Filing taxes for cryptocurrencies can be a confusing and daunting task for many individuals. The United States Internal Revenue Service (IRS) treats cryptocurrency as an asset subject to capital gains tax. That knowledge seems to make filing crypto taxes simple, but the unique nature of cryptocurrency means there are many unanswered questions.
Accurately reporting profits and losses can be a nightmare. While everyone worried about tax season knows that keeping accurate records of every crypto transaction is a must, there are other things to keep in mind.
There is a difference between short-term and long-term capital gains taxes, with tax rates varying depending on a number of factors. These capital gains tax rates are available online and are beyond the scope of this article, which will focus on avoiding potential problems with the IRS when filing your cryptocurrency tax return.
How to report crypto taxes
Filing taxes on cryptocurrencies is not an option; it is an obligation that every individual and company has. Those who track their transactions — including the prices of the cryptocurrencies they make — will find it easier to report their activities.
Even those who have not received any tax documents related to their cryptocurrency movements may have taxable events to report. Speaking to Cointelegraph, Lawrence Zlatkin, VP of Tax at Nasdaq-listed cryptocurrency exchange Coinbase, said:
“Crypto assets are treated as assets for US tax purposes, and taxpayers should report gains and losses when there is a sale, exchange or change of ownership (other than gifts). Only HODLing or transfers of crypto between taxpayer wallets are not taxable events.”
Zlatkin added that more advanced trading “where there is a change in economic ownership, literally or substantially, may be taxable,” even if the taxpayer does not receive an IRS Form 1099, which relates to miscellaneous income.
Meanwhile, Danny Talwar, head of tax at crypto tax calculator Koinly, told Cointelegraph that investors can report cryptocurrency gains and losses via Form 8949 and Schedule D Form 1040.
Talwar said investors with losses in cryptocurrency after last year’s bear market could save on current or future tax bills by harvesting tax losses.
Tax loss harvesting refers to the timely sale of securities at a loss in an attempt to offset the amount of capital gains tax that would be paid by selling other assets at a profit. The strategy is used to offset short-term and long-term capital gains. Coinbase’s Zlatkin addressed this strategy, saying, “losses from selling or exchanging cryptocurrency can result in capital losses that can be used to offset capital gains and, in limited circumstances for individuals, some ordinary income.”
Zlatkin added that the losses “may not have been sufficiently crystallized due to pending bankruptcy or fraud,” adding:
“Taxpayers should be careful in how they treat losses and also consider the possibility of losses due to theft or fraud when the facts support those claims.”
He said crypto investors should consult their tax advisors regarding available tax credits or deductions. Investors should also be aware of losses from “wash selling,” which Zlatkin described as “selling a crypto at a loss followed shortly thereafter by repurchasing the same type of crypto.”
Speaking to Cointelegraph, David Kemmerer of cryptocurrency tax software firm CoinLedger said that losses incurred in 2022 could be an “opportunity” to reduce the tax bill, with capital losses offsetting capital gains and up to $3,000 of income per year.
David Kemmerer added that “it’s important to remember that exchange fees and blockchain gas come with tax benefits,” since fees “directly related to the acquisition of cryptocurrency can be added to the cost base for the asset.”
He added that fees associated with the disposal of cryptocurrency can be deducted from income to reduce capital gains tax.
While the IRS has somewhat clear guidelines on the taxes owed on buying and selling cryptocurrency, the tax patterns for those involved in the sector can become more complex if they delve deep into, for example, the world of decentralized finance (DeFi).
Tax complexities with DeFi, staking and forks
Using DeFi can be complex, with some strategies involving multiple protocols to maximize returns. Between crypto-backed loans, transactions involving liquidity provider tokens, and airdrops, it’s easy to lose track.
According to Zlatkin of Coinbase, “most forms” of cryptocurrency rewards or returns are subject to US tax when received.
He said the current US laws on role income are “underdeveloped” and the IRS treats role awards as “taxable income when an individual taxpayer receives role awards over which the taxpayer has ‘dominion and control,’ or substantially when the asset can be monetized.”
When it comes to airdrops and forks, CoinLedger’s Kemmerer noted that income from cryptocurrency forks and airdrops is subject to income tax, just like income from any other business. He said that when a fork or airdrop results in earnings of a new cryptocurrency, investors “recognize ordinary income based on the fair market value” of that cryptocurrency at the time of receipt.
However, cryptocurrencies go beyond these use cases. Many use crypto debit cards in their daily lives, which means that in the eyes of the US government, they are paying for goods and services using assets. What happens when it’s time to notify the IRS?
Tax implications of using crypto for payments
While defining cryptocurrency payments as property transactions sounds like a complex ordeal, according to Kemmerer, using cryptocurrency as a payment method “is considered a taxable disposition, just like selling your cryptocurrency or trading your cryptocurrency for another cryptocurrency.” He added:
“If you use your cryptocurrency to make purchases, you will realize a capital gain or loss depending on how the price of your cryptocurrency has changed since you originally received it. “
Coinbase’s Zlatkin said this is true “even if the transaction is small, like buying a cup of coffee or a pizza.” If the payment is taxable when made in cash, it remains taxable in crypto as well, he added, stating:
“Furthermore, the recipient is generally treated as having received the money in the transaction and subsequently purchased cryptocurrency with that money, and is taxed accordingly.”
At this point, it is clear that filing tax returns related to cryptocurrency transactions is a complex process that needs to be carefully considered. Cryptocurrency users should consider all of this and avoid common pitfalls.
Record keeping is vital
Tax experts have repeatedly emphasized that keeping records of every cryptocurrency transaction is essential to avoid incidents with the tax administration. CoinLedger’s Kemmerer noted that without accurate records, “calculating capital gains and losses can be difficult.”
He added that records should include the date users originally received their cryptocurrency and the date they settled it. This should be accompanied by the price of the cryptocurrency at the time of receipt and disposal.
Koinly’s Talwar told Cointelegraph that “it’s often easy to miss the number of taxable events that can happen throughout the year” because acquiring and spending cryptocurrency “is becoming more accessible than ever, with exchanges and products providing seamless user interfaces.” Talwar added:
“It’s easy to get it wrong when the point of taxation for crypto comes up. Many people don’t realize that their stake rewards are taxed as income when they receive them, even if they haven’t sold the underlying investment asset.”
Talwar advised those heavily involved in cryptocurrencies to consult with a tax professional during tax season to help them make sense of it all.
Filing crypto taxes can be daunting for many, adding a new layer of complexity to an already difficult-to-understand and ever-evolving sector. Offsetting tax accounts with potential losses can encourage sophisticated investors to take risks in the space, as even their losses can help reduce their tax burden.
Since the law is still unclear regarding some of the more complex operations in the cryptocurrency sector, those looking to avoid risks and stay on the good side of regulators should consider avoiding DeFi. In any case, consulting with an expert is cheaper and less stressful than dealing with fines and enforcement by the tax authorities.
This article does not contain advice or recommendations on tax reporting. Readers should do their own research and consult with a professional when reporting their investments and holdings.