Cryptocurrency has been a topic of much discussion for several years now. To some it’s the future of economics, to some it’s a poorly disguised scam, and to some it’s that confusing thing their grandson keeps talking about. What is going on with this stuff?
Whatever the answer, one thing is for certain: there is money moving around, and that means somebody needs to pay taxes. Are you that somebody?
Contents |
| What is cryptocurrency, anyway? |
| How do I know if I owe taxes on my cryptocurrency? |
| What if my cryptocurrency lost value? |
Well, first things first: it’s not considered currency, despite the name. Cryptographic currency is actually a type of digital asset that is, in theory, not controlled or maintained by any central authority. Instead, it utilizes a technology called blockchain to keep track of the units and maintain their security.
The idea was that this technology could be used to create a decentralized currency, but in practice, it’s rarely used as a currency outside of illegal transactions on the Dark Web. Instead, cryptocurrency is a speculative asset: you buy it hoping it will be worth more later.
The backbone of all cryptocurrency is the blockchain, a “distributed ledger” that stores records of transactions across many computers simultaneously, so that nobody can alter the information it contains. Instead of updating the ledger by altering the data, the new data is attached in a “block” to the existing data, creating a “chain”.
To ensure that the information cannot be fraudulently altered or added to the chain, individual users download a program on their computer to verify transactions and update the ledger in a process known as mining (most famously, bitcoin mining). They also must use their computer power to solve complicated math problems in order to gain access to the end of the chain.
The process uses massive amounts of electricity and computing power (bitcoin alone consumes more electricity than Norway or Argentina), but the inefficiency is also a security feature – the expensive energy consumption makes altering the blockchain more trouble than it’s worth.
And to offset the expense of the electricity usage, miners are granted units of cryptocurrency in exchange for using their computers to support the code. That’s why it’s called mining: this process is how new units of cryptocurrency are brought into circulation.
These days, cryptocurrency miners rarely use their home computers, instead assembling massive crypto mining rigs that are often large enough to fill up entire buildings. There is a programmed-in limit to how many units can be created of any given cryptocurrency – bitcoin, for example, is supposed to be limited to 21 million units – but we haven’t reached the limits of any major cryptocurrencies yet.
So, we’ve mentioned that cryptocurrency functions, in practice, as a speculative asset rather than a currency. Since the IRS happens to agree with this assessment, that’s key to how cryptocurrency is taxed.
Buying crypto with cash and holding it, giving crypto as a gift or donation, or transferring crypto to yourself between digital wallets you own are all non-taxable events, but most other activity involving crypto will incur a tax penalty of some kind.
There are two types of tax that might be owed on cryptocurrency: income taxes and capital gains taxes.
If you are paid a wage in crypto, or you receive crypto as payment in exchange for goods or services, that is considered income for tax purposes. However, the most common reason by far that cryptocurrency might incur a tax liability is when mining crypto. The new units of cryptocurrency created by your mining efforts are income and are taxed as such.
Capital gains taxes are incurred whenever you sell certain assets like stocks, bonds, jewelry, or real estate for more than it was worth when you acquired it. Cryptocurrency is included in that category: whenever you sell your crypto at a gain, you owe taxes.
Pretty straightforward, right? But there are a few important situations in which crypto can be sold as part of another process without it being immediately obvious that such a sale is taking place.
Though it’s usually held as an investment, if someone does want to spend the crypto as currency, it’s currently only accepted as legal tender in two places: El Salvador and the Central African Republic. To get around that, anyone attempting to spend cryptocurrency in the United States must use an app service that exchanges it instantly for the appropriate amount in dollars. That exchange is, in fact, counted as a cryptocurrency sale, and that means capital gains tax.
The same is true when exchanging one cryptocurrency for another: you are technically selling one capital asset for dollars and using those dollars to purchase another capital asset.
So if you sell cryptocurrency, use it to purchase something, or exchange it for another cryptocurrency, and it was worth more than when you bought it, you owe capital gains taxes.
| 👩🏫 Note: If you earn more than $600 in secondary income in a given year, you should be receiving a 1099 form – used to report certain nonwage income types – from whoever paid you. However, the IRS has delayed implementing this rule for cryptocurrency trading, so the old $20,000 threshold is still in effect in some states. Check with the requirements in your home state to be safe. |
That’s a bummer. Luckily, you can still claim it as a loss on your taxes if you sell or otherwise dispose of it, up to a $3,000 deduction. You can even use that loss to offset other capital gains, like from selling stocks or mutual fund holdings.
Cryptocurrency, and the blockchain technology it’s based on, can be a bit of a legal gray area in many ways, but the tax situation is very straightforward.
It’s not a currency, it’s a speculative asset, and it’s taxed that way. If you’re moving it around or making money from it, you probably owe some taxes.
Want an expert to double check? Schedule a call with DiMercurio Advisors and we’ll make sure your tax returns are accurate and easy to file.