The IRS released its first cryptocurrency guidance in 2014 and specified this asset class is taxed as property. Since that time, the crypto community has seen increased enforcement, audits, and pending regulations – and TaxBit has helped millions of taxpayers automate and file their cryptocurrency taxes.
The question of whether or not a taxpayer deals in crypto assets (also referred to as “virtual currency ” and officially now “digital assets”) is now placed front-and-center for millions of Americans to see. The U.S. Individual Income Tax Return (Form 1040) for 2022 asks,
“At any time during 2022 did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”
Understanding digital asset tax liabilities may be confusing, especially in regard to blockchain jargon such as “airdrops,” “staking,” etc. But as a taxpayer or an enterprise leader, it’s your responsibility to stay educated on potential tax liabilities for dealing with digital assets such as BTC, ETH, NFTs, etc. Regulators are taking notice – especially as an estimated $50 billion worth of crypto taxes have gone unreported.
How does the IRS classify crypto?
The IRS 1040 Form Instructions note the following description of crypto, referred to holistically as “digital assets”:
“Digital assets are any digital representations of value that are recorded on a cryptographically secured distributed ledger or any similar technology. For example, digital assets include non-fungible tokens (NFTs) and virtual currencies, such as cryptocurrencies and stablecoins. If a particular asset has the characteristics of a digital asset, it will be treated as a digital asset for federal income tax purposes.”
By prominently highlighting the question of whether a taxpayer has dealt with digital assets in the broadest sense on Form 1040, the IRS has indicated there’s no longer room for taxpayers to claim they were unaware that crypto transactions need to be reported. If a taxpayer checks Yes, then the IRS looks to see if Form 8949 (which tracks capital gains or losses) has been filed. If the taxpayer fails to report their taxable cryptocurrency transactions, the IRS may impose a penalty on any underreported taxes.
Are all crypto transactions taxable?
No, not every crypto transaction is taxable. The following activities are not considered taxable events:
Buying digital assets with cash
Transferring digital assets between wallets or accounts that you control
Gifting cryptocurrency (excluding large gifts that could trigger other tax obligations)
Donating cryptocurrency, which is actually tax deductible
What crypto transactions are taxable?
The following crypto activities are taxable events:
Selling digital assets for cash
Trading one type of digital asset for another
Using crypto as payment
Mining or staking crypto
Receiving airdropped tokens
Getting paid in crypto
Receiving interest or yield in crypto
When you sell, trade, or use crypto as a form of payment, you dispose of digital assets; that disposal could result in gain or loss depending on your cost basis in the units disposed of and the value of the digital assets at the time of disposal. Regardless of whether you had a gain or loss, these transactions need to be reported on your tax return on Form 8949.
When you receive cryptocurrency from mining, staking, airdrops, or a payment for goods or services, you have income that needs to be reported on your tax return. The amount of income you report establishes your cost basis.
What is cost basis?
Cost basis is the original purchase or acquisition price of an asset. If you purchase 1 BTC for $10,000, that is your cost basis which is then used to calculate any capital gain or loss from disposing of it thereafter. Tracking cost basis across the broader cryptoeconomy can be difficult, as assets are transferred across different wallets and exchanges.
At TaxBit, we have found that come tax season, customer support issues regarding “missing cost basis” dominates the industry at large. It is for this reason that TaxBit and other industry leaders are partnering to solve this widespread issue. TaxBit is building the industry-leading solution for tracking cost basis across a network of top exchanges, wallets, and platforms.
What is a Form 8949?
Form 8949 is used to track the Sales and Other Dispositions of Capital Assets. In other words, Form 8949 is used to track capital gains and losses for assets such as cryptocurrency. On Form 8949, a taxpayer details the number of units acquired, their dates of acquisition and disposal, cost basis, and any capital gain or loss.
Capital gains and losses are taxed differently according to whether an asset was held for more than one year. Long-term capital gains for assets held longer than one year are taxed more favorably compared to short-term capital gains for assets held less than one year.
