Crypto taxation has been complicated for many years due to the lack of suitable guidance from the Internal Revenue Service (IRS). So news in October that they were updating the guidance for investors on how cryptocurrencies should be recorded on tax returns was welcomed by many.
For anyone completing this year’s tax return, there is now much greater clarity on what should and shouldn’t be included. The past 12 months have been transformative for the cryptocurrency industry, the popularity of initial coin offerings (ICOs) has all but dried up, while the whole sector has experienced a prolonged bear market that many labelled as ‘crypto winter’. Despite this, Bitcoin is still one of the most popular asset classes, continuing to outperform all competitors.
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The IRS’s new crypto taxation guidelines is the first update it has made since 2014, and it offers some useful pointers on how it will treat the asset class.
The changes it introduces, included:
- Providing specific identification is allowed – though first in, first out (FIFO) can be used as a default
- It places greater emphasis on fair market value (FMV) based on the timestamp of transactions
- A “Crypto-to-Crypto” trade or “Exchanging Crypto for goods/services” are taxable events
- Cost basis includes fees, commissions and other acquisition costs in US dollars.
- Being paid in crypto is also considered income and should be reported as income by the Fair Market Value of the crypto on the date of payment.
Understanding Crypto Taxation
Here we take a look at the key points from the IRS’s guidance, so that investors can ensure their return is completed accurately and on time.
As a starter, it’s important to remember that for tax purposes, the IRS treats cryptocurrency the same way it treats property. Thereby, taxes need to be paid on the capital gains you realize when you sell an asset. So, in simple terms, if you bought crypto for $10k, then later sold it for $40k, you have a gain of $30k which is taxable, which needs to be recorded on your tax return.
As with any guidance the IRS publishes, it has been welcomed by some, and criticized by others. Such a range of views is understandable given the complexity of cryptocurrencies and taxation.
The government still has its work cut out to try and keep up with a sector that is evolving rapidly, especially the decentralized finance (DeFi) sector, which is impacting traditional sectors such as insurance, investment and more. Whilst many are concerned there is a lack of guidance from the IRS specifically on DeFi, many of these activities simply fall under general crypto tax regulations.
For lenders, making money available to borrowers doesn’t attract taxes. However, the interest earned from an investment or lending activity creates a taxable event. Another important thing to note is to identify the purpose of these lending activities.
For tax purposes, lending activities are classified either as a hobby or business. If businesses are keeping proper records, investing a chunk of their time, and devising strategies to make a profit, then they are clearly doing business. Therefore, under IRS regulations, they will have to file taxes under “Profit or Loss from Business”, falling under Section C, Form 1040. This also means that they will pay tax as a self-employed or sole proprietor, which puts them in the 15.3% tax bracket of their reported income.
New guidance on crypto taxation
Investors now have a much better idea and clearer picture on how to classify the cost basis of their crypto, that is the fair market value of their holdings.
The guidance’s FAQs state: “Your basis is the amount you spent to acquire the virtual currency, including fees, commissions and other acquisition costs in U.S. dollars.” Key to this is how to record the cost basis of each unit of crypto investors may have sold.
The recent guidance helps investors who may have invested in an asset over a long period, for example, a number of years. Prior to the new advice it was unclear what price should be used to calculate taxable gains, but this point means investors can document the exact crypto they are selling, providing each unit’s unique identifier has been included.
The guidance’s FAQs add: “You may identify a specific unit of virtual currency either by documenting the specific unit’s unique digital identifier such as a private key, public key, and address, or by records showing the transaction information for all units of a specific virtual currency, such as Bitcoin, held in a single account, wallet, or address.”
Record keeping is more important than ever. Investors must now be able to identify all the assets they have bought and traded, the asset in question (for example Bitcoin, or Ethereum), the date of purchase, the value, the quantity, the date of sale, the value at sale, losses and gains, wallet movements and exchange movements.
It’s a huge list of information, but thankfully there are plenty of tools available to help make this evidence-gathering process as easy as possible.
For example, smart matching algorithms can help traders to find and match transactions made across different exchanges, eliminating many of the errors of trying to find and track trades across multiple platforms manually.
While the new guidance does place additional requirements on what traders and businesses should include in their tax return, thankfully tax platforms can help reduce the pressure.
Although we’ve had some guidance on how airdrops and hard forks should be treated, some organizations have criticized the IRS for the new rule which states: “If a hard fork is followed by an airdrop and you receive new cryptocurrency, you will have taxable income in the taxable year you receive that cryptocurrency.”
This means investors suddenly find themselves in a position of having to account for additional assets they might not have wanted in the first place, with tax payers becoming liable for tax on the asset the moment new tokens from the fork are recorded on the blockchain.
This means any project that forks or airdrops tokens to its investors is effectively creating an additional tax burden for them.
Crypto Taxation: So where next?
Completing this year's tax return to account for your cryptocurrencies should be more straightforward, but investors should take the time to carefully collate the information about their trades, losses, and gains, and ensure they do so as honestly and transparently as possible.
On the whole it is good news that the government has updated their guidelines on how it treats cryptocurrencies, but watch this space, further updates are most certainly expected.
About the Author
Vamshi Vangapally is the founder of BearTax; the Cryptocurrency Tax Software for Traders and Accountants that helps file cryptocurrency taxes with confidence. BearTax Integrates with all major exchanges, fetching trades from everywhere, identifies transfers across exchanges, auto generates tax documents and calculates tax liability in minutes.