The Most Trusted 2020 Guide to Cryptocurrency Taxes

Produced by Cryptocurrency Tax Attorneys and Blockchain CPA’s

Overview

This past year TaxBit has helped thousands of taxpayers automate and file their cryptocurrency taxes. Although the IRS released its first guidance specifying that cryptocurrency is taxed as property in 2014, this year brought the first time that the IRS aggressively audited crypto traders. The IRS typically audits two years in arrears, meaning the first and most recent audits were for the 2017 tax year. Notably, the IRS released a question on the newly released 2019 tax forms that asks every taxpayer “[a]t any time during 2019, did you sell, send, exchange, or otherwise acquire any financial interest in any virtual currency.”

With the IRS sending out tens of thousands of audits for the 2017 tax year, and the new crypto question in 2019, there will be increased enforcement going forward. Whether you only need to file crypto taxes for this upcoming year, or if you need to amend previous tax years, TaxBit provides all historical tax forms for its users included in its Plus and Pro plans. TaxBit’s team of tax experts and software developers are here to make the process simple and easy for taxpayers to file their cryptocurrency taxes.

What is the Definition of Cryptocurrency?

The IRS’ Definition of Cryptocurrency is,

“Virtual currency is 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.”

Essentially, the IRS has a broad view of what classifies as virtual currency.


How is Cryptocurrency Taxed?

In 2014, the IRS issued Notice 2014-21, clarifying that 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.

Beginning in 2019, the IRS added a new question to Form 1040 that asks taxpayers “[a]t any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

If a taxpayer answers “Yes” to the new question then the IRS will look to see if the taxpayer filed an IRS 8949 capital gain/loss report for virtual currency transactions. If the taxpayer fails to report their cryptocurrency taxes then the IRS can now prove intentional disregard for knowingly failing to report cryptocurrency taxes. 

Fortunately, similar to the sale of stock, 26 U.S. Code § 1211 of the Internal Revenue Code provides relief in the form of a deduction for losses on capital assets. If taxpayers had net capital losses on their cryptocurrency for the year then they may be eligible for an increased tax refund.

Non-Taxable Events

Cryptocurrency is taxed as property, meaning you must report gains/losses when disposing of an asset. Importantly, transferring assets between exchanges does not constitute a disposition of an asset and should not be reported as a taxable transaction. Similarly, buying cryptocurrency is not a taxable event, rather it sets the taxpayer’s cost basis in the asset. Gifting cryptocurrency is also not a taxable event. (excluding large gifts that may trigger other tax obligations). 

Cost Basis Methods

After much anticipation, the IRS issued guidance on acceptable cost basis methods for calculating gains/losses on cryptocurrency.

Prior to the IRS’ guidance there were numerous potential cost basis assignment methods taxpayers were choosing from including:

  • First in First Out (FIFO)
  • Last in First Out (LIFO)
  • Highest Cost
  • Lowest Cost
  • Average Cost
  • Specific Identification

However, the IRS’ new guidance specifically allows for only two cost basis assignment methods:

  1. First in First Out (FIFO)
  2. Specific identification

The IRS’ preferred cost basis assignment method is FIFO. Pursuant to FIFO, the first assets that you purchased will be the first assets that will be disposed of. In the example above using FIFO for the disposition of 2 BTC would result in taxable gains of $7,000.

Pursuant to the IRS’ recent revenue ruling, taxpayers may also use specific identification to report cryptocurrency taxes. Specific identification allows taxpayers to select which assets they are disposing of. For example, in the previous example the taxpayer is able to specifically identify that they are disposing of assets that were acquired on July 1 and September 1. Using the same example of disposing of 2 BTC above, using Specific ID would result in a $2,000 net capital loss as opposed to a $7,000 net capital gain.

Using Specific ID to Select which assets you are disposing of can optimize your taxes. For example, it is typically better to dispose of assets that have a higher cost basis. Disposing of assets that have a higher cost basis will result in a lower overall tax liability. TaxBit automates the process by specifically identifying the assets with the highest cost basis for disposition and therefore lowering realized taxable gains.

Taxpayers could arguably still file using specific identification, but then choose to allocate their asset’s basis based according to LIFO or another tax calculation method. TaxBit takes the position that using Specific ID and allocating according to LIFO makes little sense because if a taxpayer uses Specific ID then it almost always makes more sense to dispose of the highest cost basis asset.

Cryptocurrency Fees & Cost Basis

Prior to the Tax Cuts and Jobs Act (TCJA) certain investment-related expenses were eligible for itemized deductions. For tax years 2018 to 2025 these deductions have been eliminated. However, cryptocurrency traders can still save money on their transactions fees by adding the cost of fees into their cost basis on the acquisition of crypto and deducting fees from the proceeds from the disposition of the asset.

