A Guide to Crypto Tax Obligations

By: Lee Bratcher & Joshua Smeltzer

Understanding Cryptocurrency Tax Obligations: A Guide for Investors 

Cryptocurrency has grown from a niche digital curiosity to a mainstream financial instrument. With the surge in popularity and the increase in transactions involving cryptocurrencies, the IRS has intensified its focus on ensuring proper tax reporting. They have also over-corrected with guidance and rules that many consider overreaching and anti-competitive. In some instances, the IRS has failed to provide sufficient guidance such that taxpayers can reasonably know how to treat and report transactions involving this new and unique financial asset. Correctly reporting cryptocurrency transactions is crucial for investors not only to avoid hefty penalties but also to stay compliant with the current legal framework. As the IRS continues to evolve its guidelines, it's imperative for cryptocurrency investors to understand their tax obligations so that they can comply. Greater compliance by taxpayers leads to less concern and justification for overreaching enforcement efforts by the IRS.    

The IRS treats cryptocurrencies as property for tax purposes pursuant to a notice it issued in 2014. Although other guidance and FAQs have been issued since then, in general, this means that general tax principles applicable to property transactions apply to transactions using virtual currency. This classification has several implications: 

1. Capital Gains and Losses: When you sell or exchange cryptocurrency, the resulting gain or loss is a capital gain or loss. The duration for which you held the cryptocurrency before selling or exchanging it determines whether the gain or loss is short-term or long-term. 

2. Ordinary Income: Certain transactions involving cryptocurrency can result in ordinary income. For instance, receiving cryptocurrency as payment for goods or services is taxable as ordinary income based on the fair market value of the cryptocurrency at the time of receipt. 

3. Airdrops and Forks: Receiving cryptocurrency from an airdrop or a hard fork is also considered taxable income, but this can be a controversial topic.  

4. The tax treatment for staking can still be confusing. We recommend consulting with an attorney that specializes in digital asset tax reporting, but you can also find more information directly from the IRS here.  

Here are the key aspects that cryptocurrency investors need to know about reporting their transactions:  

Keeping accurate records of all cryptocurrency transactions is vital. You should maintain records of: 

- The date of each transaction 

- The fair market value of the cryptocurrency at the time of the transaction 

- The purpose of the transaction (e.g., investment, purchase, sale) 

- Any receipts, statements, or other documentation  

To calculate capital gains and losses, you need to determine your cost basis. The cost basis is the amount you spent to acquire the cryptocurrency, including any fees. The gain or loss is the difference between the cost basis and the fair market value at the time of the sale or exchange. This can be more difficult if the cryptocurrencies are not listed on known exchanges or regularly traded and are, instead, transferred through the peer-to-peer blockchain system only.  

- Short-Term vs. Long-Term: If you held the cryptocurrency for one year or less before selling, the gain or loss is short-term. If you held it for more than a year, it's long-term. Long-term gains typically benefit from lower tax rates. 

Form 1040 Question 

The IRS now includes a question about virtual currency transactions on Form 1040. Taxpayers must indicate whether they received, sold, sent, exchanged, or otherwise acquired any financial interest in virtual currency during the tax year. This question has become more and more prominent on the tax return with each new iteration of the form, emphasizing the IRS focus on self-reporting.  

Given the complexity of tracking and reporting cryptocurrency transactions, several software solutions can help. The IRS is using its own software to analyze the public blockchains as well for their own verification and enforcement purposes.  

In this brave new world, it is important that taxpayers and the government work together to ensure that both the interests of innovation and reasonable compliance with the law are honored.  

 IMAGE SOURCE: CoinLedger