Taxes and Crypto
[Disclaimer: I’m not a tax expert. Consult tax experts before engaging in financial decisions. TaxBit is a sponsor. Use the promo code “dheld” for 25% off their service]
I’m a libertarian, so naturally, I’m not a fan of taxes.
But as Bitcoin became more mainstream in 2013, various regulatory agencies came out of the woodwork to opine as to what aspect they wanted to govern.
The IRS came out with its guidance in 2014, which clarified that virtual currency is treated as property for tax purposes.
My dad is a tax CPA, so early on I was exposed to how CPAs think through crypto and taxes.
And one of my friends from high school, Jake Benson, started the first crypto tax startup called “Lukka” where I was an advisor.
This newsletter will be focused only on US customers. Unfortunately, it would take an eternity to write about every geography.
Before we go further if there is just one thing I could convey to you it would be the section below on “Tax Loss Harvesting” which could save you a HUGE amount of money in taxes. But you have to act before the end of year!
How is Crypto Taxed in the US?
Virtual currency is treated as property for tax purposes. This means that cryptocurrency is taxed as a capital asset and every taxable event must be reported on an IRS 8949 cryptocurrency tax form. Now over the years, there were many other types of crypto assets + a spectrum of taxable events:
Forks: The IRS takes the position that hard forks that result in an airdrop of a new currency are akin to a dividend for tax purposes. Put simply, a hard fork occurs when a distributed ledger undergoes a protocol change resulting in a permanent diversion of the continuing historical ledger through a new airdropped token.
Airdrops: The IRS takes the position that you are taxed on the fair market value of the airdrops when you have “dominion and control” of airdropped tokens. A taxpayer has dominion and control when an exchange issues the airdropped token into the taxpayer’s account. With a self custodied wallet, that is assumed to be the case.
DeFi: Here are some of the most common types of activities:
Lending: Lending out your cryptocurrency generates interest, which can be taxable as ordinary income or capital gains depending on the DeFi platform.
Receipt of incentive tokens: Some platforms issue tokens to reward their users, which are generally taxable as ordinary income at their fair market value upon receipt.
Transfers into tokens and liquidity pools: In general, it’s safest to assume that these transactions trigger capital gains and losses.
DeFi is one of the most rapidly evolving areas of the cryptocurrency industry. Again, the IRS has yet to issue any specific guidance, but it’s generally safest to assume similar rules apply to those that govern other crypto transactions. When in doubt, always consult a tax professional.
NFTs: NFTs are usually capital assets, just like digital currencies. You can either create NFTs to sell in a marketplace, or you can invest in them to buy and sell as a trader.
Investors should generally treat them as property and follow the typical rules for capital gains and losses. It is possible, however, that NFTs could be viewed as collectibles. The IRS defines collectibles as:
Any work of art,
Any rug or antique,
Any metal or gem (with exceptions),
Any stamp or coin (with exceptions),
Any alcoholic beverage, or
Any other tangible personal property that the IRS determines is a "collectible" under IRC Section 408(m).
Collectibles are subject to a 28% long-term capital gain tax rate, regardless of income levels. The IRS has yet to confirm which NFTs are subject to collectible rules. However, it’s important to note that the difference only comes into question when assets are held for over one year.
With that being said, any NFTs sold after a holding period of less than one year will be subject to short-term capital gains tax rates (which equals ordinary income tax rates), regardless of whether they’re viewed as property or collectibles.
Mining: When a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income. This means that successfully mining cryptocurrency creates a taxable event and the value of the mined coins must be included in the taxpayer’s gross income at the time it is received.
Selling mined cryptocurrency also creates a second taxable event. The value of the cryptocurrency at the time it is mined (the amount included as ordinary income) becomes a taxpayer’s cost basis in the capital asset. When a taxpayer sells mined crypto then the amount received will be reported as proceeds and will be offset against the taxpayer’s cost basis in the asset. If the value of the crypto is higher at the time of the sale, then the taxpayer has a capital gain. If the value is lower then the taxpayer will have a capital loss. Every sale or trade of mined crypto must be reported on an IRS 8949 cryptocurrency tax form.
Staking: There is no specific IRS guidance on the taxation of staking yet. The best we have currently is Notice 2014-21, which is the tax guidance on mining income.
The notice states that you should report crypto income at the time of receipt for rewards, and a taxable event also occurs when you sell the mined currency. The current interpretation of the notice is that staking rewards are taxable as ordinary income upon receipt.
However, this 2014 notice fails to consider the inflationary effect of newly staked tokens and the ordeal of initiating a taxable event each time there are new tokens, which could be multiple times every day.
