May 2, 2022

2021 was a big year for crypto, with the market reaching numerous record highs and lows. There was a massive influx of new traders and investors who made their first purchases and many people are entering this market because they believe it is a tax-free way of generating wealth and conducting transactions. However, the windfall for many individuals has not gone unnoticed; the senate finance committee and IRS Commissioner Charles Rettig announced that the IRS could be missing out on approximately $1 Trillion in tax revenue from tax cheats/evaders per year!

Yet, 2021 is the second year in a row that the IRS is asking about your crypto activity. In March of 2021, the IRS launched Operation Hidden Treasure, an enforcement initiative for tax violations related to crypto. To avoid claims of ignorance, there is a question on the first page of your tax return asking “at any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency.” This clearly shows how serious they are about cracking down on crypto transactions.

In 2016, the IRS issued a “John Doe” summons to Coinbase, a cryptocurrency platform, petitioning them for information about their users in the United States and the information provided includes data about who purchased, sent, or acquired cryptocurrency of a minimum value of $20,000 in the year. Based on the information received, the IRS sent 10,000 compliance letters to taxpayers notifying them of their negligence in properly documenting cryptocurrency transactions.

Many large crypto agencies like Payward Ventures (Kraken) and Internet Financial (Circle) have reported that the IRS has applied pressure and requests that they report their users' crypto activity ranging from the year 2016 to 2020, similar to how a Vanguard or Fidelity would report brokerage statements.

In this article, we will discuss the different transactions that the IRS takes interest in and how you can properly file your documents. 

Taxable Events

Taxable crypto is any event or transaction where you sell, exchange or barter, or receive crypto for services performed. These transactions are subject to capital gain taxes; thus, Simply buying/holding crypto is not a taxable event. IRS Notice 2014-21 says that crypto is treated as property for tax purposes.

 1. Selling Crypto at a Gain/Loss

The difference between how much you bought the crypto and how much you finally sell it is the capital gain or loss — what you’ll report on your tax return. If Bitcoin fell in value during that period, you’d have a capital loss. Individual filers can gain a deductible up to $3000 from their taxable income if their losses exceed your gains.

The length of time you held the cryptocurrency, or the holding period, is also essential. It’s considered a long-term capital gain (LTCG) if you held on to a unit of Bitcoin for more than a year before selling. It is, however, a short-term capital gain (STCG) if you acquire and sell it within a year. These distinctions may have an impact on the tax rate used. STCG is taxed at ordinary income tax rates, which are less favorable than LTCG tax rates.

This can mean a huge difference because if you have been holding onto a coin for over a year, you save more because what you have is an LTCG. You could be in a 24% tax bracket for a short-term capital gain but take advantage of a 15% LTCG rate. That is a 9% ROI swing just by waiting the whole year!

The tax rate is also dependent on your total taxable income, and the number of capital losses you can deduct if your crypto asset loses value is limited.

2. Exchanging Crypto for Crypto

A simple trade such as swapping Bitcoin for Ethereum will also create a taxable event and you have to report this on your tax returns. Usually, exchanging crypto for another crypto results in a capital gain or loss because your new total, if converted to fiat, will either be less or more than how much you bought the initial crypto.

3. Using Your Crypto to purchase goods or services

It’s becoming a common practice to use crypto to purchase goods or services. However, if the crypto’s value has increased in value since your initial purchase and the moment you barter it for goods or services, it creates a taxable event. Again, this creates a wherewithal to pay problem.

4. Receiving Crypto for Services

When you provide a service in exchange for cryptocurrency- you will be taxed in the same way as cash. It’s the same when you receive crypto for rent or for goods sold. The fair market value of the crypto on the date you received it is the amount that you pay tax on. So make sure you keep good records of the date and time you received your crypto.

Wherewithal to Pay Problem

Many taxable crypto events, especially when they don’t involve liquidating for cash or fiat, create a problem called wherewithal to pay problem; it’s a fancy term used by accountants and lawyers to describe a situation when an individual does not have the money to pay tax earned from a taxable event. However, you don’t physically have any cash from this transaction! This may then force you to sell the crypto, creating another taxable transaction.

How to Report Crypto Events on Your Tax Return

Cryptocurrency reporting can be a nightmare, to avoid lots of fees, use a crypto tax tracker like coin tracker to avoid your accountant charging you more in prep fees due to so many transactions!

The first step is to amass a record of all your exchanges and trades (including any 1099 forms exchanges sent you). Next, enumerate your capital gains and losses then you fill out IRS Form 8949 for all taxable events(as stated above). Transfer the total from the 8949 form to a 1040D form, and add any other cryptocurrency income.

While it was advertised as a tax-free method of generating wealth, the IRS is quickly putting that theory to rest. To avoid future stress from an unseen audit, it is best if you file your tax return and include all the necessary information.