Cryptocurrency, also known as virtual currency, is a digital asset. Investors and business owners are drawn to it, and so is everyone else – with cryptocurrencies’ values skyrocketing in the past few months, even average people with little investment know-how are getting involved with this new digital money. Backed by mathematical algorithms and software rather than the government or a big bank, cryptocurrency isn’t heavily regulated. While the chance to be your own bank captivates many, there’s also a danger hiding in cryptocurrency: taxes.
Since cryptocurrency has only existed for a decade, the government is still catching up when it comes to taxation. Early crypto adopters were able to avoid any liabilities for their holdings. However, if you’re a regular investor or purchaser, your cryptocurrency will most likely impact your obligations and tax returns.
Do you know if your cryptocurrency is held to the same tax law as your hard-earned dollars? The question of tax obligations for cryptocurrencies is a big one this year, and it’s important to know whether or not you need to pay up when you file your tax return.
How is Cryptocurrency Taxed?
Cryptocurrency’s digital nature means it’s extremely liquid. While it’s easy to complete transactions with people around the world, only a few nations have begun regulating this new currency for tax purposes.
In the U.S., virtual currency counts as a form of property for tax purposes. This has been the standard since the IRS published a guidance document in 2014. What does this property status mean for cryptocurrency holders? Here are a few important takeaways:
Those who make virtual currency payments need to report the details the same way they would when using cash.
If you pay employees in cryptocurrency, you need to withhold and report taxes.
Self-employment tax rules apply to independent contractors, freelancers, and service providers who accept cryptocurrency payments.
Gains and losses derived from buying or selling cryptocurrency should be included in taxes. This affects your tax return if the cryptocurrency counts as a capital asset (something that you own or utilize for investment, personal or pleasure reasons as defined in IRS Publication 544).
Do You Need to Report Your Cryptocurrency?
Your use of cryptocurrency determines what you’re able to report or not report on your tax returns. For instance, you might not have to worry about reporting capital gains on crypto that you acquire to fund your payroll, but you’d still have to calculate and withhold regular income taxes.
Those who tend to get in trouble with the IRS are those who obtain large amounts of cryptocurrency and then sell it after its value has grown. If you do this and do not report your gains properly, you’ll come under increased regulatory scrutiny. The IRS is cracking down on those who use digital exchange platforms to turn a profit by converting virtual currency as they would with traditional investing.
As a general rule, you’ll incur a tax liability whenever you:
- Exchange cryptocurrency for traditional fiat money, like Japanese Yen, U.K. Pounds, or U.S. Dollars
- Exchange one form of cryptocurrency for another
- Pay for services or goods.
It’s smart to be as cautious as possible. As official documents like IRS Publication 544 make abundantly clear, tax rules for cryptocurrency aren’t exactly straightforward. For instance, you can give someone cryptocurrency as a gift and not pay taxes yourself, but your lucky recipient may incur a gift tax if you transfer more than a certain amount.
How to Properly Document Your Cryptocurrency for Tax Returns
The vague tax law isn’t necessarily problematic if you’re a cryptocurrency holder. In fact, there’s even a benefit to property-status-based cryptocurrency tax obligations: gains and losses don’t come into effect until you sell your cryptocurrency. This distinction has some important implications, including that:
- You can hold some cryptocurrency for years before incurring a liability
- You should use the fair market value of the cryptocurrency you’re trading at the time of the trade to determine gains and losses
- Hold onto cryptocurrency for a year or more and you can pay long-term capital gains tax rates, which are significantly lower than their short-term alternatives.
Unsure whether you had a long- or short-term gain? For tax accounting, the period of ownership begins the day after you initially acquired the asset, and it ends on the day you sold it. From there, you’ll be responsible for capital gains tax rates based on the total taxable income you report. For 2017 tax returns, this means that
- You’ll pay around 20 percent on long-term gains if you fall beyond the high-earner 39.6 percent maximum tax bracket
- You might pay nothing on long-term gains if your tax bracket is between 10 percent and 15 percent
- You’ll pay whatever your normal tax rate is if you claim short-term gains.
If you received cryptocurrency from events that don’t occur with other types of investments, such as Coinbase’s 2017 distribution of Bitcoin Cash, then you’ll need to report it in your return for the year. This distinction between two similar virtual currencies, Bitcoin and Bitcoin Cash, just goes to show that not all digital assets are viewed equally by the IRS. In short, each specific tax situation should be handled on a case-by-case basis.
Penalties You Could Face for Nonpayment
Neglecting your tax obligations is a dangerous idea. According to Publication 594, the IRS can take action by charging you late fees, garnishing your wages, or seizing your property and assets. They might also prosecute you for tax evasion, especially if you make enough money trading virtual currency for the IRS to subpoena your transaction history from a major exchange.
In short, pay taxes on your cryptocurrency, and if you’re not sure how to get started, talk to an expert. Acting proactively rather than reactively can prevent financially damaging tax situations.