It’s been theorized that the IRS may issue guidance stating that taxpayers should consider staking rewards to be the creation of new property. In that case, there would be no taxable event until the sale of the property. That would do away with the need to regard their dilutive and inflationary effects on the wealth of a user. For now, though, staking rewards remain taxable as ordinary income, just like earnings from mining activities.
Regardless of the type of asset you’re trading, these next sections are applicable:
Tracking cost basis
Tracking Cost Basis
Cost basis = original cost when you bought the asset. When you have multiple units of the asset, say 3 Bitcoin or 4 shares of Uber, you need to track which exact units you sold. It’s typically better to dispose of assets that have a higher cost basis because that reduces the gains you’ve realized.
Prior to their highly anticipated 2019 guidance, there was some ambigiutiy as to which methods were acceptable. Here is what people would previously choose from:
First in First Out (FIFO): first units in are the first ones sold
Last in First Out (LIFO): last units in are the last ones sold
Highest Cost: highest cost units are the first ones sold
Lowest Cost: lowest cost units are the first ones sold
Average Cost: total number of dollars invested divided by units
Specific Identification: tracking specific units
However, the IRS’ new guidance specifically allows for only two cost basis assignment methods which are listed below with graphics for further clarity if you hadn’t already grasped the concept.
First in First Out (FIFO)
The United States distinguishes between long-term and short-term capital gains.
Short-term Capital gains
If you hold a particular cryptocurrency for one year or less your transaction will constitute short-term capital gains. Short-term capital gains are added to your income and taxed at your ordinary-income tax rate.
Long-Term Capital Gains
If you held a particular cryptocurrency for more than one year then you are eligible for tax-preferred long-term capital gains. In 2018 the capital gains tax rates are either 0%, 15% or 20% for assets held for more than a year. I don’t want to bore you by going into what income levels each one of those represent, but you can check it out here.
The difference between your capital gains and losses is called your “net capital gain.” if your losses exceed your gains, you can deduct the difference on your tax return, up to $3,000 in losses per year. If you have net capital losses for the year that exceed the deductible amount then the IRS allows you to carry the excess into the next year, allowing you to deduct it on that year’s return.
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Tax Loss Harvesting
If everything before this has been a bit boring, I get it. However, you’ll want to pay attention to this section.
Tax-loss harvesting is an investment strategy that maximizes after-tax returns by taking advantage of dips in cryptocurrency market prices. Imagine if you could appreciate wealth over time while in the process increase your tax refund, or at a minimum reduce what you may owe in taxes. Tax-loss harvesting does exactly that!
How it works
Let’s say you want to HODL Bitcoin long-term, but you’ve bought higher than where the price is at today.
You can sell Bitcoin to realize the loss, then immediately buy it back. You’ll have the exact same amount of Bitcoin, but now have the losses to offset gains. This is called “wash trading.” A common question is whether or not there is any risk of the wash sale rules applying to crypto. At this time, wash sale rules specifically apply only to stocks and securities, not crypto.
This technique may not exist forever. If the infrastructure bill is passed, it may reduce or close this loophole.
How am I possibly going to do my taxes?
Picking the right tax software
There are many tax software products out there. None are perfect.
It’s nearly impossible to automatically reconcile various exchange, DEX, on-chain, etc. transactions. But what these tools can do is do some of the heavy lifting, and get you closer to your goal.
After seeing all these tools, I think TaxBit is the solution that fits the bill. I love the product and the team. In fact, I met the CEO Austin Woodward at his conference booth in 2018 when he was first starting the company. They just hit unicorn ($1B+ valuation) status earlier this year! They’ve partnered with PayPal, Gemini, BlockFi, OkCoin, Coinlist, etc.
Here’s a sneak peek of their product.
In January they’ll be launching functionality to reconcile DeFi and NFT transactions! So if that’s something you’re trading in, then they should be able to cover most of your transactions.
If you haven’t signed up for a tool yet, or are looking for a new one, I definitely recommend you check them out. They’ve hooked up my newsletter subscribers with the promo code “dheld” which you can use for 25% off your service.
I know it’s a massive pain to connect all these exchange accounts, wallet addresses, CSV exports, etc, but there’s a silver lining to all this tax work you’ve had to do.
If you’re an active trader or participant in the ecosystem, it’s super tricky to track your performance/PnL (profit and loss). With TaxBit you now have that central dashboard where you can monitor everything going on in your crypto portfolio.
I’ll leave you with one last short and sweet note. If you HODL, you don’t have to mess with any of the above ;)
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Thank you for this great report Dan. It helps with understanding what we are up against paying “dues”. It’s been a great year reading your report. Thank you for being there to share your experiences. 👍🏻
This is incredibly useful. Thanks Dan.