Cryptocurrency has become one of the most exciting topics in personal finance, and it seems like everyone wants to hop on in hopes that prices will continue to go to the moon. This naturally leads to questions about crypto taxes, especially: Do you have to pay taxes on crypto?
The short answer is yes — you have to pay taxes on cryptocurrency. Cryptocurrency is a capital asset and is taxed as property by the IRS. And recently, the IRS stepped up their enforcement efforts to make sure everyone is on the up-and-up and paying their crypto taxes.
Whether you acquired crypto for the first time this year, or if you have some you want to cash out and sell, there are several things you need to understand about taxes on cryptocurrency.
Crypto Taxes - 7 Things You Need to Know
1. Cryptocurrency is treated as property and taxed accordingly
Back in 2014, the IRS issued a notice stating that cryptocurrency is treated as property in the government’s eyes. Here are the exact words:
For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.
That means there are a number of taxable events related to cryptocurrency that will cause you to pay taxes on crypto, including:
- Receiving crypto as payment: If someone sends you crypto as a payment for goods or services, you add the value of the crypto to your gross income so it can be taxed as income. You use the fair market value of the crypto on the day you received it.
- Selling crypto: Selling is a taxable event, whether you experience a gain (the value of the crypto when you sell is worth more than when you bought it for) or experience a loss (the value of your crypto has decreased since the purchase date).
- Using crypto to buy something: Spending crypto to make a purchase is basically the same as selling in the eyes of the IRS. Your tax liability depends on whether or not the value of the crypto has decreased or increased in value since the purchase date. So if you just bought a Lamborghini with a few bitcoins you acquired back in 2017, you will pay capital gains on the bitcoin because it’s worth more now.
- Being paid for crypto mining: Mining virtual currency is considered a trade or business. If you mine crypto for a company, then the company will file taxes on the coins you’ve earned. But if you’re considered self-employed, you’ll pay self-employment taxes on the crypto you receive as payment.
Basically, no matter how you acquire cryptocurrency, it will need to be factored into your taxes when you do something with it because it’s a capital asset.
Learn more about how bitcoin is taxed in Bitcoin Taxes | How to Make Sure You’re Covered.
2. You can be penalized for not reporting reporting crypto taxes
As the prices of bitcoin and other cryptocurrencies rise, the IRS has gotten serious about making sure they get their cut. This means that you must report any crypto you earn as income, gains you make from owning crypto, and pay taxes accordingly.
Not reporting is considered criminal tax evasion and is defined by IRC section 7201 as:
Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law.
I don’t want to get too in the weeds here talking about how you define someone as “willful,” but the point is the same: you can be penalized for not reporting your crypto taxes.
The vast majority of people aren’t going to jail because they didn’t realize they should report crypto gains or income on their taxes, but you can easily be penalized. The penalty is a steep 75% of the understatement of tax.
To show how serious the IRS is, they launched Operation Hidden Treasure early in 2021 to look at blockchains to root out tax evasion. Hidden Treasure is a joint effort between the IRS’ civil office of fraud enforcement and it’s criminal investigation unit.
Carolyn Schenk, national fraud counsel in the IRS Office of Chief Counsel, was very direct in an interview with Forbes, “We see you.”
3. Understand crypto capital gains tax
Capital gains tax is a tax on assets that have increased in value since you came to own them. You “realize” your gains when you sell or offload your crypto.
If the value of the asset decreases, then it’s called capital losses. You can use your capital losses to offset your gains, which can decrease your tax liability. It’s the same concept when you’re buying and selling stocks, ETFs, bonds, etc.
Capital gains and losses fall into two categories:
- Short-term capital gains: Gains or losses you’ve made on a crypto asset that you’ve held for one year or less. The tax brackets for ordinary income taxes apply for short-term gains, and you can use short-term losses to offset your income tax up to $3,000.
- Long-term capital gains: Gains or losses you’ve made on a crypto asset that you’ve held for more than a year. The tax rate on long-term capital gains depends on your income tax bracket.
Here’s a chart so you can see the long-term capital gains tax rates for the 2021 tax year:
Up to $40,000
$40,000 to $441,450
Married filing jointly
Up to $80,000
$80,000 to $496,600
Married filing separately
Up to $40,000
$40,000 to $248,300
Head of household
Up to $53,600
$53,600 to $469,050
One strategy that many investors use, whether that’s crypto or the stock market, is to sell underperforming assets in the same year that you’re realizing gains. It’s often referred to as tax-loss harvesting, and it can help you minimize your taxes for the year.
