The Internal Revenue Service (IRS) broadly classifies Cryptocurrency as "a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the United States dollar or a foreign currency." This broadly defined view by the IRS encompasses all digital currencies.
Most cryptocurrencies are based on blockchain technology. Blockchain technology provides the benefit of being immune from counterfeiting or double-spending. Cryptocurrency that is based on a decentralized blockchain is not bound to a sovereign government and therefore relies on consensus protocols rather than a central authority.
Cryptocurrency exchanges provide market liquidity to buy, sell, or trade cryptocurrency. Similar to an equity broker selling stocks, you can buy thousands of different cryptocurrencies through exchanges. When you purchase cryptocurrency on an exchange it will be deposited into a wallet on their platform. Most exchanges allow the ability to transfer assets into offline hardware wallets, or onto other exchanges. It is recommended to trade on exchanges that have the proper licenses and security measures.
IRS Form 1099
IRS Form 1099 is a federal tax form provided to tax filers who receive money from sources other than their employer. Form 1099 comes in a variety of different types depending on the economic substance of the transaction These include:
- 1099-B for brokerage transactions and barter exchanges, such as a Cryptocurrency trade or sale;
- 1099-C for a cancellation of debt over $600;
- 1099-DIV for income received through dividends or stock distributions of $10 or more;
- 1099-INT for interest of $10 or more earned.
- 1099-R for retirement income;
- 1099-K for third party network transactions relating to the payment for goods or services;
- 1099-MISC for other income; or
- 1099-NEC for non-employee compensation (independent contractor income).
IRS Form 1099-B
IRS Form 1099-B provides a taxpayer with a record of proceeds and cost basis received from broker and barter exchanges. A taxpayer will then need to transfer this information onto an IRS Form 8949 when doing their federal income taxes.
Form 1099-B is generally the form used by brokerage firms to report stock, commodity, or cryptocurrency gains and losses for the year. This form reflects a taxpayer's cost basis, making it easy for the taxpayer to determine their overall tax position for the year.
IRS Form 1099-K
IRS Form 1099-K provides a taxpayer with a record of their payment receipts from sellings goods and services. IRS Form 1099-K is intended for sellers of goods or services, such as Ebay or Etsy sellers. Some cryptocurrency exchanges have previously issued Form 1099-K aggregating a user's trading volume. This approach is incorrect and leads to IRS audits for unreported income. Most exchanges have correctly transitioned to reported trading activity on Form 1099-B.
IRS Form 8949
IRS Form 8949 is filed with an annual federal income tax return and lists a taxpayer's "sales and other dispositions of capital assets," including gains derived from Cryptocurrency transactions. The information required for Form 8949 will generally come from a Form 1099-B provided by a taxpayer's cryptocurrency exchange. TaxBit makes it easy to aggregate information across trading sources and generate the required IRS 8949 tax forms.
Cryptocurrency Losses (I.R.C. §§1211 and 1212)
A Cryptocurrency loss occurs when a taxpayer sells Cryptocurrency for less than their cost basis, meaning the price they paid when they purchased the asset. If a taxpayer has a net capital loss for the year then they may claim the capital loss deduction. Taxpayers may claim up to $3,000 a year in capital loss deductions, as well as carry forward excess losses into future years. TaxBit tracks capital loss carryforwards for its users in order to maximize their tax refund.
Cryptocurrency Gains / Capital Gains (I.R.C. § 1202)
Selling cryptocurrency for more than your cost basis (the price you paid for the asset) will result in a capital gain. Your capital losses will offset capital gains on individual transactions. Capital gains can be either long-term or short-term. A gain will be considered long-term if it was held for more than one year or short-term if under a year. Long-term gains are eligible for favorable tax rates, whereas short-term gains are taxed pursuant to the ordinary income tax rates.
Cryptocurrency Information Reporting
The IRS requires Cryptocurrency exchanges to report certain taxable transactions to a taxpayer and to the IRS on the applicable 1099.. Taxpayers should use the information on the 1099 to complete their taxes. TaxBit specializes in information reporting and is skilled in helping exchanges and users with information reporting.
FIFO Cryptocurrency Cost Basis Method
First in First Out (FIFO) is one of two supported methods for determining the cost basis of Cryptocurrency.
