Cryptocurrency may seem like it isn’t real. You can’t touch it or see it, after all.
But the kind that functions as money in the real world is called a “convertible virtual currency” for a reason: its value is pegged to traditional currency. Therefore, it can be converted into stuff you can actually fold into your wallet — and all the things that money buys.
Indeed, some cryptocurrency is as real as it gets. And as with money of other kinds, earning and spending it has tax implications.
Here’s a run-down of vital info about cryptocurrency taxes.
What Is Cost Basis?
The first thing to know about how to calculate taxes on cryptocurrency is that the currency changes in value over time. And how much the value changes between when you acquire it and when you sell or use it is very important.
The amount you spend in U.S. dollars to get the cryptocurrency, including fees, commissions, and other costs, is called your basis (also known as your “cost basis”). If you earn the cryptocurrency by providing a service, then your basis is the fair market value of the currency on the day you receive it.
The basis of your currency is the starting point for figuring out your gain or loss when you eventually sell or use the currency. Knowing how to calculate that change is essential because the IRS holds that the sale or use of cryptocurrency triggers capital gains tax.
Cryptocurrency and Capital Gains
The IRS has decided to treat cryptocurrency as capital assets, probably because most people hold onto their cryptocurrency as an investment instead of spending it like cash. A 2014 IRS ruling (Notice 2014-21) states that “For federal tax purposes, virtual currency is treated as property.” This means that tax principles that apply to property transactions also apply to cryptocurrency transactions.
So, like property, cryptocurrency is taxed when you sell it for a profit. The trick here, though, is that the IRS doesn’t see any difference between spending cryptocurrency and selling it. So, if you use cryptocurrency to buy something, the IRS treats the transaction as if you have sold your asset. Capital gains taxes are due on any amount the currency’s value has increased since you acquired it; that is, any amount above its “basis” value.
Sound confusing? It’s certainly different than buying something with paper money. Here’s an example: You buy $100 worth of Bitcoin and hang onto it while it increases in value to $1,000. When you use that Bitcoin to buy a new computer, you owe capital gains taxes on the $900 gain in your Bitcoin investment that you just “sold” to the computer company.
If you keep your $1,000, you don’t owe taxes on it. And if your original $100 decreases in value to, say $60, and then you spend the $60 on groceries, you do not owe tax on that transaction. In the latter scenario, you can even use the $40 loss to offset other capital gains.
Capital gains taxes also apply if you convert or exchange one type of crypto for another. Say you buy $400 worth of Ethereum using $400 worth of Bitcoin that has a cost basis of $100. You’ll owe capital gains taxes on that $300 gain.
Income Tax and Cryptocurrency
The IRS requires that when a taxpayer acquires convertible cryptocurrency, they must include its fair market value in their gross income and pay income taxes on it. Self-employed taxpayers also need to pay self-employment tax on the acquired amount.
No matter how you come across your crypto, it needs to be counted as income. For example, you must pay income tax on your acquired crypto regardless of whether you:
- Mined it
- Were awarded it through a marketing promotion
- Received it in an airdrop
- Got it in exchange for goods or services
The same is true for convertible cryptocurrency received in exchange for a service: You treat it as income and use as its cost basis the amount it was worth when you received it.
So Do I Owe Crypto Taxes?
The answer is likely yes, assuming you acquired or got rid of any cryptocurrency within the tax year. If you acquired some crypto but didn’t spend it, you’ll simply have to include that amount in your taxable income and pay taxes accordingly.
If you spent or traded crypto during the tax year, then things get a bit more complicated, as you may be on the hook for capital gains taxes if the currency you spent had increased in value since you got it.
The IRS offers a Frequently Asked Questions page to answer all your queries. But it’s a good idea to get professional tax help if you’ve been involved in cryptocurrency transactions. Taxfyle can help you make sure you’re handling this unusual part of your tax return correctly.