How to determine crypto gains or losses
Whether you have a gain or loss on the disposal of a digital asset depends on the value of the asset at the time of disposal measured against the cost basis of that asset.
In late 2019, the IRS issued guidance on acceptable cost-basis methods for calculating gains and losses on cryptocurrency. The IRS guidance specifically allows for only two cost-basis assignment methods:
First in First Out (FIFO)
Specific Identification
What is FIFO (first in, first out)?
First-in, First-out (FIFO) is a method of assigning the cost basis where the oldest unit of crypto you own is sold or disposed of first.
What are the potential benefits of FIFO?
FIFO currently allows the universal pooling of assets, which makes this an easier method to apply than Specific Identification.
The IRS FAQs don’t specifically address what method is required for FIFO, so a taxpayer can use either approach – pool all their accounts together or prepare separate FIFO calculations for each wallet or account.
You can weigh your options, but if the exchange issued a Form 1099 to you, then it probably used a by-exchange approach. The same approach is likely easiest when completing your personal tax forms and could also reduce the chance of an audit because your return will match the information that the exchange provided to the IRS.
What is Specific Identification?
Taxpayers can also elect to use Specific Identification. Specific Identification allows you to select which particular cryptocurrency unit is being disposed of in a transaction so as to minimize any gains or obtain losses.
In the following example, you purchase 1 BTC at a price of $5,000 on June 1, 2023. On August 1, 2023, you purchase an additional 1 BTC at a price of $7,000. Later, you sell 1 BTC for a price of $10,000. Using Specific Identification, the taxpayer can choose to dispose of the 1 BTC with the highest cost basis first as an approach called HIFO (highest, in first out) – so as to minimize capital gains.
So instead of tracking the proceeds of the $10,000 sale for 1 BTC against the unit purchased at $5,000 on June 1, 2023, the net capital gains are matched against the unit purchased at $7,000 on August 1, 2023. In this case, Specific Identification and HIFO enable a taxpayer to minimize their net capital gains liability by $2,000.
What are the requirements for Specific Identification?
The IRS, however, has imposed requirements upon taxpayers that want to use Specific Identification.
First, a taxpayer must, “show (1) the date and time each unit was acquired, (2) your basis and the fair market value of each unit at the time it was acquired, (3) the date and time each unit was sold, exchanged, or otherwise disposed of, and (4) the fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.” In simpler terms, the IRS requires a complete set of transaction records when a taxpayer wants to use Specific Identification.
Second, the IRS guidance requires that Specific Identification be done on a per account and per wallet basis. TaxBit provides support for Specific Identification on a per account or wallet basis in order to legally minimize users' taxes and reconcile to any Forms 1099 issued by exchanges. TaxBit automates the process by specifically identifying, by exchange, the assets with the highest cost basis for disposition to reduce taxable gains.
Although HIFO by exchange is the most common approach for optimizing taxes under the Specific Identification method, HIFO isn’t the only option. Taxpayers could choose to assign their cost basis under a different method such as Last In, First Out (LIFO), but this approach typically makes little sense because they would likely end up with a larger tax bill.
Tax forms issued by cryptocurrency exchanges
A cryptocurrency exchange could issue Forms 1099-MISC, 1099-B, and/or Forms 1099-K to its users. Regardless of whether any of the below forms are issued, taxpayers are always responsible for reporting any and all digital asset income, gains, and losses on their annual income tax return.
1099-MISC
The Form 1099-MISC is used to report ordinary income that will be taxed according to your personal income tax bracket. This form provides information for a wide range of income payments such as crypto earnings, referral bonuses, staking, yield generation, mining, airdrops, hard forks, and other income received through a centralized cryptocurrency exchange. If you’ve received $600 or more this year in crypto earnings or bonuses, a 1099-MISC will likely be made available by the platform that issued the payments (most top exchanges provide them).
