It is important to note that each country views and regulates virtual currency differently. The scope of this article covers the crypto tax laws in the United States. The IRS defines virtual currencies as digital representations of value that function as mediums of exchange, units of account, and/or stores of value. Further, the U.S. views crypto as property subject to capital gains and losses for US federal tax purposes. Based on its designation as property, in general, there are four taxable events when dealing and transacting with cryptocurrency.
How does the U.S. tax cryptocurrency?
The following four cryptocurrency events trigger a taxable occurrence under current U.S. tax guidance for individuals holding crypto as a capital asset.
1. Selling crypto for fiat (i.e. exchanging crypto for USD)
When you sell crypto for USD, you must recognize a capital gain or loss on the sale. This is a more obvious taxable event as it follows the same tax principles applicable to other property transactions like stocks. To determine your capital gain or loss on the sale of crypto, you should calculate the difference between the basis in the crypto sold and the amount received as a result of the sale.
In general, the cost basis is the amount you spent to purchase the virtual currency, which includes any applicable fees, commissions, and acquisition costs. Each separate transaction to purchase crypto will have its own cost basis.
Lastly, the length of time you held the applicable cryptocurrency determines the capital gain tax treatment. Again, this length of time relates to each individual crypto transaction. For example, let us assume you purchased 1 BTC on January 1, 2021 and another 1 BTC on June 1, 2021. If you sell 2 BTC on January 2, 2022, the capital gain or loss relating to the BTC purchased on January 1, 2021 is long term while the capital gain or loss relating to the BTC purchased on June 1, 2021 is short term. Additionally, the gain or loss for each coin will be different based on the applicable cost basis at the time of purchase. These rules of cost basis and long term versus short term are applicable to all the taxable transactions stated in this article.
2. Receiving crypto in exchange for services or goods
When you receive property in exchange for a good or a service, you should recognize ordinary income. This applies to employees, independent contractors, business owners, etc. The amount you recognize as ordinary income is the fair market value of the cryptocurrency when received. This amount recognized as ordinary income becomes your cost basis for the cryptocurrency.
3. Trading one type of cryptocurrency for another type of cryptocurrency
If you exchange cryptocurrency for other property, you should recognize a capital gain or loss. As implied, other property includes other virtual currencies, and so, an exchange of one cryptocurrency for another cryptocurrency is a taxable event. This is important for those that exchange one crypto for another before transferring balances between wallets or exchanges.
The capital gain or loss recognized from an exchange of crypto for other property is the difference between the fair market value of the property received and the cost basis of the virtual currency exchanged.
4. Paying for good/services with crypto
If you pay for a good or service using cryptocurrency, you should recognize a capital gain or loss. As stated, the capital gain or loss is the difference between the fair market value of the goods or services you received and the cost basis in the virtual currency exchanged. This is an unfortunate regulatory downside of using crypto as a medium of exchange.
5. (BONUS) Receiving staking crypto rewards
The regulatory environment surrounding staking or proof-of-stake rewards remains unclear. As of now, the IRS has not issued specific guidance relating to the tax treatment of proof-of-stake rewards; therefore, the best practice is to follow the tax guidance set forth for cryptocurrency miners. By following this guidance, any amount of crypto received as staking rewards should be taxed as ordinary income upon receipt. The amount recognized as ordinary income is the fair market value when received.
An issue arises when a proof-of-stake reward remains locked-up for a period of time. Cryptocurrency is considered received when you receive the cryptocurrency in your designated wallet and possess control over said cryptocurrency. However, in the event of a lock up period, you do not have control of the crypto rewards received until the end of the period; therefore, should you recognize a taxable event when rewarded or at the end of the period when received and controlled? The answer is unclear but the general belief is that the act of staking is similar to a loan in which you as the recipient must recognize taxable income on an annually basis even if the rewards are paid at maturity.
If you hold, exchange, and transact with virtual currency, it important for you to have a strong understanding about the U.S. tax laws and guidance governing cryptocurrency. The regulatory environment surrounding the cryptocurrency industry continues to evolve, and so, you must remain up to date on cryptocurrency tax law. Please share with others to help them learn more about U.S crypto tax rules.
Disclaimer: As stated in my disclaimer page, this post and all posts on Textbook Tax are informational only and are not intended as tax advice. For tax advice, please consult a tax professional.