2021 was a year of record growth for the cryptocurrency market. It was also a year of increased IRS attention on cryptocurrency. Now more than ever, it’s essential for tax professionals to know how cryptocurrency is taxed. In this post, we’re covering the basics of crypto tax law, so you’re prepared to help your clients avoid costly mistakes on their returns.
What is cryptocurrency?
Cryptocurrency is virtual currency that isn’t secured by a government or bank. Instead, it’s secured through cryptography and recorded on a digital ledger called a blockchain. While there are some nuances between the terms “cryptocurrency” and “digital currency,” all are “treated as virtual currency for Federal income tax purposes” by the IRS.
How is cryptocurrency taxed?
Because the IRS has only issued limited guidance around cryptocurrency, navigating taxes can be tricky. However, two basic guidelines provide the framework for most tax situations involving crypto. 1) If the cryptocurrency was bought and sold as an investment, the IRS regards it as property, and it will be subject to short or long-term capital gains taxes. 2) If cryptocurrency was paid or received as income, it will be subject to regular income taxes.
When is cryptocurrency an investment?
For most people involved in crypto, it’s treated as an investment, similar to stock. If your client bought and held the currency less than a year before selling it, any profit will be taxed at the short-term capital gains rate, which is the same as the income tax rate for their tax bracket. If they held it for more than a year, they’ll pay long-term capital gains tax:
2022 Tax Rates for Long-Term Capital Gains
|Single||Up to $41,675||$41,676 – $459,750||$459,751+|
|Head of household||Up to $55,800||$55,801 – $488,500||$488,501+|
|Married filing jointly||Up to $83,350||$83,351 – $517,200||$517,201+|
|Married filing separately||Up to $41,675||$41,676 – $258,600||$258,601+|
You’ll calculate capital gains or losses using Form 8949 and report them on Schedule D Capital Gains and Losses (Form 1040).
While that may sound relatively simple, in order to calculate capital gains or losses, you’ll need to know which transactions are taxable and which aren’t.
When are crypto transactions taxable?
Before you can calculate any capital gains or losses, you’ll need to know which crypto transactions are taxable. If your client simply purchased cryptocurrency during the year but never sold it or exchanged it for another cryptocurrency, this is not a taxable event, and they don’t need to report it. If they transfer their crypto holdings from one personal digital wallet to another, this is also a non-taxable event. (However, this might cause the exchange or platform they use to issue a Form 1099-B, so it’s important that your client maintains accurate records to prove that the currency was simply transferred between personal virtual wallets and was not sold for a gain or loss).
When your client sells currency or exchanges it for another cryptocurrency, these are taxable events, and they’ll need to keep records of each one.
For each taxable event, your client should have a record of the cryptocurrency’s fair market value in U.S. dollars on that day. If they purchased one Bitcoin when it was valued at $25,000 and sold it when it was valued at $30,000, they’d have a capital gain of $5,000 minus any fees associated with the transactions. Most crypto exchanges will automatically keep records of these transactions, but if your client uses multiple platforms or personal virtual wallets, they’ll need to be more careful about keeping their own records.
When is cryptocurrency income?
If your client received cryptocurrency as payment for services or mined new coins, then it should be regarded as income. They’ll need to keep track of the cryptocurrency’s fair market value in U.S. dollars on the day it was received. They’ll report it using Form Form 1040, U.S. Individual Tax Return, Form 1040-SS, Form 1040-NR, or Form 1040, Schedule 1, Additional Income and Adjustments to Income, as applicable.
How are NFTs taxed?
Non-fungible tokens (NFTs) can be any type of digital item such as a piece of art, a song, a news column, a trading card, or other collectible. Their ownership is verified and tracked using the blockchain, and they are often bought and sold using cryptocurrency such as Ether. Since the IRS hasn’t issued guidance specific to NFTs, they are a point of confusion for many crypto traders and tax professionals alike. While NFTs aren’t technically cryptocurrency, they are blockchain-backed digital assets and face similar tax laws.
When they are purchased using cryptocurrency (as they almost always are), this is a taxable transaction for the buyer. The IRS regards this as converting the cryptocurrency to “real,” government-backed currency like the U.S. dollar and then using those dollars to purchase the NFT. If the currency grew in value from the time the buyer first acquired it to the time they “sold” it to buy the NFT, the purchase would result in capital gains. Similarly, if the cryptocurrency had gone down in value, the purchase of the NFT would result in a capital loss. Selling an NFT for cryptocurrency also results in a capital gain or loss.
Creators of NFTs will be subject to regular income tax for the sale of their digital items. If they create NFTs as a business, they can deduct the expense of creating and minting their NFTs. If creating NFTs is simply a hobby, however, they won’t be able to deduct the associated expenses.
What happens if you don’t report cryptocurrency on taxes?
As with any other form of taxable income or investments, it’s important that your clients accurately report their cryptocurrency transactions. If the IRS suspects that they aren’t, your clients could find themselves facing an audit. Beginning in 2023, cryptocurrency exchanges will be required to issue Form 1099-B to taxpayers and the IRS for cryptocurrency transactions. Any discrepancies between your clients’ tax returns and the 1099-Bs issued by the exchanges will be an automatic red flag to the IRS.
For the 2022 tax year, tracking those transactions is still the responsibility of the taxpayer. In most cases, the IRS will not receive a 1099-B from the cryptocurrency exchange, but that doesn’t mean taxpayers can get away with hiding their crypto investments. If your clients know they have not complied in previous years, now is the time to work on reporting and paying up if they want to avoid an audit in the future.
What are the tax preparer’s responsibilities when it comes to cryptocurrency?
In certain situations – such as when a client claims the Earned Income Tax Credit – professional tax preparers have a legal responsibility to perform due diligence and ensure that their clients are telling the truth on parts of their tax return. No due diligence laws exist for cryptocurrency, and the IRS does not issue specific questions that tax preparers should ask their clients about virtual currencies.
However, it’s still to you and your clients’ benefit to ask a few questions about their cryptocurrency. First off, be sure to ask if they have any cryptocurrency at all and inform them that they are required to report their cryptocurrency activity to the IRS. Some clients may be genuinely unaware of the reporting requirements. You’ll also want to determine whether the cryptocurrency was received as payment for services or purchased by your client. Ask to see their transaction history from every exchange or platform they use to buy and sell crypto. You can help them determine which events are taxable and what their capital gains or losses were for each transaction. From there, your TaxSlayer Pro software supports Form 8949 and Schedule D (Form 1040), making it easy for you to calculate and report capital gains or losses.
This article was last updated on June 10, 2022.