A recent decision by the Internal Revenue Service (IRS) to clamp down on cryptocurrency back taxes has understandably concerned many investors and thrown a host of complicated legal questions into sharp relief. In an effort to collect capital gains taxes on cryptocurrency trades, the IRS recently sent out a series of letters to about 10,000 investors warning them that failure to account for capital gains accrued in cryptocurrency markets could invite an audit or the imposition of even harsher penalties.1 The IRS has reportedly sent out three types of letters – one gently reminding investors to update their tax returns, another warning about the costs of tax evasion, and a third threatening an audit if a response is not received – “depending on the severity of the [tax] issue.”1
The IRS’ legal authority to send such letters and threaten enforcement action is rooted in the designation of cryptocurrencies as taxable property, rather than as currencies. In explaining this classification, the key consideration employed by the agency is that while cryptocurrencies can “be used to pay for goods or services” just like regular currencies, they can also be “held for investment,” a status that makes cryptocurrency subject to capital gains taxes.2 Cryptocurrency’s status as taxable property has a host of ramifications for tax preparation, the most important of which will be summarized below.
Before any investor can assess their cryptocurrency-related tax liability, they need to tabulate their “taxable events.” Taxable events, according to CryptoTrader.tax, encompass the following: “trading cryptocurrency to fiat currency” or to another form of cryptocurrency, “using cryptocurrency for goods and services,” and “earning cryptocurrency as income.”3 (Importantly, these provisions apply to cryptocurrency “miners,” the individuals who are paid in cryptocurrency to maintain blockchain networks).3 Whenever any of these taxable events occur, cryptocurrency investors need to log the “fair market value” of the cryptocurrency (plus any fees associated with the cryptocurrency purchase, sale, or trade) and determine if they incurred any gains or losses in the transaction.3 The tax rate on each transaction is determined by the length of time for which the investment was held. That is, cryptocurrencies purchased, held, and sold within a year are subject to the short-term capital gains tax (equivalent to regular income tax rates).4 Because U.S. tax law seeks to incentivize long-term investing, assets purchased and held for more than a year are subject to the long-term capital gains tax, which is considerably lower than the short-term rate.4
Although these rules may seem complex and burdensome, there are many ways to minimize your cryptocurrency tax liability. First and foremost, investors can actually claim deductions on their cryptocurrency losses - just as capital losses are deductible for more conventional assets.3 Moreover, as Accounting Today notes, investors can avoid capital gains taxes by gifting or donating cryptocurrency.5 Because the long-term capital gains rate is lower than the short-term rate (as discussed above), investors can lower their tax bill by making long-term investments.5 Finally, investors can reduce their tax liability by immediately converting cryptocurrency that has appreciated in value into a fiat currency like U.S. dollars, rather than using it to purchase another form of cryptocurrency.5 This is because both the conversion to U.S. dollars and the act of purchasing another cryptocurrency with capital gains are both taxable events.5
Despite the uncertainty and mystique surrounding cryptocurrency, these novel investment opportunities are governed by laws and regulations familiar to any experienced investor. Common sense, sound legal advice, and diligence will prevent your cryptocurrency tax bill from growing exorbitant.