When it comes to bleeding-edge technology, digital assets like cryptocurrency, virtual currency, and non-fungible tokens (NFTs) get a lot of attention. There’s plenty of talk about how these might change the world or make people rich. But what’s often not talked about are the tax consequences for those who own and/or use these technologies.
Because these are all so new, the IRS is trying to catch up by creating regulations and rules on how digital assets like cryptocurrencies should be taxed and reported. Even though this tax area is still evolving, individuals who deal with cryptocurrency still have certain obligations when it comes to reporting and paying taxes to the IRS.
Let’s take a broad look at what these obligations are and how cryptocurrency users and owners can better comply with them. But before we get to that, let’s briefly go over what cryptocurrency is. Need help with a crypto-related tax problem today? Then, contact us at Seattle Legal Services, PLLC.
What Is Cryptocurrency?
Cryptocurrency (crypto) is a type of digital currency that doesn’t rely on a central authority or entity to maintain it. The most famous and commonly used form of crypto is bitcoin, which came out in 2009 although there are many other types of cryptocurrency, such as Ethereum. Both use a blockchain, which is a type of distributed ledger.
A distributed ledger is a database that exists in multiple locations and is maintained by multiple parties. This is important because it’s the general public that maintains the integrity of the database, not a single entity, like a government or company. And the entries in the ledger are also encrypted.
This encryption, along with the distributed nature of the blockchain, means it’s almost impossible for any single entity to falsify the ledger without being detected. Why would a person want to falsify information on the ledger? One reason would be to make money.
For example, bitcoin’s blockchain is basically a long list of Bitcoin transactions. A hypothetical person named John might try to add an entry that says, “Bob gave John five bitcoins.” Depending on the value of Bitcoin at the time, this could amount to John making hundreds of thousands of dollars.
Adding this fraudulent entry wouldn’t be that difficult on its own. The problem with this plan is that the false entry would exist on only one database, even though there are thousands (if not tens of thousands) of databases. This means this false entry would quickly be spotted by other people monitoring the Bitcoin blockchain.
So, the only way for John’s plan to work is to falsify the entries of a significant percentage (perhaps 51% or more) of the databases. This would be practically impossible to do in a cost-effective manner.
As interesting (and confusing) as all of this is, the fact that cryptocurrency has no central authority controlling it is probably its most important feature that draws users. Not only does it make crypto more secure from fraud (at least in theory), but it also means it’s harder to track and monitor its use.
Therefore, it’s no surprise that governments get nervous about people using cryptocurrency, as it makes it a lot easier to engage in illegal activities without being identified. But many (if not most) people who deal with crypto aren’t doing so for illegal reasons. However, if they profit from their cryptocurrency activities, it could lead to taxable income, at least as far as the IRS is concerned.
Tax Requirements of Crypto
The IRS considers cryptocurrency as a type of digital asset, which means they treat it like property for federal tax purposes. Despite this designation, an individual’s tax obligations relating to cryptocurrency depend on how they acquire and dispose of the property, as well as how long they own it and whether it gains or loses value during ownership.
Tax implications of receiving crypto as income
Generally speaking, you’ll pay taxes on cryptocurrency dealings in two situations. First, there’s receiving cryptocurrency as income you earn for doing something.
This includes an employer or client paying you in cryptocurrency as compensation for the work that you do or using crypto to pay for goods that you sell. It can also include successfully “mining” Bitcoin and receiving cryptocurrency as a reward for this computational work you completed to validate information on the blockchain. Even crypto received from an airdrop is considered to be taxable income.
When you receive crypto as income, you must report it on your tax return. Use its fair market value on the day you receive it. Then, you will pay taxes accordingly.
Tax implications of selling or using crypto
Second, there’s selling cryptocurrency after it’s risen in value. So imagine you bought one bitcoin for $5,000 a few years ago, and you sell it today for $35,000. You’ll have to pay taxes on that $30,000 increase in value. But this won’t be taxed as ordinary income, but instead as a capital gain.
Because you held it for more than a year, you’d be taxed at the applicable long-term capital gains tax rate. If you had held on to it for less than a year before selling it, you’d be taxed at your usual income tax rate, as this would be a short-term capital gain.
In this second situation where your cryptocurrency has appreciated, the cryptocurrency is a lot like a stock for tax purposes. If you sell the stock after it’s increased in value, you have a taxable gain. But if you sell the stock (or crypto) when it’s lost value, you have a loss. You can use the loss to offset other capital gains, and you may be able to use a small part of the loss to offset ordinary income.
You could also owe taxes for the gain in value of your cryptocurrency even if you don’t sell it, but use it to buy something else. Let’s go back to that earlier example of buying one bitcoin for $5,000. Instead of selling it for $35,000, you use it to buy a new car valued at $35,000. In this scenario, you’d owe taxes on that $30,000 gain.
Note that this same rule applies to crypto you received as income or as a gift. Again, if you received $5,000 as crypto in income or as a gift, and then you sold it or spent it when it was worth $35,000, you’d also have a $30,000 taxable gain.
Buying crypto or receiving it as a gift
Not all dealings with cryptocurrency will result in a taxable event. If someone gives you cryptocurrency as a gift or you buy it with “regular” money, you don’t pay any taxes on it until you sell it, trade it, or otherwise dispose of it for value. If you transfer your cryptocurrency between your own “wallets,” there’s no taxable event there, either.
