Someone paid you in crypto. Do you have to pay the taxman?
Taxpayers have always displayed remarkable creativity with ways to minimize their tax obligations. Lately, many have been enticed by the promise of generating massive wealth while escaping the taxman’s clutches through the allure of decentralized currencies and encrypted transactions, otherwise called cryptocurrency.
Crypto represents an extension of the age-old practices of bartering and conducting business in cash, allowing individuals to transact anonymously and operate within a framework of decentralized systems.
It is new that crypto utilizes blockchain technology, a digital method of recording transactions that makes it almost impossible to change, hack or manipulate the transactions ledger.
Blockchain isn’t just for shady dealings or underground economies, as the technology is not inherently illegal. A blockchain is like a ledger on a spreadsheet shared among numerous computers where currency sales and purchases are recorded. Anyone can see the data, but they can’t corrupt it.
The decentralized nature of blockchain poses unique challenges for governments and regulatory bodies, allowing individuals to bypass banks and brokers to obscure financial transactions and potentially avoid taxes.
The IRS loses an estimated $50 billion in tax payments annually from unreported crypto trades, according to a May 2022 report from Barclays.
The explosive growth has caught the attention of the IRS. The potential tax dollars at stake have led to increased regulations for reporting and paying taxes. The IRS in March 2021 said it had assembled a team of experts to conduct what has been dubbed “Operation Hidden Treasure” to audit crypto investors, according to an article by Forbes.
Here is a summary of how cryptocurrency transactions are taxed.
Cryptocurrency, like cash, can buy goods and services, trade for other cryptocurrencies or assets, or sell in exchange for traditional have-faith-in-the-government currencies like the dollar (also called fiat currencies).
In one famous example, Alex and Brady of the YouTube channel Cruisers Academy made a video about how a fan gave them a single bitcoin that they used to buy a 42-foot sailboat.
How crypto is different than cash
Unlike when you pay cash, when you spend cryptocurrency, it is considered a taxable event. I don’t pay taxes if I buy something from you for $100 in cash. You might, but I don’t. If I used cryptocurrency instead, that would become a taxable event.
On your taxes, you must report the date you acquired and disposed of the coin, how much you obtained it for, the crypto’s fair market value at the time of the disposition, and any resulting capital gain or loss.
The difference between the cost basis (the amount you initially acquired the cryptocurrency for) and the fair market value, when you spent, traded, or cashed it in, determines whether you have a capital gain or loss.
If you have a capital gain, you may be required to report and potentially pay taxes on the appreciation in value. You may be subject to long-term or short-term capital gains rates depending on whether you held it for less or more than one year.
For instance, when Alex and Brady purchased the sailboat, if the bitcoin they used had been a gift and the value increased from when they acquired it to when they used it to buy the boat, they would need to report a capital gain.
In addition to reporting crypto gains and losses, the IRS states that you must include income if you were paid for goods or services, including “mining” in cryptocurrency, equal to its fair market value when you received the currency.
Here is another example of how the taxes work.
In February 2011, a tax protester offered a particular unnamed CPA 1,500 bitcoins that traded at $1 per bitcoin (at that time) to prepare his taxes.
The CPA declined.
If the CPA had taken the job, they would have reported $1,500 of self-employment income on their taxes for the Bitcoin payment. If the CPA had held the Bitcoin and cashed it out this week, they would have received $38,618,745 in cash. They would then pay long-term capital gains on the difference of $38,617,245. The top long-term capital gains rate is 20% plus 13.3% state taxes.
What happens if I don’t report?
On the 1040 form, the IRS asked, “At any time during 2022, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
Intentionally checking the “no” box instead of the “yes” box to conceal taxable events involving crypto could be criminal. A conviction can result in imprisonment for not more than three years and a fine of not more than $100,000. Penalties and interest also would be assessed on the unpaid taxes.
If you did not know you needed to report your crypto transactions or if you forgot, you could file an extension on the previous year’s returns.
What can I do to minimize the tax?
If you hold the cryptocurrency for more than a year, you may qualify for long-term capital gains tax rates, which are lower than short-term rates.
Tax loss harvesting involves strategically selling assets, including cryptocurrency, that have experienced a decline in value (resulting in a capital loss) to offset capital gains, potentially reducing your overall tax liability.
Donating appreciated cryptocurrency directly can result in a charitable deduction equal to the fair market value of the donated cryptocurrency at the time of the donation. Because you did not sell crypto, there are no capital gains. This strategy allows you to support a cause while potentially reducing your taxable income.
By using a self-directed Individual Retirement Account to invest a small portion of your retirement, if the risk is acceptable, you can defer taxes on capital gains and enjoy tax-free growth.
Given the complexities of cryptocurrency taxation, seeking guidance from a tax professional specializing in cryptocurrencies can be highly beneficial. Crypto also has its language.
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