Clarifying the US tax code implications for cryptocurrency
Here we are once again in the beginning of a new year. If you're like me, your attention has invariably turned to getting your financial records in order to make dealing with the IRS a little less unpleasant. Unfortunately, where cryptocurrency is concerned, there is a lot of misinformation publicly available. We'll attempt to set the record straight once and for all and hopefully explain it in a way that just about anyone can understand in keeping with the stated goals of Coins Demystified.
DISCLAIMER: Before we proceed any further, it should be made absolutely crystal clear that what is described below is NOT TAX ADVICE. This is to help you get a better understanding of what you are up against so that you are fully aware of what you should be paying to the United States government, and to be able to have a more intelligent conversation with your tax professional. You should always seek the advice of a certified public accountant (CPA) or other qualified tax professional.
Now for the (not so) fun stuff...
The purchase of a cryptocurrency in and of itself isn't a taxable event. However, please note that you absolutely should note the date of the purchase, and the value of the purchase in US dollars. These two pieces of information are critically important. The US dollar purchase price will be the cost basis for your purchase.
Selling your cryptocurrency for fiat (US dollars):
When a sale of cryptocurrency is made, this IS A TAXABLE event. There are no exceptions. You will owe capital gains (or take capital losses) on the sale of your cryptocurrency.
Example: You purchase 10 Litecoin at $100 per coin, and sell 5 of them for $150 per coin. You will owe 5 * $50, or $250 in capital gains.
Note: It does NOT matter what you do with the fiat currency once you cash out. We'll get into this in a few minutes.
It is obvious why the purchase price matters in this context, but remember we noted that you should also record the date of the purchase. Why would you note this? The IRS considers cryptocurrency an asset that is subject to capital gains taxes, but depending on how long you hold your cryptocurrency for, the taxable rate changes. If cryptocurrency is held for more than one year, then the rate is 15%. If, however, you sell your cryptocurrency before a single year has passed (365 days, not a calendar year) then you will owe capital gains taxes on your nominal taxable rate (i.e., what the IRS taxes your other standard income at). So my advice to everyone is to hold on to your cryptocurrency for more than one year, simply because you'll pay less in taxes.
Trading your cryptocurrency for another cryptocurrency:
This is the single largest source of misinformation on the internet. Many people will tell you that you can perform a like-kind exchange. What this means is that if you trade in one cryptocurrency for another you don't have to pay taxes. THIS IS NOT THE CASE! I can not stress this enough. There is NO like-kind exchange in the cryptocurrency world. Let's look at a real-world example:
Example: You purchase 10 Litecoin at $100 per coin, then trade 5 coins at $150 each for 1.0 Dash. How much tax are you liable for?
In this particular example, we start with the same thing as in the example provided previously. Your capital gains will be 5 coins x $50 per coin, or $250 in capital gains. If you held longer than a year, then you will pay at a 15% taxable rate. However, the $750 that you spent (5 coins x $150 per coin) now becomes the cost basis of your Dash investment. If you turn around in a year and sell that 1.0 Dash for $950 (remember you purchased for $750), then your capital gains calculation would be $200 ($950 - $750), which would be taxable at either 15% if you held longer than a year, or at your nominal tax bracket rate if you sold the Dash before one year of holding.
Wallet to Wallet Transfers:
A transfer from a wallet on your exchange to your hardware wallet (i.e., a Trezor or Ledger Nano S) is NOT a taxable event. However, records of these transactions may be included by your exchange for reporting purposes, so please ensure to check over records thoroughly.
Believe it or not, mining is ALSO a taxable event. If you are solo mining (probably not advisable), then when you solve a block and receive the block reward to your wallet, the value of that reward in US dollars is your cost basis. Record the date and price when that reward is received.
Let's face it, though. Most people don't solo mine. We're mostly involved in mining pools which pay out a fraction of a coin each time a block is solved. Are you expected to keep track of when every single block reward comes your way? The answer is NO. All mining pools have a payout threshold. When the number of rewards you have accumulated meets or exceeds that threshold, your coins are transferred to the wallet of your choice. Many pools pay out after you have mined 5 coins. When these 5 coins drop into your wallet, you need to record the date and value in US dollars of that event for your cost basis. This is considered a part of your INCOME. Now, you are taxed when the coins drop into your wallet at your nominal tax rate, PLUS you get taxed a SECOND time for capital gains when you convert to fiat or make a trade to another cryptocurrency. Yes, you are double-taxed. Of course, this is little different from being taxed on your wages that you then invest in cryptocurrency. One way or another you're double-taxed. This makes one more reason why an outright purchase of coins on an exchange is a better investment than is the purchase of a miner.
Payment In Cryptocurrency:
Accepting wages of any kind in the form of cryptocurrency is also a taxable event. Just as with mining above, it is considered a part of the person's INCOME, and is taxable as such. As the recipient, you need to record the date and value in US dollars of what you have been paid.
Payment to contractors in cryptocurrency is similar to accepting wages above. If you are paying anyone in cryptocurrency instead of US dollars, you need to complete a 1099 form for the value in US dollars of the cryptocurrency paid to the contractor. The recipient is responsible for self-employment taxes.
Likewise, if you are paying an employee(s) in cryptocurrency, those are taxable wages that should be reported on a W-2 form (with the equivalent value in US dollars) and those wages are subject to the standard federal income tax withholding and payroll taxes.
We hope that everyone reads and understands the above rules regarding the taxation of cryptocurrency and the current stance of the United States government. Failure to properly pay your taxes will result in additional interest on unpaid taxes if you are ever audited in the future, so it is always best to play by the rules to avoid any potential problems in the future. Again, we implore everyone to consult a qualified tax professional as the above are the Federal rules for taxation only. Your state may have additional rules to which you may be subjected. Remember, attempting to hide assets is tax evasion, and is a federal offense.
Here are some references for more information:
https://cryptocurrencyfacts.com/2017/12/30/the-tax-rules-for-crypto-in-the-u-s-simplified/ (if this page is unavailable, Google has a cached version here: http://webcache.googleusercontent.com/search?q=cache:iYPdPRffpsEJ:cryptocurrencyfacts.com/2017/12/30/the-tax-rules-for-crypto-in-the-u-s-simplified/+&cd=1&hl=en&ct=clnk&gl=us)