1099-B
A Form 1099-B is used to report the disposal of taxpayer capital assets to the IRS. Traditional financial brokerages provide 1099-B Forms to customers, but cryptocurrency exchanges have not been required to do the same in the past.
A law passed by Congress in 2021 will soon require digital asset brokers to report users’ capital gains and losses via Form 1099-B (or another form specific to digital assets called 1099-DA). When digital asset brokers begin providing 1099 Forms to customers, it will become much easier for taxpayers to know their tax liability and ultimately file Form 8949. Gains reported on Form 8949 are taxed pursuant to capital gains treatment instead of ordinary income.
1099-DA
Digital asset brokers, as outlined in the Infrastructure Investment and Jobs Act (IIJA) will be required to significantly expand tax information reporting. Digital asset brokers will be required to report customers’ transfers and original cost basis – for both broker to broker and broker to non-broker (or external wallet address) transfers – in a new form called the 1099-DA (digital assets) to both individuals and the IRS. The final format of the 1099-DA is not yet released but is expected to be clarified soon.
How are exchange and network transfer fees taxed?
Millions of Americans have participated in the cryptoeconomy – buying, selling, or transferring digital assets. These activities typically require fees to be paid as part of the transaction, either to a centralized exchange or as a network transaction fee to the validators confirming the transactions on a blockchain. For many, the question is how those fees are treated for tax purposes – can they be deducted, or do they provide any potential benefit?
Fees incurred in conjunction with the acquisition or disposition of a crypto asset provide some tax benefit. Whenever crypto is bought or sold (or converted to another asset) on a centralized or decentralized exchange, the U.S. tax code permits fees paid with respect to those transactions to be taken into account for tax purposes.
Fees incurred simply with the transfer of crypto assets among accounts or non-custodial wallets likely provide no tax relief because they are not directly connected to the acquisition or disposition of property.
What is the tax rate for crypto?
The United States distinguishes between two main types of income—ordinary income and capital gain income. Capital gain income can be long-term or short-term. If you’re receiving crypto as payment for goods or services or through an airdrop, the amount you received will be taxed at ordinary income tax rates.
If you’re disposing of your crypto, the net gain or loss amount will be taxed as capital gains.
What are short-term capital gains?
If you hold a particular cryptocurrency for one year or less your transaction will constitute short-term capital gains. Short-term capital gains are added to your income and taxed at your ordinary income tax rate.
What are long-term capital gains?
If you held a particular cryptocurrency for more than one year, you’re eligible for tax-preferred, long-term capital gains, and the asset is taxed at 0%, 15%, or 20% depending on your taxable income and filing status.
The specific income levels change annually, but we’ve provided a general breakout below:
If you’re in the 10% or 12% tax brackets based on your filing status, you’ll generally pay a 0% capital gain rate.
If you’re in the 22%, 24%, or 32% tax brackets based on your filing status, you’ll generally pay a 15% capital gain rate.
If you’re in the 35% and 37% income tax brackets, you’ll generally pay a 20% capital gain rate.
What is a tax loss carryforward?
The difference between capital gains and losses is called net capital gain or loss. If you have a net capital loss, you can deduct that loss on your tax return—up to $3,000 per year. If your net capital losses exceed $3,000, the portion over $3,000 is a capital loss carryforward and can be included in your capital gain calculation for the following tax year.
For example, if you had a net capital loss of $5,000 for tax year 1, you would deduct $3,000 of that amount on your tax return for tax year 1. The remaining $2,000 would be carried forward and used to calculate your net capital gain or loss for tax year 2. If you also had a loss in tax year 2, then the $2,000 carryforward could be used in tax year 3 along with any carryforward from tax year 2.
How can investors offset capital gains with capital losses?
The IRS allows investors to claim deductions on cryptocurrency losses that can lessen their tax liability or potentially result in a tax refund. Crypto losses must be reported on Form 8949; you can use the losses to offset your capital gains—a strategy known as tax-loss harvesting—or deduct up to $3,000 a year from your ordinary income (referred to as the allowable capital loss deduction).
