With the staggering rise and fall of some cryptocurrencies such as Bitcoin and Ethereum, crypto traders may have serious tax questions on their minds. The Internal Revenue Service (IRS) is stepping up enforcement efforts, and even those holding the currency — let alone trading it — must make sure they don’t run afoul of the law. This may be easier than you think, given how the IRS treats cryptocurrency.
“This is a really big area of enforcement for the IRS right now,” says Brian R. Harris, a tax attorney at Fogarty Mueller Harris, PLLC in Tampa. “They generate a lot of publicity by going after people who hold, trade or use cryptocurrency. These people may be the target of an audit or compliance review.’
While one of the advantages of Bitcoin, for example, is its anonymity (or at least semi-anonymity), the authorities have been playing catch-up in recent years with some success.
“The IRS and the FBI are getting better at tracking and tracing bitcoins as part of criminal investigations,” Harris says. And they can freeze assets if necessary, he adds.
So that’s all the more reason for those who transact with popular cryptocurrencies to know the law and what taxes they could incur with their actions. The good news: The IRS generally treats cryptocurrencies the same way it treats other capital assets like stocks and bonds. The bad news: This treatment makes it difficult to use cryptocurrency to purchase goods and services.
Here are a few key things to know about cryptocurrency taxes and how to stay on the right side of the law.
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8 Important Things You Should Know About Crypto Taxes
1. You will be asked if you have received, sold or used cryptocurrency
Your tax return requires you to indicate whether you have made certain types of cryptocurrency transactions. In a prominent place at the top, Form 1040 asks if taxpayers received, sold, sent, exchanged, gifted, or otherwise disposed of a digital asset at any time during the tax year.
So you’re ready to definitively answer whether you’ve transacted in cryptocurrency, putting you in a position to potentially lie to the IRS. If you don’t answer honestly, you may be exposed to additional legal jeopardy, and the IRS doesn’t take kindly to liars and tax cheats.
Most US crypto owners have not reported their activities to the IRS, according to a recent study by Divly, a company focused on easing the tax burden on crypto. Only about 1.62 percent of US crypto owners reported their holdings to the IRS in 2022.
However, taxpayers who only purchased virtual currency with real currency are not required to answer yes to the question. The IRS also said that those who simply hold digital assets or transfer them between their own crypto wallets can also answer “no” to the question.
However, the advent of Bitcoin Exchange Traded Funds in January 2024 may shake things up a bit regarding future tax returns. Investors who sold one of these funds may be wondering if they should answer yes to the IRS question on their 2024 return.
“I would advise customers to be careful,” says Harris. “I would check yes for that.”
A yes answer won’t necessarily result in a tax liability, he explains. The actual gain or loss on a sale will determine whether you owe taxes.
2. You can’t avoid taxation just because you didn’t get a 1099
With a bank or brokerage, you (and the IRS) usually receive a Form 1099 reporting the income you received during the year. However, this may not be the case with cryptocurrency exchanges.
“There are potentially more informational reports coming out in the future and these exchanges will reveal more information about digital assets and cryptocurrency,” Harris says.
But not having a 1099 will not allow you to avoid tax liability, and you will still have to report your earnings and pay tax on them. Still, the news isn’t bad: If you were to take a capital loss, you can deduct it on your return and lower your taxable income.
“This increased reporting can cause some problems for those who have not disclosed cryptocurrency transactions before,” Harris says. “It’s in people’s best interest to start reporting.”
Even if you filed taxes years ago and think you evaded taxes on crypto earnings, the IRS can still come back to you and demand that you pay.
3. Just using crypto exposes you to potential tax liabilities
You might think that if you only use – but do not trade – cryptocurrency, you are not liable for tax.
Not true!
Any time you exchange virtual currency for real currency, goods or services, you can create a tax liability. You will create a liability if the price you realize for your cryptocurrency – the value of the good or real currency you receive – is greater than your cost basis in the cryptocurrency. So if you get more value than you put into the cryptocurrency, you have a tax liability.
Of course, you can also have a tax loss if the value of the goods, services or real currency is below your spending base in the cryptocurrency.
In either case, you’ll need to know your cost base to do the calculation.
It is important to note that this is not a transaction tax. This is a capital gains tax – a tax on the realized change in the value of cryptocurrency. And like stocks you buy and hold, if you don’t exchange the cryptocurrency for something else, you’ve made no profit or loss.
4. Crypto trading profits are treated as ordinary capital gains
So you made a profit from a profitable trade or purchase? The IRS generally treats cryptocurrency gains the same way it treats any type of capital gain.
That is, you’ll pay ordinary short-term capital gains tax rates (up to 37 percent in 2023 and 2024, depending on your income) on assets held for less than a year. But for assets held for more than a year, you’ll pay long-term capital gains tax, possibly at a lower rate (0, 15 and 20 percent).
And the same rules for netting capital gains and losses against each other apply to cryptocurrencies. So you can deduct capital losses and realize a net loss of up to $3,000 each year. If your net losses exceed this amount, you will need to carry them forward to the next year.
5. Crypto miners may be treated differently than others
Are you mining cryptocurrency as a business? You may then be able to deduct your expenses as a typical business would. Your revenue is the value of what you produce.
“If you’re mining cryptocurrency, you’re making income at fair market value, so that’s your basis in cryptocurrency,” Harris says. “If it’s a trade or business, your expenses may be deductible.”
But the last part is the key point: you have to run a trade or business to qualify. You cannot operate your mining equipment as a hobby and enjoy the same deductions as a real business.
6. A gift of crypto is treated the same as other gifts
If you gave cryptocurrency to someone, perhaps a younger relative, as a way to generate interest, your gift will be treated the same way any similar gift would be. So it may be subject to gift tax if it’s over $17,000 in 2023 or $18,000 in 2024. And if it comes time for the recipient to sell the gift, the cost basis remains the same as the donor’s cost basis.
However, you can avoid gift tax if you exceed the annual threshold by taking advantage of the lifetime exemption.
7. Inherited cryptocurrency is treated like other inherited assets
Legacy cryptocurrency is treated like other capital assets that are passed down from one generation to another. They may be subject to estate tax if the estate exceeds certain thresholds ($12.92 million in 2023; $13.61 million in 2024).
Like stocks, cryptocurrency enjoys an increased cost basis to fair value on the day of death. So, in general, cryptocurrency is treated for most people as a typical capital asset, Harris says.
8. The wash rule does not apply to cryptocurrency
Although the IRS treats cryptocurrency mostly as capital assets, it takes a completely different approach when it comes to laundry sales. And this actually benefits crypto traders.
Generally, when a trader sells an asset and declares a loss, the trader must not have purchased the asset (or a very similar one) within 30 days before or after the sale. If the trader buys back the asset within this 30-day window, it is declared a wash sale. So the loss cannot be claimed as a write-off until the trader refrains from buying the asset within at least the 30-day window.
But the wash sale rule does not exist for cryptocurrency. So traders can sell their position, record a loss, and then literally buy back the asset moments later and still be able to claim the loss. This rule is advantageous because it allows traders to capture the full value of the tax loss while they are still invested, effectively meaning it is risk-free to take advantage of the tax write-off.
But lawmakers are debating closing that loophole, so it may not be around much longer.
Bottom row
It can be surprisingly onerous to actually use cryptocurrencies, from tracking your cost base, noting your effective realized price, and then potentially paying tax (even without an official Form 1099 statement). In addition, the IRS is stepping up enforcement and surveillance of potential tax evasion by taking a closer look at who exchanges cryptocurrencies.