It’s that time of year again when papers are shuffled (even if it is electronically), calculators are dusted off, and prayers to Saint Jude the Apostle, patron saint of lost causes, are said with gusto. Yep, it’s tax season. Going into the third year of the pandemic, you’ve made good use of the time that’s been on your hands. Perhaps you trifled with sourdough and banana bread at the onset of the pandemic and graduated to tinkering with tether and bitcoin. Maybe you even paid for a pizza with some of the bitcoin you earned here and there. You look at the first page of the 2021 IRS Form 1040 and notice the question just under your address:
“At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?”
You might have seen a similar question on the 2020 Form 1040 but didn’t think much of it. At that point, you hadn’t dipped your toe into the world of cryptocurrency. Indeed, a dabble in dogecoin here and there is not anything Uncle Sam is interested in, right? It’s not like you became one of those bitcoin millionaires. But you can’t get rid of this nagging feeling that the time you spent investing in cryptocurrency to winnow away the monotony of the day-to-day had unexpected tax consequences. You start to question what kinds of cryptocurrency transactions are considered reportable tax events and how they are taxed in the first place. Let’s go over some of the nitty-gritty on cryptocurrency and taxes.
First, the essential concept to understand is that cryptocurrency is not treated as money for U.S. federal income tax purposes but is treated as property. All the general tax principles that apply to property transactions will apply to cryptocurrency transactions. This means that some common transactions that generally are not considered taxable events have now become reportable.
Usually, when someone makes a personal purchase using money, the transaction is not taxable. Buying a slice of New York’s finest cheese and pepperoni for dinner with the $10 you have in your pocket would not be a transaction you would report to Uncle Sam. Replace that $10 with bitcoin, and suddenly you have a taxable transaction. This is because you are, in essence, trading property (bitcoin) that has value for something else (pizza). The difference between the price of the bitcoin when you received it and the fair market value at the time it is used to purchase a slice of pizza would be a reportable gain or loss. For this example, the fractional unit of bitcoin that bought the pizza was initially purchased on February 9, 2021, for $7. On July 2, 2021, you used that same fractional unit of bitcoin to purchase the pizza. The fair market value of the bitcoin at the time the pizza was purchased was $10. You would not only have pizza for dinner but have gained an extra $3 for your pocket. The transaction would be reported just like the sale of stock. For investment purposes, stock sales are reported on Forms 8949,
Sales and Other Dispositions of Capital Assets and Schedule D,
Capital Gains and Losses. Depending on how long you hold onto property like stock, mutual funds, real estate, and cryptocurrency, the sale or exchange of the property for a good, service, or money will either be reported as a short-term gain or loss (if held for one year or less) or long-term capital gain or loss (if held for more than one year). Short-term capital gain income is taxed at the taxpayer’s ordinary tax rate, and long-term capital gain income is taxed at a special rate that is dependent on the taxpayer’s filing status and taxable income. Reportable cryptocurrency transactions must be reported in U.S. dollars for income tax purposes.
The following are examples of taxable cryptocurrency transactions that would be reported on Form 1040:
- Being paid in cryptocurrency, whether as an employee or independent contractor. The U.S. dollar value at the date and time the cryptocurrency is received would be includable as earned income on Form 1040.
- Converting wages paid in cryptocurrency into U.S. dollars or any other type of fiat. If the wages paid in cryptocurrency were not immediately converted into fiat but held as cryptocurrency and later converted to cash, the transaction would be reportable.
- Selling cryptocurrency for cash.
- Using cryptocurrency to pay for goods or services, no matter if the expense is business or personal in nature.
- Buying (exchanging) one type of cryptocurrency with another type of cryptocurrency. This action is considered a sale. For example, using bitcoin to buy dogecoin.
- Receiving cryptocurrency rewards for lending out your cryptocurrency.
- Receiving cryptocurrency rewards for mining or staking activities.
- Receiving cryptocurrency through validating transactions on a cryptocurrency’s blockchain.
- Using a cryptocurrency debit card to purchase goods or services.
- Receiving cryptocurrency through airdrops or giveaways.
- Receiving cryptocurrency through social media platform upvotes.
- Receiving cryptocurrency “tips” for Twitter and Instagram posts.
- Receiving cryptocurrency through play-to-earn opportunities.
Let’s look at another example of how cryptocurrency transactions can become reportable, taxable events.
Katrina loves the waves, especially when she is surfing them. For her, surfing is just like walking in the sunshine. On August 17, 2019, Katrina participated in a surfing competition and won .50 BTC (bitcoin). That day, 1 BTC was worth $10,346. Since Katrina is a pro surfer, she reported $5,173 ($10,346 x .50 = $5,173) as income on her 2019 Form 1040, Schedule C, Profit or Loss From Business.
It has always been her dream to surf at Playa Grande in Costa Rica and, due to the rise in the value of bitcoin, Katrina is making her dream come true. On June 15, 2021, Katrina exchanged her .50 BTC for U.S. dollars. When Katrina exchanged her .50 BTC, the value of 1 BTC in U.S. dollars was $38,347. Katrina received $19,173 ($38,347 x .50 = $19,173). Since she held the .50 BTC for over one year, the income on the exchange will be subject to long-term capital gains tax rates. The basis (the value when she received the bitcoin) of the .50 BTC was $5,173, so Katrina will report a $14,000 ($19,173 - $5,173 = $14,000) long term capital gain on her 2021 Forms 8949, Sales and Other Dispositions of Capital Assets and Schedule D, Capital Gains and Losses.
Not all cryptocurrency transactions trigger a taxable event. Buying cryptocurrency with cash and holding it is not a reportable transaction. Transferring the same cryptocurrency between different wallets is not a taxable transaction. (A cryptocurrency wallet is where private keys are stored. Private keys allow a person to access their cryptocurrency. Without the private key, the cryptocurrency attached to it cannot be accessed.) Likewise, transferring cryptocurrency between different exchanges without converting the cryptocurrency to cash or another cryptocurrency is not taxable. Receiving cryptocurrency as a gift is a nontaxable transaction. The recipient of a cryptocurrency gift does not have to report the cryptocurrency as income until a reportable transaction has occurred.
If this information has given you more dread than delight and you are concerned your cryptocurrency transactions may be audited, good news! You have an ally in your corner to help. The tax professionals at
TaxAudit are here to help. For over thirty years, TaxAudit has been making a positive difference in the lives of taxpayers who faced the IRS and state income tax agencies. And we are here for you! Don’t face the IRS alone. We are just a
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