How Is Cryptocurrency Taxed?

The IRS treats cryptocurrency as capital asset for tax purposes in the U.S., rather than as a currency. That means it’s treated the same way you would treat any other property you buy and sell at a profit or loss. All the generally applicable tax principles that apply to property transactions also apply to cryptocurrency transactions.

Cryptocurrency Income Tax
If you receive cryptocurrency as wages, or in compensation for services performed as an independent contractor, you must declare the crypto as income, based on its fair market value on the day you receive it. If you are self-employed or working as an independent contractor, you may also be liable for a 15.3% self-employment tax in the United States – just as if you received the payment in cash.

Taxation of Cryptocurrency ‘Forks’
A ‘soft fork’ is generally not a tax-generating event.

A ‘hard fork’ may generate an income tax, if the fork is followed by an air drop in which you actually receive cryptocurrency. If you receive new crypto in an air drop as a result of a hard fork, you must report the fair market value of that cryptocurrency at the time you received it as ordinary income.

Cryptocurrency Capital Gains Taxes
If you sell your crypto at a profit, outside a tax-advantaged account such as an IRA, you will realize a capital gain. As of 2021, the U.S. short-term capital gains tax ranges from 10% to 37%, and is generally equivalent to your top marginal income tax rate for the year. If you held the crypto asset for longer than a year, your capital gains tax will range from 0% to 20% of your profit.

Warning: Every time you use crypto to buy goods or services, the IRS sees that as a sale – and a taxable transaction. Your gain is the difference between your basis in the cryptocurrency (essentially, what you paid for it in the first place). This can be a big issue if you frequently use crypto as a currency in routine transactions.

Cryptocurrency and Tax Loss Harvesting
Whenever you sell crypto at a profit, or even if you simply spend crypto to buy a hot dog at a convenience store, it still counts as a sale, and you need to report that sale on your income tax return for that year.

This may prove to be a significant compliance problem for people who use cryptocurrencies as currency for frequent and everyday transactions.

The good news is that if you sell cryptocurrency at a loss, you can use those losses to offset an unlimited amount of capital gains elsewhere in your portfolio. And you can also use other capital losses from selling other assets to offset capital gains in your crypto portfolio.

FIFO vs. Identifying Shares
Generally, crypto assets are taxed using the FIFO (first-in, first out). That means that unless you can identify which cryptocurrency units you sell and the prices at which you bought and sold them, the IRS will assume that you are selling the crypto you have held the longest.

In rising markets, this is very tax inefficient. It generates the highest-tax liability possible if markets have been rising.

With careful record-keeping, you may be able to designate which cryptocurrency units you are selling, and therefore may lower your realized taxable gains. To do this, you must document the following information:

• Which unit or units of virtual currency are involved;
• The date and time each unit was acquired;
• Your basis and the fair market value of each unit at the time it was acquired;
• The date and time each unit was sold, exchanged, or otherwise disposed of, and;
• The amount of money or the value of property received for each unit.

Cryptocurrency and Charitable Donations
If you want to support a charity, it may be advantageous to donate cryptocurrency directly, rather than converting it to cash before donating. Converting highly-appreciated crypto to cash may generate a taxable gain, resulting in a lower net donation. On the other hand, if you’ve taken a loss, it may be better to convert, realize the capital loss, and then donate.

For more specific information on IRS treatment of cryptocurrencies, or virtual currencies, see Rev. Rul. 2019-24, IRS Notice 2014-21 and their Virtual Currencies page.

For more information on the tax treatment of property transactions in general, see IRS Publication 544.

About AbitOs
AbitOs specializes in the unique accounting needs of high net-worth individuals with international lifestyles as well as for entities doing business in LATAM and across the globe. The taxation of cryptocurrencies, tokens, and related assets can be quite complex. If you would like to benefit from our expertise in these areas or if you have further questions on this Alert, do not hesitate to contact us.