As each tax deadline approaches, the question of how cryptocurrency is taxed is on many minds. The world of cryptocurrency is a relatively uncharted financial sector that is growing rapidly. Due to its remarkable growth, cryptocurrency has drawn in many first-time investors who are new to owning a digital asset. In this article, I’ll break down how cryptocurrency works and the tax implications involved.
What exactly is Cryptocurrency?
If you’re not familiar with cryptocurrency, it’s a digital currency that can be exchanged online for goods and services. These currencies work using blockchain technology.
Okay, so what’s blockchain? It’s a decentralized technology (spread across many computers) that manages transactions in an online ledger. Because of this technology, cryptocurrency is widely considered the most secure form of online payment.
Bitcoin and Ethereum are the two most popular types of cryptocurrencies.
Ownership of Cryptocurrency
If you want to own or invest in cryptocurrency, you can purchase/invest in the currency in an online exchange. You can buy and sell your shares (called coins or tokens), much like you would any stock.
Since this is an emerging market, there will likely be upcoming changes for how cryptocurrencies are taxed. For this article, I’ll explain how they are currently being treated and I will not make guesses about future regulations.
Cryptocurrency gains are currently being treated the exact same as stock gains, subject to the capital gains tax rate.
Short Term: If you own the coin for less than 1 year and sell it for a gain, that profit is considered ordinary income and will be taxed at your current income tax rate. This ranges from 10%-37% depending on your income
Long Term: If you own the coin for more than 1 year, it is considered a long-term capital gain, the rates for these range from 0%-20% depending on your income.
You will need to report any earnings or losses with cryptocurrencies using the 8949 tax form.
Capital Gain Tax Events
Selling your cryptocurrency for currency (USD, Euro, etc), the gain will be taxed based on how long you held it and your total income. This is pretty straightforward and the most common type of capital gain. Once you cash out your crypto, if you made a profit then you will need to pay taxes on it.
Now let’s take a look at some more complicated situations that yield invisible gains. While these are a little more difficult to track, taxes will still be owed when these invisible gains are realized.
Buying a good or service with cryptocurrency. Using bitcoin as an example, you could have purchased it for anywhere from $150-$500 (if you are lucky and got in early), the value is now hovering around $50,000. If you trade a coin for a good or service valued at the new increased price (like a car) then you need to report that gain on your taxes. Since this is not a direct cash out of your crypto holding, it may not feel like a realized gain, however, it is. This is why we call it an invisible gain; since the increase in value from your cryptocurrency is transferred directly to another asset, it has gained value from your original purchase price. Because of this, a tax event has occurred and needs to be recorded and taxed accordingly.
Swapping one crypto asset for another. This is very similar to purchasing a good or service, however, you are selling one form of cryptocurrency to purchase another one. You still need to report this gain if the coin went up in value from your original purchase. This is another example of an invisible gain. Since an increase in value from your original investment is being used to purchase another digital asset, a taxable event has occurred.
Crypto is here to stay. Many investors are drawn to it for many reasons. However, if you decide to get in on the action you should educate yourself on any implications that may be imposed and make sure you (or your accountant) are recording your earnings correctly.
If you’re looking for additional tax information, check out our articles on the home office deduction during the pandemic, pandemic-related tax deductions (or not), and tax planning explained.