There are limits to that strategy, like short-term losses can only offset up to $3,000, and you can carry additional losses over to the following year. It’s also worth mentioning that you have to offset losses of the same type first (so short-term losses offset short-term gains before applying to long-term ones).
The important thing here is that gains on crypto are treated like regular capital gains taxes.
4. Holding on to your crypto for longer is generally a good idea
The majority of people who own crypto will benefit from holding on to their cryptocurrency for at least a year. There’s the obvious benefit of your coins increasing in value, but it’s also beneficial for tax purposes.
The key is the difference in long and short-term gains because they are taxed at different rates.
If you look back at the chart in the last section, you can see there’s a good chunk of people who will pay long-term capital gains tax at the 0% or 15% rate. If you remember, the short-term rate is the ordinary income tax rate.
The federal income tax brackets on ordinary income and subsequent rates are much different than long-term capital gains rates. The ordinary tax rate if you’re a single person making less than $40,000/year is 12%. Compare that to the long-term rate of 0%. That’s major.
Besides waiting for the one-year mark to offload your crypto, you can also wait for a low income year when you’ll fall in a lower tax income bracket anyway.
5. Reducing your income may reduce your crypto taxes
This follows the logic I just mentioned about waiting for a low income year: reducing your taxable income may help you minimize your crypto taxes.
Tax professionals are especially helpful with this strategy, and they can often find tax credits and deductions you didn’t realize would apply to you. Besides hiring someone to help you with your taxes, here are a few ways to reduce your taxable income:
- Put more money towards your retirement savings
- Contribute to a flexible spending account (FSA)
- Contribute to a health saving account (HSA)
- Take business deductions if you’re self-employed
One way to go above and beyond here is to direct crypto earnings into an IRA. You’ll get to choose your tax benefit with a Roth or traditional IRA.
Contributions to Roth IRAs are made with after-tax dollars and your money grows tax free, whereas traditional contributions are made with pre-tax dollars and you pay taxes on that money in retirement. Generally, Roth IRAs are better for people who believe they will be in a higher tax bracket during their retirement years.
6. Keep good records for paying crypto taxes
To stay on the up-and-up with the IRS and make sure you’re tracking gains and losses correctly, you need to get good at record-keeping.
You should start by tracking every cryptocurrency transaction you incur throughout the year. Remember, this includes taxable events like trading or being paid in crypto, not just selling it. You need to track the date and fair market value of your crypto when you acquired it, and the fair market value and date when you used it.
Keep track of that information because you’ll need it to file your taxes using the following forms:
- IRS Form 8949 is “Sales and Other Disposition of Capital Assets” can be used for crypto because it’s considered a capital asset. Form 8949 asks for dates, fair market value, and gains and losses.
- IRS Form 1040 (Schedule D, Capital Gains and Losses) is where you total up the information gathered on Form 8949.
- Cryptocurrency you earn as income needs to be reported on Schedule 1 Form 1040.
- Self-employed crypto earnings need to be reported on Schedule C.
If you’ve made over $20,000 and at least 200 transactions in one year, a Form 1099-K may be issued to you, but the average person won’t meet both of those requirements.
Your crypto exchange may send out year-end statements or forms, but you should keep track of everything on your own in case they don’t.
7. Take steps to pass on your cryptocurrency
You probably aren’t thinking about end-of-life plans right now, but if you own cryptocurrency, you need to think about this because it can affect your heirs’ tax bill.
Cryptocurrency is treated like other types of capital assets (stocks, for example) when it’s listed as part of your estate. In terms of taxes, capital assets enjoy stepped-up cost basis at the time of your death.
That means your cryptocurrency increases to its fair market value when you die. Your heirs can then sell the crypto and pay taxes based on the fair market value they received it instead of when you purchased it. You can imagine the potential tax savings if that crypto has been heading to the moon since you acquired it.
Take bitcoin, for example. If it was bought back in 2016 at around $600 per share, someone inheriting shares of it in early 2021 could see it step-up to $30,000+ per share. They could sell it without realizing such expensive capital gains.
The final word on crypto taxes
No matter how you feel about taxes, they are part of your reality and something you need to consider if you own cryptocurrency.
Make sure you keep good records of the value and dates you’ve acquired your crypto, and pay attention to when you sell your crypto. Those two things can go a long way to make sure you’re on top of your crypto taxes and minimizing them as much as possible.