When offsetting your capital gains with losses, pay attention to the holding period of the assets in the red. You’re only allowed to offset long-term capital losses against long-term capital gains and short-term capital losses against short-term capital gains. Once you’ve offset losses of the same type, your short-term losses are used first against your allowable capital loss deduction of $3,000. If, after using your short-term losses, you have not reached the limit on the capital loss deduction, use your long-term losses until you reach the limit. Any remainder above $3,000 will be carried forward into the next year, retaining its long- or short-term character.
How are crypto taxes enforced?
The IRS doesn’t say how it decides which tax returns to examine, but the assumption is that it will review the information provided on a tax return; such as the answer to the virtual currency question on Form 1040 or the information on Form 8949.
The IRS appears to pay close attention to individuals that received a Form 1099 from an exchange and will use its computer system to check the Form 1099 information against what a taxpayer reports on their tax return.
Notably, if a taxpayer answers No to the virtual currency question, or doesn’t include a Form 8949, and is issued a Form 1099 from an exchange, that taxpayer is more likely to be audited; the IRS now has information that may result in penalties on top of whatever additional tax may be owed. Honest answers are always recommended.
Other crypto tax considerations
How is crypto staking or mining taxed?
ETH staking rewards may potentially be taxed as income equal to the value of the coins at the moment of receipt. But without the ability to unlock funds until an eagerly-awaited network upgrade is complete, and given ETH’s price volatility, staking tax liabilities can be confusing. Without formal IRS guidance, a taxpayer may be able to reasonably argue that taxable income should be deferred until funds are completely unlocked.
Rewards or yield earned by staking other cryptocurrencies will be taxed as ordinary income – and the same applies to any income earned by mining on networks such as Bitcoin.
How are crypto airdrops or hard forks taxed?
Any crypto units earned by airdrops or hard forks should be taxed as ordinary income. Hard forks are similar to airdrops in that you can receive new coins, but they are fundamentally different occurrences. An airdrop is when new coins are deposited into your wallet or crypto exchange account, but a hard fork is an event where a single blockchain splits into two separate, parallel chains. Holders of coins on the original chain could also receive coins on the new unique chain after the hard fork’s split.
How are crypto debit card payments taxed?
Whenever you spend cryptocurrency it qualifies as a taxable event - this includes using a crypto payment card. If the price of crypto is higher at the time of a purchase than when you acquired it, the disposal of that crypto would be recognized as a capital gain and taxed accordingly. If you make purchases with your crypto debit card when your assets are in a loss position, you can actually use this capital loss to offset capital gains with a strategy called tax-loss harvesting.
How are crypto bankruptcies taxed?
In 2022, market turbulence and bankruptcies swept the crypto industry. Many users were left with inaccessible funds and severe uncertainty as to their tax situation.
From a tax perspective, if customers are not made whole in the bankruptcy, a tax deduction may likely be claimed, but only after payout from the company is made or known:
The deduction can be claimed once the amount of any payout is determined with reasonable certainty
The amount of the deduction should be equal to an individual’s investment (cost basis) in the lost crypto less the amount of any payout received
The deduction will likely be treated as an ordinary loss rather than a capital loss
How are crypto gifts and donations taxed?
The IRS makes a distinction between a donation and a gift for tax purposes dependent on who receives the cryptocurrency. If you send cryptocurrency to a qualified charitable organization, this is considered a donation, also referred to as a charitable contribution. If you send cryptocurrency to family, friends, or a crowdsource campaign for someone with medical bills, it’s considered a gift.
Neither gifting cryptocurrency to a friend nor donating cryptocurrency to an eligible charity are taxable events, but donating the crypto may have an additional tax advantage - depending on your situation, you may be able to claim a charitable deduction on your tax return for donated crypto. Learn more about donating or gifting crypto and its potential tax implications here.
How are crypto-to-crypto transactions taxed?
