Introduction
Cryptocurrency investors and traders may think that trading cryptocurrencies are the easiest and most profitable method of generating income. However, cryptocurrencies are also taxed despite being part of the DeFi or decentralized finance sector.
This article is going to introduce the reader to the various methods of cryptocurrency taxation and the various aspects attached to it that can be very beneficial and essential for every investor.
What are Crypto Taxes?
Taxes are a decided cut of income of any other asset that is imposed by the government. Before the presence of democratic governments, the monarchy ruling system also collected taxes from their subjects.
Taxes are used by the government to run the country and perform administrative and welfare tasks such as building the infrastructure or giving subsidies to the masses. Cryptocurrencies are also taxed since they allow their users to generate profits and can be a source of income for crypto traders.
Governments can enforce the right to collect taxes from their citizens on account of providing them with basic services like law and order in the region or offering national Identification, etc.
Crypto Tax Requirements
It is important to note that every sovereign nation collects and imposes unique cryptocurrency taxation laws. Therefore, the readers who are reading this article must visit the website of their regional taxation authority and learn about the taxation requirements they have established.
For this article, we are going to take a look at the taxation laws that are observed and followed in the USA by the local regulatory authorities in the region.
When a person purchases cryptocurrencies and sells them for a profit, they can earn profits. The taxation authority in the USA, called IRS, can treat the income generated from cryptocurrency in various ways.
Depending on the utility of the cryptocurrency and the way that the user has spent it, the taxes that are levied on their crypto-generated income can be classified as Capital Gains or Income. In most countries, cryptocurrencies are taxed according to the aforementioned taxation laws.
At present, most countries have insufficient cryptocurrency regulations, and there is a clash among different regulatory departments about the nature of digital currencies as stocks, commodities, or other assets.
Types of Crypto Taxes
As mentioned earlier, two basic types of taxes are imposed on cryptocurrency traders given as under. Another important aspect to keep in mind about crypto taxation is that taxes become applicable in the event when the investors sell their crypto reserves or dissolve their crypto positions into fiat currencies.
Capital Gains Tax on Cryptocurrencies
Capital gains are a tax that a property owner has to pay when they have sold their asset. This type of tax is also imposed on individuals who are creating profits by trading or investing in various types of assets.
When cryptocurrency owners purchase and hold their reserves for any period, they may earn capital gains or losses when they sell their cryptocurrencies. Depending on the purchase price and the current market value, the seller can earn profits or report losses on their crypto sales.
Income Tax on Cryptocurrencies
In normal circumstances, a person has to pay a small portion of their salary as income tax to the government. Most people do not know about income tax because it is cut automatically from their employee accounts.
In the event that a person earns cryptocurrency rather than purchasing it, they are bound to pay income taxes on their cryptocurrency assets. Here are some scenarios that qualify a person to pay income taxes on their cryptocurrency holdings:
- Earning cryptocurrencies as mining rewards.
- Earning crypto assets through Airdrops.
- Staking rewards in the form of cryptocurrencies.
- Referral returns are received as cryptocurrencies.
- Giving or receiving cryptocurrencies as a gift above the tax-free threshold.
How much Income Tax is Applied to Cryptocurrency?
It can be a challenge to calculate the total tax that a person has to pay on their cryptocurrency holdings. The taxation ratio can depend on the type of utility and acquisition of the crypto holdings, current government policies, the type of cryptocurrencies, and the duration of the holding period.
If a person is having trouble calculating and reporting their cryptocurrency taxes, they can hire a consultant and use their guidance to tax other individuals. However, in general, users can understand different rates of cryptocurrency trading based on short or long-term trading periods.
Short-term Crypto Taxes
Short-term crypto taxes are applied when cryptocurrency investors have held their reserves for less than 12 months. This rule has been introduced by IRS, the taxation authority in the USA, and people hailing from other jurisdictions must check with their local federal agency. The taxes applied on short-term positions are usually higher.
Long-term Crypto Taxes
Long-term taxes are applied to cryptocurrency users when they have retained their crypto holdings for at least one year. The taxes on long-term crypto positions are lower in comparison to the short-term positions.
Tax Threshold
Another factor that decides the percentage of taxation on crypto is a taxable threshold. According to IRS, taxes are applicable on short positions starting from $25K. Therefore, the application of taxation is not uniform or flat.
The cryptocurrency investor may pay a 10% tax on one portion of their short-term crypto income and 12% on the remaining after it has crossed the taxable income threshold.
