Disclaimer: You should ensure that you understand the potential tax implications of trading in cryptocurrencies. You are responsible for all taxes and stamp duty in respect of your trades. We do not offer any tax advice or tax recommendations, and you are responsible for your own tax affairs. If you are in any doubt as to the tax treatment or liabilities of the cryptocurrencies we offer, you should seek independent advice.
What exactly is a cryptocurrency, and do you pay taxes on it?
Cryptocurrency is a form of digital currency; a digital representation of value. Bitcoin – the most known crypto – is essentially a reward for the use of computer processing power. While one can spend and save digital currency just like any other form of currency, it’s not always recognized as a currency depending on the country. That’s because most governments do not back it. But some governments are adopting, such as Ghana which now recognizes and accepts digital currency payments.
Crypto is a new type of investment. It’s a digital asset that can’t be seen or held, unlike traditional stock that’s tied to a physical business. Intangibility makes it difficult to picture how digital currency fits into tax laws that have been passed before it even existed. This begs the question: “Do you need to pay tax on cryptocurrency?”
The answer is yes. Instead of being classified as a currency, cryptocurrency is an asset just like stocks, real estate, and art. That means it’s taxable like any other assets. The amount of taxes paid will vary widely and depends on the type of taxable event that occurs.
Taxable Events: When to Pay Taxes on Cryptocurrency
According to the Internal Revenue Service (IRS), crypto is treated as a capital asset. But ￼not every action you take will be taxable, like buying into a cryptocurrency. Here are a few that are and what type of tax they are subject to. In that sense, ￼these taxes aren’t too different from other capital asset taxes like real estate, stocks, or bonds.
When selling cryptocurrency, one may owe taxes on any capital gains. To figure out the value of the crypto, calculate the difference in value from when bought it versus at the time it’s sold. This will determine whether there’s a gain or loss in value. If applicable, a tax loss can be used to offset other gains and income.
When buying crypto, the purchase isn’t immediately taxed. The buyer is only taxed depending on when the asset is sold and the amount of capital gains. We suggest buyers keep track of the value of the digital currency that they buy so that they can compare its value when sold.
When an investor trades or exchanges one type of crypto for another, they’ll also be subjected to capital gains taxes. In this case, it doesn’t matter if the digital currency was held for days or years, the taxable gain will be the same.
Cryptocurrency Payment as Income
If crypto is used as payment for income, the employer must be reported to the IRS using W-2 forms. The value of the digital currency used must be converted to U.S. dollars, which is then subjected to the same withholding as regular income.
Cryptocurrency Payment for Goods or Services
If investors use digital currency to make purchases for goods or services, they’ll also owe taxes on all capital gains. They get taxed on the amount that increases in value from when they purchased until the exchange takes place. The crypto will be taxed based on its short-term or long-term gain.
Crypto Tax Rates
Because the IRS considers digital currency to be an asset and subject to capital gains, investors owe taxes but only when that gain is realized. The type and rate of taxes paid depend on when the cryptocurrency is sold.
How Do Digital Assets Get Taxed?
In most cases digital assets get taxed as capital gains. A capital gain is a difference between what was paid for an asset and what it was sold for. A capital loss can also happen if the selling price is less than the purchase price. Capital losses can offset capital gains.
Short-Term Capital Gains
When investors sell a digital asset within a year of buying it, the profit is a short-term capital gain. A short-term gain gets taxed at the ordinary-income tax bracket. They’ll pay the same tax rate as they pay on their employment income unless the gains increase income and push them into the next tax bracket.
Long-Term Capital Gains
If investors wait a year or longer to sell, the gains are long-term. In the U.S., long-term capital gains qualify for special tax rates.
- If one makes less than $40,400 for total adjusted gross income in 2021, one doesn’t pay taxes on long-term capital gains.
- If one makes more than $40,400, up to $445,850, they pay 15% on long-term capital gains.
- If income is higher, investors pay a crypto rate of 20%.
The reporting of crypto capital gains and losses is required using IRS Form 8949. The IRS also provides a worksheet to help calculate total capital gains and losses. Check the current years’ Instructions for Schedule D section of the tax return for details.
“There are multiple tools available which will help capture your trades and positions to correctly reflect the tax due on your trades, this is important for both day trader and long-term holders. These are easy to use and go a long way in preventing tax evasion.”
Harbind Likhari, Director of Finance at Fabriik.
How to Calculate Your Gains and Tax
Calculating capital gains and taxes owed for digital currency can be complicated. Simply put, math will be needed. When investors complete their tax returns, they need to enter their sales as well as what they originally paid. The profit made is the capital gain.
If investors didn’t sell all their coins or they sold them at different times, there are a few different ways to calculate profit.
- Specific Identification: Identify the exact coin or coins sold and use that purchase price.
- Average Cost: Take the average purchase price cost of all the coins.
- FIFO: Use the purchase price of the first coin bought. This is called first-in, first-out.
- LIFO: Use the purchase price of the last coin bought. This is called last-in, first-out.
There are several free and paid crypto tax calculators available online. Once personal data is entered (i.e., tax year, filing status, taxable income, etc.) and crypto sales (i.e., purchase date and amount, sale date and amount), the calculator will help figure out the crypto taxes owed.
Crypto Trading and the IRS
Many may think the IRS has no way of knowing about digital currency sales. Previously, they might have been right. With millions of dollars in taxes on the line, the IRS is changing this.
How does the IRS know about transactions?
Nowadays, exchanges are under increasing pressure to report trading activity the same way stockbrokers do. As a result, the IRS is using existing laws when possible, and lobbying Congress to pass additional requirements.
The IRS could also find out about extra income during a routine, random audit. The penalties for not properly reporting income include fines, interest on back taxes, and possible criminal charges for tax evasion.
How to Prepare for the Crypto Tax Season
The taxation of digital currency is very complex and requires good record-keeping. It’s important to be well-prepared for tax season by keeping both detailed records and supporting documents.
It’s important to keep records of transactions for various reasons but especially in case of an audit. This is the information needed for digital currency on tax returns.
- Detailed Records — keep detailed records of all digital currency transactions to complete tax returns.
- Support Documentation — be able to back up the calculations in the event of an audit. U.S. tax law requires preserving records supporting tax returns. For digital assets, this would include all buying, selling, investing, and usage documentation.
- Permanent Records — Many may end up selling their digital currency years or decades after they originally bought it. If one buys and sells multiple times, they’ll also need records of past transactions and holdings to show that they used an appropriate cost-basis for the sale.
What if an Investor Didn’t Pay Taxes in the Past?
If an investor didn’t pay any crypto taxes in the past, it’s crucial to speak to a tax accountant as soon as possible. Interest and penalties will add up until taxes are paid, so not paying will only make matters worse over time. Normally, one needs to amend any prior-year tax returns to include the income and pay any additional amounts one owes.
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