FIFO calculates capital gains according to the difference between the price of the sale and the earliest buy price. For example:
Tina Taxpayer purchased one Bitcoin in January, one Bitcoin in February, and one Bitcoin in March. She then sells one Bitcoin in October and one Bitcoin in December. Tina's gain on the October sale will be the difference in the sales price and the January purchase price, as January was the first purchase date. The December sale will be the difference in the sales price and the February purchase price. And so on. First in, first out, got it?
LIFO Cryptocurrency Cost Basis Method
Last in First Out (LIFO) is an accounting method that calculates gains on the difference between the price of the sale and the most recent buy price. Taxpayers typically have superior tax results through specific identification and therefore LIFO is rarely recommended.
Specific Identification Cost Basis Method
Under Specific Identification, a Cryptocurrency trader can specify which asset it is selling and determine gains/losses based on the cost basis of that specific asset. TaxBit automates this process by selecting the most tax beneficial assets to dispose of. Specific identification is typically the best tax method for minimizing liability.
Cryptocurrency Tax Rate
Cryptocurrency gains are classified as either short or long-term. As of 2020, the long-term (investments held for more than twelve months) capital gains tax rate is as follows:
|Tax Rate||Single||Married Filing Jointly||Head of Household||Married Filing Separately|
|0%||$0 to $40,000||$0 to $80,000||$0 to $53,600||$0 to $40,000|
|15%||$40,000 to $441,450||$80,000 to $496,600||$53,600 to $469,050||$40,000 to $248,300|
Short-term (investments held for less than twelve months) capital gains scale with the federal income tax brackets. The 2020 short-term capital gains rates are as follows:
|Tax Rate||Single||Married Filing Jointly||Head of Household||Married Filing Separately|
|10%||$0 to $9,875||$0 to $19,750||$0 to $9,875||$0 to $14,100|
|12%||$9,876 to $40,125||$19,751 to $80,250||$9,876 to $40,125||$14,101 to $53,700|
|22%||$40,126 to $85,525||$80,251 to $171,050||$40,126 to $85,525||$53,701 to $85,500|
|24%||$85,526 to $163,300||$171,051 to $326,600||$85,526 to $163,300||$85,501 to $163,300|
|32%||$163,301 to $207,350||$326,601 to $414,700||$163,301 to $207,350||$163,301 to $207,350|
|35%||$207,351 to $518,400||$414,701 to $622,050||$207,351 to $311,025||$207,351 to $518,400|
If an asset is in a capital gain position then it can be beneficial to hold the asset for a year in order to realize long-term tax advantaged rates.
Proceeds is the price you sold or traded a cryptocurrency for. If you trade frequently then you will have a larger proceeds amount. Notably, you are not taxed based solely on the proceeds you generate. Rather, deducting your proceeds against your cost basis will give you your gain or loss amount.
A hard fork is when nodes of the newest version of a blockchain no longer accept the previous version. If there is a split in consensus among the newer version and the older version then a new token is essentially created. Most of the time there is consensus and no new token is created. However, if there is a dispute as to the changes made to the blockchain then a new coin will have been created. For example, in 2017 Bitcoin underwent a hard fork and Bitcoin Cash was created. Bitcoin Cash did not receive full consensus and therefore both tokens are no in existence. The new coin that was received will be treated as ordinary income at the time it was received.
Airdrops often come into existence through a hard fork. For example, in 2017 Bitcoin underwent a hard fork and Bitcoin Cash was created and airdropped to existing Bitcoin owners. Airdrops can also occur through promotional incentives, such as watching an educational video.
Initial Coin Offering (ICO)
An ICO is the cryptocurrency equivalent to an initial public offering. However, oftentimes ICO's come from new companies that have not yet developed a product or received traction. In the U.S. it is typically in violation of SEC regulations to distribute tokens through an ICO to people who are not accredited investors.
Margin trading is leveraging your assets in order to have greater market exposure. Exchanges that allow margin will essentially make you a loan with your cryptocurrency as collateral in order to have the potential for greater returns. Trading cryptocurrency on margin can carry greater risks, but have the potential for greater returns.
Mining is the process in which proof of work (POW) protocols verify transactions and give miners cryptocurrency in return for their work. Miners do the work of verifying blockchain transactions and prevent double-spending of assets. This process was developed by Bitcoin's founder, Satoshi Nakamoto.
Staking cryptocurrency is the process of holding cryptocurrency to verify transactions and support the network. Staking allows you to generate passive income by holding coins. The proof-of-stake mechanism avoids the need of the special equipment and energy costs associated with mining.