Tax-Free Crypto Transactions
There are some scenarios where cryptocurrency investors may be able to make cryptocurrency transactions that are not taxed. Here are some scenarios where crypto transactions become legally tax-free:
Keeping the cryptocurrencies in reserves or as holdings. Crypto taxes are not applied as long as they are dormant under the custody of their owners.
Sending cryptocurrencies from one wallet to another that is under the ownership of the same person. Using cryptocurrencies as collateral for applying for loans.
How does IRS Track Your Crypto?
Regulators have taken an issue with cryptocurrencies on account of their potential to facilitate tax evasion and money laundering. Many people assume that since cryptocurrencies are traded online, therefore federal taxation agencies might not be able to track them.
However, most people purchase their cryptocurrencies from regulated exchanges such as Coinbase. These regulated exchanges are under obligation to the government to share the crypto transaction and holdings history of their users with the government or IRS.
Since regulated exchanges require their users to undergo account verification, the users can get incriminated if they choose to hide their crypto trading details. On the other hand, agencies like IRS can also use the information received from these exchanges to retrace the anonymous wallets to their original owners.
IRS can also work with cryptocurrency enterprises like Chainlink to research the data from blockchains and track the individuals who are trying to commit tax fraud. IRS officials have been working on improving the technology at their disposal to ensure that they can intercept any type of unknown crypto trading activity.
The infrastructure bill introduced in 2021 has put stricter tax reporting policies in place for the crypto exchanges operating out of the USA.
There may be some people who assume that they can get away with not reporting their cryptocurrency trading and transaction details to the government. However, it is important to note that failure to report taxes to the government deliberately or out of ignorance is classified as tax evasion.
In most countries around the world, tax evasion is considered one of the most serious crimes, and it can not only open an individual to heavy financial penalties but can also lead to jail time and other legal consequences.
IRS can also try failure to report crypto trading details as tax fraud that also carries severe legal consequences. A defaulter can have to spend up to 5 years in prison, undergo criminal prosecution, and have to pay a legal fine of $250K to the government. To reduce the chances of tax evasion with cryptocurrencies, IRS has introduced another question in the 1040 form for income declaration.
The question explicitly asks the subject about sending, receiving, selling, purchasing, or exchanging any virtual currencies in the current financial year. Answering this question is mandatory, and failure to do so is termed perjury.
How to Legally Avoid Cryptocurrency Taxes
It can be very risky and rather impossible to avoid paying taxes on cryptocurrencies. There are many ways that every cryptocurrency holder and investor can legally lower their cryptocurrency taxes. Here are some of the rules that anyone can adopt to benefit from legal tax cuts:
Long-Term Crypto Holding
It has been mentioned before that the taxes applied on a long-term position is usually smaller in comparison to the short-term trading closure. Therefore, it is ideal for cryptocurrency investors to keep track of their purchase dates for every cryptocurrency in their portfolio.
In this manner, they can wait for a few weeks or days to ensure that their positions remain intact for the long term to take advantage of smaller tax obligations.
As per IRS, the short-term capital gains taxes on cryptocurrencies can be 10-37%; meanwhile, the long-term capital gains tax obligation on cryptocurrencies is as little as 20%.
Tax-Loss Harvesting
Cryptocurrency investors can always offset their tax obligations by claiming their losses on the sales of their positions. There are some scenarios where cryptocurrency investors might be prompted to sell their reserves to avoid furthering their losses.
Under such circumstances, these investors have not accomplished any capital gains. Therefore, they can show their losses in their tax declaration forms and reduce their tax deductible accordingly.
Tax-Deferred Retirement Plans
With capital gains, the citizens of the USA have an option of reducing taxes by using their assets to work with retirement plans such as 401(k), 403(b), or Individual Retirement Accounts (IRA). The users may also be able to make transactions within their government-sanctioned retirement accounts without triggering tax obligations.
Investors can lower their tax payables upon cashing their retirement plans as long as they fall into the lower tax brackets. There are options like Bitcoin IRA that expose the user to the same tax benefits.
Using Cost Basis
The cost basis is the amount spent to purchase a new cryptocurrency. Some accounting methods are based on a Cost basis that allows crypto investors to save their taxes. If a cryptocurrency trader is going with the FIFO or first-in, the first-out method, they may have higher tax obligations when they close their positions.
Meanwhile, if the investors go with LIFO (last-in, first-out) or HIFO (highest-in, the first-out) method, they might be able to get some leeway on their tax deductions.
