reduce your long-term gains. Any remaining net losses can be used to offset the other kind of capital gain (e.g., remaining short-term losses can offset remaining long-term capital gains). If you still have any capital losses available, they can be used to offset up to $3,000 of ordinary income. After that, any remaining capital loss is rolled over to the following year.

Other Ways to Obtain Cryptocurrency

There are other ways to obtain virtual currency beyond simply buying it. For instance, you can earn cryptocurrency by mining it. You can also receive it as a promotion for goods or services, for free from cryptocurrency platforms, or for staking cryptocurrency. This latter activity allows you to earn interest by purchasing and setting aside your tokens to become an active validating node for a crypto network. In these situations, you owe tax on the entire value of the crypto on the day received and it counts as ordinary income.

Using Cryptocurrency to Pay for Goods and Services

A complicating factor for crypto investors arises when they attempt to use their virtual currency to pay for goods and services. The IRS chose to treat cryptocurrency as property in 2014 because most people only saw it as a capital asset at the time. Now, as more companies choose to accept cryptocurrency as a form of payment and people begin to adopt it as a unit of account, many people have begun to see it as a viable alternative currency. However, the current tax treatment of crypto impedes the wholesale replacement of fiat currency.

With traditional fiat currencies, you simply pay for your purchase and have no tax consequences related to cost basis or the value of your currency at the time of payment. However, cryptocurrency users must deal with capital gains and losses in addition to whatever sales taxes they might face at the point of sale.

For example, let's imagine you bought $10 worth of Bitcoin two years ago and it has since appreciated to $100 in value. If you sold it on an exchange, you'd have $90 of realized long-term capital gains, just like you would with any other capital asset.

If you instead used that same $100 worth of Bitcoin to buy groceries from the supermarket, you'd still have to pay long-term capital gains taxes on the $90 difference between appreciated value and your cost basis.

As you can imagine, tracking your capital gains and losses for everyday transactions like this can become tedious and a downright impediment to replacing fiat currency altogether.

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