The past decade of investing in cryptocurrency has been the equivalent of a modern-day gold rush for casual and sophisticated investors. Those who have followed the journey of Bitcoin (BTC) have seen people spend 2 BTC on a pizza back in 2011 when 2 BTC could buy a luxury automobile today. Nowadays, BTC is not the only player, and an explosion of cryptocurrencies has entered the market, with each providing promising solutions using blockchain technology.
CleverProfits clients are typically savvy business owners with higher risk tolerance and have invested quite a bit of their excess business profit into cryptocurrency. Many of our clients simply buy and hold, but a few risk seekers have turned into complete degenerates entering previously uncharted territory with sophisticated yield farming strategies for maximum returns.
Unfortunately, dealing with crypto tax is a massive headache for any investor who has put money into this. Our goal is to help educate you on the fundamental tax issues around basic crypto investing strategies surrounding buying, selling, creating, mining, and exchanging cryptocurrency.
Fundamental rules of property taxation
Cryptocurrency is treated as property by the Internal Revenue Service (“IRS”). When you buy a piece or all of a cryptocurrency, you buy property much like you would buy a share of stock. It just happens to be an intangible piece of code instead of a stock certificate that you own the rights to.
Let’s say you’re feeling lucky and you decide to buy 1 BTC for $40,000. Your tax basis in that 1 BTC is $40,000. That means in the future, when you have a recognition event, you will be able to offset your proceeds by your tax basis of $40,000. If you sell your 1 BTC tomorrow for $60,000, you can offset the proceeds on that by your tax basis of $40,000 and recognize a gain of $20,000 on your tax return.
|Gross Proceeds on Sale of 1 BTC||$60,000|
|Less: Tax Basis in 1 BTC||($40,000)|
|Taxable Gain on Recognition Event||$20,000|
This makes fundamental sense under the tax rules because you should only pay taxes on your appreciation.
Now, what constitutes a recognition event that would trigger a tax hit? Under the tax rules, a recognition event occurs when you sell or exchange your property. This means under a few examples:
- if you sell your 1 BTC for dollars, you have a taxable event
- if you trade your 1 BTC for 10 ETH, you have a taxable event
- if you trade your 10 ETH for 1 Bored Ape NFT, you have a taxable event
- if you pay for a pizza with 1 BTC, you have a taxable event
- consuming 0.1 ETH in gas or transaction fees is a taxable event
These taxes can add up quickly even though you never exchanged that final 1 NFT for real dollars, which creates taxable gain for you even though you have not received any cash to pay the tax. For this reason, crypto investors have to be extra vigilant when they are selling or exchanging their crypto. Even if all of your crypto is still sitting in your Coinbase account, you are creating a recognition event if you trade one for another.
TIP: One goal as a crypto investor should be to avoid creating recognition events to shelter it from taxation and preserve your capital.
Character of gain
The last piece of the puzzle is what type of tax gain you will have. The importance of the character of your gain cannot be understated. Savvy investors know that long-term capital gains are the most favorable in the tax code with a maximum 23.8% federal tax rate. This lower tax rate is much more favorable when compared to the 40.8% highest marginal rate on investment income. To the extent possible, we want to maximize long-term capital gains.
Short-term capital gains are still taxed at the highest marginal rate so they aren’t that favorable except to absorb other capital losses. Net capital losses cannot be deducted beyond $3,000 per year, and any excess must be carried forward to future years.
For the character of your crypto gain to be capital, it must be a capital asset to you. This is an easy requirement since most people purchasing crypto buy it as an investment. However, if you are day trading full time, the gain could be ordinary in nature. It depends on how you approach buying and selling crypto.
To be long-term capital gain, you must hold your property for at least 366 days before selling or exchanging it.
Mining and staking rewards
Mining and staking rewards are a little different because, in our view, they are generated by you for work you are doing with your computer or existing crypto. The IRS treats mining rewards as ordinary income, which means you will have an ordinary income recognition event every time you receive a reward.
For example, let’s say you mine a block and receive 0.0001 BTC worth $0.40. You will recognize $0.40 on your tax return and have a tax basis in the 0.0001 BTC of $0.40 – the exact amount that you recognized into ordinary income.
One important thing to note is that these rewards will be self-employment income and subject to self-employment tax. Self-employment tax is the federal government’s way of getting you to contribute to social security and medicare. Some investors opt to treat their rewards as part of an S-corporation, but we don’t recommend this because you don’t want to lock up appreciated property in an S-corporation.
Let’s say you decide to buy another 1 BTC for $50,000 on May 1, 20×1, and 1 BTC for $60,000 on June 1, 20×1. You sell one BTC. How do you know which is taxed?
The IRS lets you choose to specify exactly which one you sold. This requires you to keep highly diligent records on all of your crypto purchases, sales, and exchanges so you can keep tabs on what is being traded and when.
You can also go with a simpler first-in, first-out (“FIFO”) approach. Some investors prefer using the last-in, first-out (“LIFO”) approach because their tax basis is higher for later purchases, and they realize their gain will be lower that way. Whatever method you choose, you must track it and it must be consistent every year.
The best way to go about keeping tabs on all of your crypto purchases, sales, and exchanges is to use software to track everything. The #1 tool we have seen used in crypto communities is https://cointracking.info (we don’t get a commission for referring you.) You can plug in your exchanges and wallets using APIs or importing CSV data into your account, and CoinTracking will calculate your balances and your tax gain at the end of the year. You can provide these reports to your CPA or EA, who will use them to prepare your income tax returns and calculate your tax liability on crypto gains.
This is way too confusing…
It gets even worse when we start diving into advanced crypto investing strategies, NFT sales, and more. If you need help navigating the crypto tax rules, CleverProfits helps our CFO clients navigate their taxes fluidly and efficiently. Schedule a consultation with an advisor today.