Regulators have struggled for years to define cryptocurrencies. Are they securities? Assets? Contracts? Something else? There is one agency that hasn’t had any trouble nailing down Bitcoin and its ilk, and that’s the Internal Revenue Service.
What are cryptocurrency taxes?
The US government’s tax collector treats cryptocurrencies as property. When investors sell tokens and pocket profits, usually in exchange for US dollars, they are obliged to pay capital gains taxes. That’s no different from paying Uncle Sam on returns from stocks, real estate, or other money-making investments. So even though someone may feel like they’re trading virtual instruments outside the bounds of the financial system, in the eyes of the IRS, they’re not.
Moreover, there’s a push by Washington lawmakers to require cryptocurrency exchanges and platforms to record their clients’ transactions and provide customers with 1099 forms to submit with their annual tax returns. These forms report non-employment income, such as investment gains, of at least $600. (Coinbase, the publicly traded crypto exchange, started issuing 1099s to its customers in 2020.) The application of 1099s to cryptocurrencies further shows how blockchain-based assets are being assimilated into the financial mainstream with all the necessary requirements.
As for US states, the rule of thumb at the moment is that they follow federal guidelines and treat cryptocurrencies as property. Tax lawyers say some states are considering adding special provisions. New Jersey officials, for instance, have said wages paid in cryptocurrencies are subject to withholding. Likewise, Wisconsin has said tax rules for property transactions apply to crypto.
What is the cryptocurrency tax rate?
When determining how much tax is owed, investors don’t have to worry about special rates or treatment for cryptocurrencies. The first thing to do is tally the proceeds from cryptocurrency sales in the tax year and subtract the purchase price from the sum. That’s the gain.
Next is determining the tax rate. It’s set by how long the investment was held and the taxpayer’s income. Short-term capital gains earned within 12 months of the cryptocurrency’s purchase are subject to a tax rate that ranges from 10 to 37%, which is essentially the same as one’s ordinary income tax rate. Long-term capital gains on holdings of more than a year go from zero to 20%.
Taxpayers’ income levels determine the precise rate. The more they earn, the higher the rate. An individual, for example, who earned between $80,000 and $441,450 in employment income and made, say, $10,000 on the short-term sale of Bitcoin would be taxed at 15%. That translates into a bill of $1,500.
It’s important to note that, just as with most other investment income, cryptocurrency losses can offset capital gains. This is calculated by subtracting the losses on the sale of underwater cryptocurrencies from the wins; taxes are owed only on the net difference. One other note: Short-term losses can only offset short-term capital gains, and likewise with long-term capital gains and losses.
Are cryptocurrencies taxed like stocks?
The short answer is yes. They are taxed at the same rate and with the same general criteria. Just like equities or other assets, taxpayers can donate cryptocurrencies to tax-exempt charities or give them as gifts with no liability.
Even so, there is one major difference between cryptocurrencies and stocks: Digital tokens can be used to buy goods and services. Lest we forget, Bitcoin was introduced in 2009 as an alternative form of money. There’s a whole panoply of things investors can buy with the token and others such as Ethereum or Litecoin. They run the gamut from real estate to works of art— Sotheby’s recently started accepting Bitcoin and Ether as payment for non-fungible tokens (NFTs)— to trips on Virgin Galactic’s space flights. And, of course, investors can use crypto to buy a beer and a pizza at any number of Bitcoin-friendly cafes. That’s something they can’t do with shares of Walmart.
So what does that mean? Well, as soon as a consumer pays for something with cryptocurrency they’ve just cashed in a taxable asset. That’s how the IRS sees it. “In general, the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability,” the agency states in a notice.
In other words, a consumer would be responsible for calculating how much the cryptocurrency has appreciated in value at the time it was used as payment and subtract the purchase price to yield the taxable gain. Quite a hassle for a slice and a pint. The cryptocurrency industry is lobbying to exempt relatively small transactions from this treatment.
How are decentralized finance tokens like Ethereum taxed?
There’s another consideration for crypto investors: Exchanging digital tokens is also a taxable event (see Question 16 in this IRS FAQ). That’s important because in the world of decentralized finance (DeFi), swapping tokens is huge.
DeFi is built around Ethereum. And unlike Bitcoin’s rather singular purpose to serve as legal tender, the second most valuable cryptocurrency is designed to support software applications and virtual organizations on a variety of blockchains. To make things work in the DeFi ecosystem, users often swap tokens from one platform to another. That activity is a key driver in the value of big DeFi names such as Uniswap, Curve, and MakerDAO.
Another rapidly growing business in DeFi is lending tokens to other investors. A number of platforms (Aave, which sports a market capitalization of $4.2 billion, is one of the biggest) accept deposits from investors and then turn around and lend the tokens to other customers just like a bank. In contrast with traditional lenders, DeFi outfits pay annual interest rates that can top 10%. That’s not a capital gain, but the IRS does consider that taxable income.
Likewise, when DeFi platforms conduct “airdrops” of free tokens to users as part of marketing campaigns, recipients are also on the hook to report the windfalls and pay income tax. The same treatment applies to earnings derived from mining cryptocurrencies. That’s the business of using loads of computing power to process and record cryptocurrency transactions on blockchains and mint tokens as rewards. The IRS says that revenue is also subject to income tax.
How are tax rules and enforcement changing?
It’s unclear how the IRS may ultimately treat token swapping and other activities in DeFi because it is such a new phenomenon. Yet the agency, in tandem with Gary Gensler, the chair of the Securities and Exchange Commission, appears intent on applying existing law to cryptocurrencies and bringing the industry inside the regulatory perimeter.
In May 2021, a federal judge authorized the IRS to seek information from Kraken, a major cryptocurrency exchange, on trades executed by customers exceeding $20,000. The message was clear. “There is no excuse for taxpayers continuing to fail to report the income earned and taxes due from virtual currency transactions,” IRS Commissioner Charles Rettig said in the statement.
The upshot for investors is simple: They will be on the hook for recording and maintaining thorough records of their cryptocurrency investments. The accounting industry has swung into action with services for a marketplace that is now worth more than $2.5 trillion. The American Institute of Certified Public Accountants has released guidance on handling cryptocurrency assets. A crop of companies such as Taxbit are specializing in this burgeoning practice area.
The bottom line
The days when cryptocurrencies were considered untamable assets operating outside the bounds of the financial system are gone. Having defined Bitcoin and other digital tokens as property, the IRS treats them as taxable assets like stocks, real estate, and other non-employment income.
Investors must record and report their gains and losses and pay appropriate taxes when they file their annual returns. Taxpayers can account for cryptocurrency gains under the same rules as stocks. But Bitcoin and DeFi enthusiasts must recognize that the IRS considers spending digital tokens on goods and services or other cryptocurrencies as potentially taxable events. Moreover, earning interest from lending crypto deposits or receiving airdrops is considered taxable income.