Exchanging one crypto for another is a taxable event, regardless of whether it occurs on a centralized exchange or on a DeFi exchange. If you trade 1 BTC for 10 ETH, for example, that would qualify as a taxable disposable of 1 BTC priced at the fair market value of the 10 ETH acquired in the transaction.
How are NFTs taxed?
NFTs qualify under the IRS definition of “digital assets.” As such, they are considered property and are thus subject to capital gains or ordinary income taxes. In addition, certain NFTs may be considered “collectibles” by the IRS and therefore would be subject to higher taxes than other capital assets. NFT stakeholders are eagerly awaiting formal IRS guidance on the matter of whether they should be taxed as “collectibles.”
How TaxBit Can Help
At TaxBit, we are building industry-leading solutions for digital asset compliance. Our technology is trusted by some of the world’s largest regulatory agencies, accounting firms, and Fortune 500 companies with features such as:
Scalability to handle tens of millions of transactions
A controlled environment to support robust control frameworks such as ISO 27001 or SOC 1 & 2
Audit support that is built with your auditors in mind
Leading expertise from our team of IRS, AICPA, and Big Four alumni
Contact us to learn more, explore partnership opportunities, or schedule a demo of our enterprise solutions.
As a seasoned expert in cryptocurrency taxation, it's evident that the landscape of digital asset taxation has evolved significantly since the IRS released its first guidance in 2014. The article provides a comprehensive overview of various concepts related to crypto taxation. Here's a breakdown of the key concepts discussed:
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IRS Classification of Crypto:
- The IRS classifies crypto as "digital assets," including virtual currencies like cryptocurrencies and stablecoins, as well as non-fungible tokens (NFTs).
- The IRS requires taxpayers to report their dealings with digital assets on Form 1040.
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Taxable and Non-Taxable Crypto Transactions:
- Non-taxable events include buying digital assets with cash, transferring assets between wallets, gifting cryptocurrency, and donating crypto (which is tax-deductible).
- Taxable events encompass selling, trading, using crypto as payment, mining, staking, receiving airdrops, and getting paid in crypto.
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Cost Basis:
- Cost basis is the original acquisition price of a crypto asset.
- Tracking cost basis is crucial for accurate tax reporting, and the article highlights the challenges users face, especially during tax season.
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Form 8949:
- Form 8949 is used to track capital gains and losses for assets like cryptocurrency.
- It requires details such as the number of units, dates of acquisition and disposal, cost basis, and capital gain or loss.
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Cost-Basis Assignment Methods:
- FIFO (First in, First out) and Specific Identification are the two IRS-approved cost-basis assignment methods.
- FIFO is simpler and widely used, while Specific Identification allows users to choose which units to dispose of, potentially minimizing gains.
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Tax Forms Issued by Exchanges:
- Cryptocurrency exchanges issue Forms 1099-MISC, 1099-B, and 1099-DA to report various income and capital gains.
- The article explains the significance of these forms and the impending requirement for digital asset brokers to report on Form 1099-DA.
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Tax Rates for Crypto:
- Crypto is taxed as ordinary income for payments received and as capital gains for disposals.
- Long-term and short-term capital gains are taxed differently based on the holding period.
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Tax Loss Carryforward:
- Net capital losses can be deducted up to $3,000 per year.
- Any excess can be carried forward to offset future capital gains.
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Crypto Tax Enforcement:
- The IRS uses Form 1040 and Form 8949 information to enforce crypto tax compliance.
- Individuals receiving a Form 1099 from an exchange are at higher risk of audit if they fail to report crypto transactions.
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Other Considerations:
- The article addresses various other considerations, such as the taxation of staking, mining, airdrops, hard forks, debit card payments, bankruptcies, gifts, and crypto-to-crypto transactions.
In conclusion, the article emphasizes the importance of staying informed about tax liabilities related to digital assets and the need for accurate reporting to avoid penalties and audits. It also highlights how TaxBit and other industry leaders are addressing challenges in tracking cost basis and facilitating compliance in the evolving crypto tax landscape.