Wash Sale
A wash sale is a phenomenon where investors try to offset their tax liabilities by selling their assets for loss and purchasing the same assets again after paying their taxes. IRS has banned Wash sales for stock traders.
However, the regulators have not closed this loophole for cryptocurrency traders thus far. Therefore, investors who are looking to reduce their tax obligations can benefit from this method without breaking the law.
Unnatural Losses
Cryptocurrency investors may be able to declare some tax deductions by declaring unprecedented and unnatural losses. These losses can take place in the form of getting hacked, losing access to the crypto wallet, misplacing crypto reserves on account of exchange bankruptcy, etc.
FAQs
Here are some of the most important cryptocurrency taxation questions that can help investors understand the dynamics:
How Much Tax is Applied on Cryptocurrency Purchases?
If a person purchases a new cryptocurrency with fiat currencies, they are not obligated to pay any taxes. Therefore, the investors can rest assured that until they have sold their cryptocurrencies or purchased them into any other cryptocurrency, they are free from any type of tax liability.
How Much Tax is Applied on Cryptocurrency Reserves and Holdings?
The users who have purchased cryptocurrencies and now are holding them under their custody or in a non-custodial digital wallet are not under obligation to pay any taxes.
For clarity, cryptocurrency traders should know that holding cryptocurrencies does not open them to any type of taxes. The taxes only apply when these positions are dissolved and sold.
Does Transferring Cryptocurrencies Between Two Wallets Get Taxed?
Transferring cryptocurrencies between two digital wallets that are under the ownership of the same person is not taxed. However, the investors might have to pay transaction or service charges when they are exchanging between different wallets.
Are Crypto Fees Subjected to Taxes?
Crypto exchange and custodial services providers can charge fees from their users. These fees are not taxed by the government. However, the record of these charges can be added to the tax declaration forms and used to reduce the tax liability on account of cost basis and subtracted from gross proceeds (the sales amount).
Is Crypto Mining Subjected to Taxes?
Crypto miners may have to pay taxes on the cryptocurrencies they earn as mining rewards. In this instance, their mining rewards are classified as income tax. The rate of income tax is based on the fair market value of the earned cryptocurrencies and their total amount.
When miners dispose of their crypto rewards, they will pay additional capital gains. Businesses have the option to reduce their tax liability by using their operating expenses as an offset. However, the miners who are not operating as an enterprise cannot benefit from expense offsets.
Are Crypto Staking Positions Taxed?
Much like mining rewards, the cryptocurrencies earned as staking rewards are also subjected to crypto income taxes. Furthermore, the earner of these staking rewards will also pay capital gains when they trade them. The same rule also applies to cryptocurrencies that are received from an Air Drop and new cryptocurrencies received after a hard fork.
Is Interest Income Earned from Holding Cryptocurrencies Taxed?
Some lending platforms, such as Gemini and BlockFi, offer interest income or rewards to their users in exchange for holding certain cryptocurrencies. Both Interest and staking rewards generated from crypto are classified as personal income and subject to income tax.
In addition, the investors are also bound to pay capital gains when they sell their interest or staking rewards later.
Can Leveraged Crypto Positions Incur Taxes?
Crypto-leveraged trading or loans are not directly subject to taxes. In case cryptocurrency investors are planning to swap their crypto reserves on several occasions as part of their leveraged trading plans, they may incur tax obligations at every swap.
Do Margin and Futures Crypto Trading have Tax Obligations?
Thus far, the IRS has not introduced any clear guidelines for the taxation process for margin or future trading using cryptocurrencies. Therefore, the only tax exposure using these methods is currently limited to capital gains.
How are Crypto Gifts Taxed?
As long as crypto gifts are within the taxable threshold, they remain tax-free for both sender and receivers. Suppose the market value of a crypto gift exceeds $11.7 million in their lifetime. For any gifts over the value of $15K, the sender must file for a gift tax return. This form is for informative purposes and does not require paying any taxes.
Are Crypto Donations Subjected to Tax?
Crypto donations are not taxed, and they are also used as tax offsets. All crypto tax deduction claims greater than $500 should be reported to IRS using the 8283 form.
Conclusion
Crypto taxation is not a simple and straightforward process. Cryptocurrency investors should spend their time learning about the intricacies, scenarios, and various aspects of crypto taxation. Failure to comply with crypto tax obligations can result in severe repercussions from the federal taxation authority.
By cooperating with the government, cryptocurrency investors may be able to make a collective appeal for gaining more tax benefits from the government.