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Cryptocurrency Tax Liability
Cryptocurrency is a form of digital currency that uses cryptography (encryption systems to protect data) to secure transactions in a decentralized context. Examples include Bitcoin, Litecoin, Ethereum.
The IRS recognizes cryptocurrency holdings as “property” and accordingly many crypto transactions will qualify as taxable events. The failure to report information related to taxable cryptocurrency transactions on a tax return will subject taxpayers to penalties.
Cryptocurrency transactions will be taxable if the value of the asset (crypto) increases as a result of the transaction. Examples of taxable cryptocurrency transactions include:
- Selling cryptocurrency
- Using cryptocurrency to purchase goods or services
- Trading different types of cryptocurrencies
Simply purchasing virtual currency with US dollars and keeping it within the exchange where you made the purchase or transferring it to your personal wallet does not trigger tax liability.
Examples of Cryptocurrency Income
Crypto income is taxed as ordinary income at its fair market value on the date the taxpayer receives it. Common examples of crypto income include:
- Receiving crypto as a payment for providing a service
- Mining crypto and earning the rewards
- Staking crypto and earning the rewards
- Lending crypto and receiving interest payments
Taxpayers are required to keep track of gains and losses from the trading of cryptocurrency. These gains and losses are reported on IRS Form 8949 Sale and Other Dispositions of Capital Assets which is ultimately incorporated into the Schedule D of the 1040 tax return.
The IRS requires disclosure of the following information:
- Name of the cryptocurrency
- Date it was acquired
- Date it was sold, traded, or otherwise disposed of
- Proceeds or sales price
- Costs basis (purchase price)
- Total gain or loss
The Internal Revenue Code and Regulations require taxpayers to keep records that are sufficient to support the positions taken on the tax return. It is advisable to maintain records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the virtual currency.
Starting in 2023, cryptocurrency exchanges will be required to issue a 1099-B and notify the IRS of cryptocurrency transactions. However, for investors who use their own crypto wallet, the information reported to the IRS on the 1099 form will be prone to inaccuracy since the exchanges reporting on trading activity will have a limited view into what investors actually paid for crypto. For this reason, investors need to keep track of what they originally paid for their crypto (cost basis) to reconcile what will ultimately get reported on the 1099 to the IRS.
Optimizing Cryptocurrency Losses
The IRS treats crypto losses differently than those of stocks and mutual funds in that the wash sale rules (typically preclude investors from selling at a loss and buying back within 30 days) don’t apply. This offers two benefits to crypto investors. First, the investor can enjoy tax-loss harvesting where realized losses can be used to offset capital gains. Second, without wash rules, investors can sell crypto at a loss and then purchase the same virtual currency almost immediately.
We note that the IRS will likely promulgate new regulations as needed in the evolving realm of digital currency.
How We Can Help You
The IRS is aggressively enforcing cryptocurrency investor income reporting and tax payment obligations thereon. Taxpayers who fail to report or under report gains from the sale or trade of crypto may be subject to IRS audit, taxes and penalties. The attorneys at Segal, Cohen & Landis are experts in this emerging field of tax law and can help you:
- Respond to IRS Notices and letters
- Achieve a successful result in a cryptocurrency audit
- Challenge tax assessments for unreported or under reported cryptocurrency
- Comply with the filing and reporting requirements associated with cryptocurrency