The basic idea of cryptocurrency being taxable is fairly straightforward and probably comes as no surprise to most people. Despite this, there are misconceptions and misunderstandings about cryptocurrency and how the IRS treats this digital currency that can sometimes lead to tax problems.
Washington State Tax on Crypto Gains
Washington State does not assess personal income tax, so you may not pay any state tax on your crypto gains. However, the state does have a capital gains tax. If you have long-term capital gains from crypto and are domiciled in Washington State, you must report the crypto if your total long-term capital gains are over $262,000. The tax rate is 7%.
Common Tax Issues with Crypto
One of the biggest potential tax issues with cryptocurrency is that because of its innately private nature, people think their ownership or use of crypto is impossible to trace. This isn’t true, as the IRS, law enforcement, or other government authorities might come across cryptocurrency transactions as part of a civil or criminal investigation. Depending on where those transactions occurred, the cryptocurrency could be linked to a person’s identity, like a name, address, and Social Security number.
Unreported crypto discovered during an audit
Even though most taxpayers don’t have to worry about these situations happening, it’s possible that the IRS could complete an audit that discovers crypto transactions. There are several reasons that unreported crypto transactions could be a serious problem.
Penalties and interest for unreported crypto gains
The taxpayer will have to pay the taxes owed on those transactions, assuming they earned income or capital gains from them. There will also be interest and penalties imposed. But the monetary consequences aren’t the biggest issue.
Criminal liability for unreported crypto related to tax evasion
The most serious problem is that the taxpayer could face criminal liability for tax evasion and/or tax fraud. There’s also a question on page 1 of IRS Form 1040 that asks if the taxpayer received or disposed of digital assets.
If a taxpayer had cryptocurrency transactions that the IRS didn’t know about, it most likely means that the taxpayer lied when answering that question on Form 1040. If there are no crypto transactions that lead to tax liability, at a minimum, the taxpayer could be liable for perjury when they knowingly lied while answering that question.
Failing to keep tax records
Another common tax issue is the taxpayer not keeping complete records of their cryptocurrency transactions. This could lead to tax problems because the taxpayer is unable to accurately report any gains or losses to the IRS. Whenever the taxpayer obtains or gets rid of cryptocurrency, they need to note the date, value of the cryptocurrency at the time of the transaction, where that transaction occurred, and any gain or loss realized from that transaction.
Proposed crypto regulations
In the next few years, it could become a little bit easier for cryptocurrency traders to keep records of their purchases and sales if a proposed regulation goes into effect. If this becomes law, it would require cryptocurrency brokers to report cryptocurrency transactions on “Form 1099-DA.” This new form would help make it easier for taxpayers to identify their gains or losses stemming from transactions with that broker.
One thing to keep in mind is that whether this proposed regulation gets enacted or not doesn’t change the tax obligation of taxpayers for cryptocurrency earnings. Even if they earn just $1 from cryptocurrency, it’s still theoretically taxable.
Misunderstandings of crypto-related tax rules
As discussed earlier, cryptocurrency users must remember that paying for goods or services with crypto could lead to tax liability if that crypto increases in value between the time it was obtained and when it was used for a purchase. That rise in value must be reported to the IRS, and taxes must be paid. And if the cryptocurrency lost value when it was used to buy something, then the taxpayer can take advantage of that capital loss.
Finally, there’s the misunderstanding of how cryptocurrency gets taxed. Because it can be taxed as either ordinary income or capital gains, a taxpayer might not pay the proper tax on a particular crypto transaction. For instance, they might pay the short-term capital gains tax rate instead of the long-term capital gains tax rate if they don’t remember when the cryptocurrency was originally purchased (another good reason to keep good records of crypto transactions).
How to Avoid Cryptocurrency Tax Issues
Taxation of cryptocurrency is a relatively new field of tax law, so there is still some uncertainty as to how all cryptocurrency activities will be viewed by the IRS. This is why the best thing to do to avoid tax problems with cryptocurrency is to consult with a tax professional who has experience handling cryptocurrency tax matters.
Consult with an experienced tax attorney
A cryptocurrency tax professional will have answers to your questions, but most importantly, they’ll know about issues that you didn’t know existed. And if they don’t know the answer to a cryptocurrency tax concern, they’ll find an answer far more quickly than you’ll be able to.
Consider tax software that supports crypto transactions
If possible, it’s also a good idea to find tax software that connects with the cryptocurrency broker or exchange that you use. This software will automatically import your transactions from exchanges and blockchains, and then calculate any gains or losses from those transactions. This software is helpful even if you hire a tax professional because it’ll give you a rough idea of your potential tax liability and make your tax professional’s preparation of your tax return go more quickly.
Maintain well-organized financial records.
Lastly, keep good records of your cryptocurrency transactions and review them often for any mistakes or issues. This bears repeating because you can’t fully meet your tax obligations without the right information, no matter how good your tax lawyer or accountant is or how honest your intentions are.
Worried About Your Tax Obligations with Crypto?
Cryptocurrency is a fascinating but potentially confusing technology, especially in regards to taxes. Depending on how you use crypto, you may have no trouble handling your cryptocurrency taxes by yourself. But if you have complex tax issues or find yourself behind on reporting your cryptocurrency transactions to the IRS, it might be a good idea to contact Seattle Legal Services, PLLC for a free consultation.