Prior to 2018, if taxpayers chose to claim the itemized deduction and deduct cryptocurrency exchange fees as investment related expenses, then they would not be eligible to adjust their cost basis for fees.

However, in 2020, with the investment-related expenses itemized deduction eliminated, taxpayers can account for all fees the same way by adding them into the acquisition and disposition costs.

Example of Fees when Purchasing Cryptocurrency

If a taxpayer buys $10,000 worth of Bitcoin and pays $500 in fees, then the IRS allows you to report a cost basis of $10,500. Adjusting for fees allows a lesser realized taxable gain.

Example of Fees when Selling Cryptocurrency

This same example applies inversely for fees from proceeds from selling cryptocurrency.

If the taxpayer sells their Bitcoin for $11,000 and pays $500 in fees, then the IRS allows the taxpayer to deduct the $500 from the proceed amount. In this example the taxpayer would report proceeds of $10,500 from selling the crypto.

In the above example, if fees were not accounted for then the taxpayer would have a cost basis of $10,000 in the Bitcoin and proceeds of $11,000. This would result in a $1,000 taxable gain. However, if fees are accounted for then the taxpayer would have a cost basis of $10,500 and proceeds of $10,500, leaving them with no taxable gains.

Tax Rate (long-term versus short-term capital gains)

The United States distinguishes between long-term and 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. Capital gains tax rates on assets held for less than a year correspond to ordinary income tax brackets (10%, 12%, 22%, 24%, 32%, 35% or 37%).

For single filers you will pay:

  • 0% in long-term capital gains if your income is $0-$39,375
  • 15% if your income is $39,376-$434,550
  • 20% if your income is $434,551 or more

For married filers filing jointly you will pay:

  • 0% if your income $0-$78,750
  • 15% if your income is $78,751-$488,850
  • 20% if your income is $488,851 or more.

Capital Loss Deduction/Carry Forward

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.

Other Cryptocurrency Events

A) Mining Income

Mining cryptocurrency has a unique problem of creating multiple tax implications that must be reported on separate forms. Fear not, TaxBit’s cryptocurrency tax software clears up this confusing paradox and ensures proper capital gain/loss and ordinary income tax reporting.

Pursuant to IRS Notice 2014-21, 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 taxpayers 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.

B) Mining Deductions

If you mine cryptocurrency as a trade or business, then you may be eligible for certain deductions to lessen your tax liability. § 162 of the Internal Revenue Code states:

“[t]here shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

Miners may deduct certain expenses from their mining income.

Some estimates place the annualized global mining revenues at ~$5.6 billion and global mining expenses at $3.6 billion. These statistics show that expenses may account for greater than 50% of the income received from mining.

Some frequent expenses that may be eligible for the trade or business expense deduction include:

  • Mining equipment
  • Electricity costs
  • Repairs
  • Rented space used to operate the equipment

(i) Equipment

Miners may deduct the cost of their mining equipment from their ordinary mining income. If the mining equipment exceeds $1 million in costs the taxpayer may need to use the modified accelerated cost recovery system (MACRS) to determine how to depreciate the equipment for tax purposes.

(ii) Electricity Costs

A large cost to mining cryptocurrency is the price of electricity. The energy used worldwide to mine cryptocurrency is equivalent to the energy consumption of the country of Australia. Electricity costs are an expense that if properly documented may be eligible for the trade or business deduction. To properly document your electricity costs you should track the amount of electricity that is used solely for mining. If you are mining from your residence then you will need to track and allocate the amount that is attributable to mining. Therefore, if you mine from your residence then you should use a seperate meter to ensure you can properly allocate the energy consumption from mining. It is important to track the electricity costs from mining because you may only deduct business expenses are not eligible to deduct the electricity costs that you used for your residence.

(iii) Repairs

If your mining equipment required repairs during the year then the repair expense may be eligible for the trade or business deduction. You should save receipts to validate the expenses in the event of an audit.

(iv) Rented Space

If you rent a space to hold and run your mining equipment then you may be eligible to deduct the rental costs as an expense. If your mining equipment is located at your residence then this will be treated similar to a home office and may be more difficult to deduct the expenses. See the rules applicable to the home office deduction to see if you are eligible to deduct costs for the business use of your home.

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.

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.

IRS Enforcement of Cryptocurrency

All taxpayers are required to attest to whether,

“[a]t any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

Additionally, exchanges are required to issue their users 1099 tax forms that show that crypto activity occurred on the platform.

If a taxpayer checks “yes” to the cryptocurrency question then the IRS will look to see if the taxpayer filed an IRS 8949 tax form representing their cryptocurrency taxable events. If a taxpayer answers “no” dishonestly to the question and then is subsequently issued a 1099 tax form from an exchange, then the IRS can now prove “intentional tax evasion.” It is recommended to answer honestly.

In 2019, TaxBit helped facilitate hundreds of cryptocurrency audits. The IRS is aggressive in sending taxpayers CP2000 notices if the taxpayer was issued a 1099, but failed to file their cryptocurrency taxes.


