Tax Basics for Crypto Investors
Cryptocurrency has become an increasingly popular topic in recent years, and as a small business CPA and Attorney, it is becoming more prevalent within the tax situations I handle for my clients. Crypto investing has also become more mainstream, and even risk-averse clients are beginning to take notice and invest small sums in Bitcoin and Altcoins (alternative cryptocurrencies to Bitcoin). There are currently estimated to be over 10,000 different types of cryptocurrencies. Without going into all the details of blockchain, mining, and wallets, I wanted to provide just a bit of an overview of how investing in cryptocurrency can impact an individual’s tax return.
How are Crypto Transactions Taxed?
As with most assets in the U.S tax code, the taxability of a transaction is determined by how the asset is used. Crypto is versatile, especially Bitcoin, as it can be used to pay for goods and services, held as an investment, or “mined” resulting in earned income. The most common use that I see among my clients is the purchase of cryptocurrency for the purpose of producing investment income, so that will be my primary focus in this article.
Purchasing cryptocurrency alone will generally not result in taxable income unless you purchased the crypto by exchanging other property in that purchase. For example, if you take $1,000 in cash and buy fractional shares of Bitcoin at the prevailing market rate, you will not pay any taxes on that transaction. But oftentimes what crypto investors do not realize is that if you exchange $1,000 in value of a coin such as Ethereum for $1,000 in value of Bitcoin, that actually is a taxable transaction. The reason why is because when you bought the Ethereum it may have only cost you $500, and now you are able to get $1,000 of Bitcoin in that transaction, so your value has increased by $500 on the date of the exchange.
One unfortunate result that I have seen from taxpayers that invest in crypto but do not conduct any tax planning throughout the year is that they may have thousands of dollars in profits simply from exchanging one coin type for another and never take any money out to pay for the taxes. After the year is over, they now see that they owe large sums of money for federal and state taxes, and by that time their investment may have declined, or they may have even had their wallet hacked and no longer can sell other coins to pay the taxes.
How Much Taxes Will I Pay?
Property held for the purpose of investment is called capital property, or a capital asset, and the way it impacts your tax return will depend on how long you held the asset before you sold or exchanged it. Assets held for more than one year receive preferential tax treatment, meaning that the related gains are taxed at lower rates on the federal tax return compared to assets held for one year or less or income that is earned such as business income or wages. So, there is an incentive under the tax code to hold investments for longer periods of time rather than to buy and sell frequently. As of 2021, the preferential long-term capital gains rates are 0%, 15%, and 20%, and these are always lower than an individual’s ordinary tax rate. The tax rates applicable to short-term capital gains and all other income types (the ordinary tax rates) for 2021 are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Surprisingly, most taxpayers that invest in crypto do not take advantage of these preferential rates. It is estimated that 65% of crypto investors sell the asset they purchased in less than a year, and over half of them sell within six months of purchase. This means that in most cases, taxpayers who sell their investments in crypto are not receiving the advantage of the preferential tax rates. Tax rates aside, selling too quickly can also result in not maximizing the investor’s return long-term.
But What if I Lose Money?
As mentioned previously, if the value of your crypto investment simply goes down due to market fluctuations, that does not necessarily result in an outcome on your tax return. However, if you sell (or exchange) crypto for less than you paid for it, then you may have a realized loss. Capital losses can only be deducted on your tax return to the extent of capital gains reported in that tax year, plus an additional $3,000 can offset other types of income. Thus, if you are a frequent crypto trader who has coins that have lost value as well as coins that have gained value, it is very important to look at your total tax picture throughout the year, preferably with a tax professional, to try to optimize your tax situation.
What if I am Scammed or Hacked?
Some crypto exchanges are better than others at securing clients’ data, and some taxpayers are better than others at protecting their own data and privacy. At any rate, it is possible that a taxpayer may lose the value of his investment in crypto due to scams, theft, lost wallet access, or other calamities. The treatment of all of these events that can occur with crypto investing are different, but there are mechanisms within the tax code in which a taxpayer can receive a potential tax benefit due to losses that might result from these unfortunate situations. Some of them are only available if you itemize your deductions, and others are available regardless of whether you itemize. The important thing to know is that if something beyond your control happens with your crypto investment, be sure to let your preparer know at tax time (or, better yet, when the event occurs if you conduct planning regularly) and he or she can guide you through the tax impacts.
Thanks for reading this article! If you have begun investing in cryptocurrency, I would be happy to assist you with optimal planning for your tax situation. Feel free to contact me using the form below.