CPA Designed Audit Trail

Many cryptocurrency tax softwares provide a taxpayer with tax forms with no information regarding how the users’ gains/losses were calculated. Because of the lack of insight into how cost basis was allocated and gains/losses calculated, results tax results often vary drastically among software providers.


Foreign Reporting Requirements

There has been much debate whether assets held on a foreign virtual currency exchange are required to be reported on FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR). 

The AICPA Virtual Currency Task Force reached out to Treasury’s Financial Crime Enforcement Network (FinCEN) to answer whether cryptocurrency on offshore exchanges requires FBAR reporting. FinCEN responded that regulations (31 C.F.R. §1010.350(c)) do not define virtual currency held in an offshore account as a type of reportable account. Therefore, cryptocurrency does not need to be reporting on an FBAR as of now.

Tax Forms from Exchanges (1099-K/1099-B)

1099-K

A few cryptocurrency exchanges have issued 1099-K’s, which is an informational return that sums up the total value a user has received throughout the year. This form leads to reporting of income when no income was actually generated on an exchange.

If you received a 1099-K from a cryptocurrency exchange then you also likely received (or will receive) an IRS CP2000 letter for unreported income two years later.

1099-K’s issued by some exchanges report only the total value exchanged and fail to include proper adjustments for cost basis.

For example, if a user purchases $100,000 of cryptocurrency and then sells it a month later for $90,000, then both the user and the IRS will receive a 1099-K form showing income received of $90,000. Form 1099-K is intended for users who generate income on a platform, such as Ebay and Etsy sellers. 

Most taxpayers correctly don’t report the grossly inflated 1099-K amount as income on their tax return. As a result, the IRS cross checks the 1099-K against the taxpayers income and then issues a CP2000 audit letter for failing to report the income.

Worse yet, TaxBit has helped many taxpayers whose accountants weren’t aware that their client’s 1099-K was inaccurate and actually reported the amount listed on a taxpayer's 1099-K as income. 

1099-B

1099-B’s on the other hand report cost basis when available and are designed to be transposed onto an IRS 8949. Gains reported on an IRS 8949 are taxed pursuant to capital gains treatment instead of ordinary income. Many exchanges are seeing the problems 1099-K’s have caused and are beginning to file 1099-B’s. This is leading to more accurate tax reporting and will eliminate the automatic IRS audits sent out to 1099-K recipients related to unreported income. 

More About TaxBit for Cryptocurrency Taxes

How to File (Forms) With TaxBit

TaxBit automates the process of producing the necessary tax forms for cryptocurrency traders. After a taxpayer downloads their IRS 8949 tax form from within their TaxBit account, they can incorporate the completed form into their full tax return.

If a taxpayer is filing their own taxes then they can easily upload their IRS 8949 tax forms into a popular tax filing software such as TurboTax, TaxAct, or TaxSlayer. Alternatively, if the taxpayer uses an accountant to file their tax return then they can provide their accountant with the completed IRS 8949 tax forms to have them incorporated into their tax return.

All previous tax years included

As a cryptocurrency tax software founded by CPA’s and tax attorneys, we believe in helping taxpayers comply with their tax obligations. To this end, TaxBit’s Plus and Pro plans include all prior year tax forms.

We have found many cryptocurrency traders are just now filing their crypto taxes based on the new cryptocurrency question on IRS Form 1040. Some users wish to amend prior year tax returns to account for their cryptocurrency activity. TaxBit includes prior year tax forms to lessen the burden of taxpayer’s backfiling to be retroactively tax compliant.

Security

Cryptocurrency traders by nature are security and privacy oriented. To this end, TaxBit hired the former Coinbase Compliance Director and former Facebook Policy and Compliance manager on Calibra to manage data security and customer privacy.

TaxBit uses “Read Only” API keys that do not grant access to custody or trading and we never sell or share our users’ information. TaxBit uses database servers hosted by AWS RDS. All data is encrypted using AES 256 in transit and at rest.

Partnerships

TaxBit is the preferred partner of leading cryptocurrency exchanges to automate cryptocurrency taxes for their users. TaxBit is the only cryptocurrency tax service partnered with industry leading exchanges such as Gemini, Uphold, BlockFi, and CEX.IO.

Venture Capital Raise

TaxBit has raised over $5 million in funding from the leading Venture Capital firms in the industry such as; Winklevoss Capital, Valar Ventures, Dragonfly Capital, Collaborative Fund, Global Founders Capital, TTV, Album, and more.

TaxBit has a large team that includes:

  • Software Developers
  • CPA’s
  • Tax Attorneys
  • Compliance and Support Representatives

TaxBit’s reputation as the most accurate cryptocurrency tax software is evident by TaxBit’s strong portfolio of investors and its preferred partnerships with leading exchanges.


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