For many, one of the main attractions of cryptocurrencies like Bitcoin was the fact that the currencies function on a decentralized blockchain, democratizing the processes of storing, saving and transferring funds outside of traditional banking channels. However, just because there are anti-establishment, crypto-anarchist roots to cryptocurrencies, doesn’t mean investors and enthusiasts are out of the reach of ‘the man’.
To the contrary, the IRS has long shown an interest in cryptoassets, and for years has put pressure on leading exchanges like Coinbase to share information about high-frequency US-based cryptotraders. In case they had not been clear enough, on March 23rd 2018 the IRS issued a gentle reminder to crypto-enthusiasts that cryptocurrencies like Bitcoin and Ethereum are not only taxable but must be tracked and reported properly to avoid underpayment penalties and interest.
So, with cryptocurrencies gaining additional scrutiny from regulatory and tax organisations every day, here are four ways that crypto-enthusiasts keep themselves on the right side of the law:
1.Know the rules
The IRS issued preliminary guidance as far back as 2014 outlining several principles which will impact the taxation of cryptocurrency for years to come. While many of the finer details are still being worked out, several points are already clear.
First, cryptocurrency is a taxable asset. Mining is taxed. Trading is taxed. And simply ignoring these facts is a sure-fire strategy for attracting unwanted attention from the IRS. When the IRS issued Notice 2014-21, few in the crypto community took heed. And yet with the upcoming tax filing deadline on April 17th, crypto miners and traders are suddenly clamoring to make sense of the six-page determination. Here are some of the key takeaways from the notice with particular emphasis on the upcoming filing deadline:
First, almost any activity related to the mining and trading of cryptocurrency is taxable. Mining generates income at a taxpayer’s “ordinary” rate, and trading gains netted against losses are taxed at the same rate.
For miners, a tax liability is created whenever a coin is mined. For traders, taxes are incurred whenever a trade is executed based on the prevailing value of the asset in USD at the date of the transaction.
Despite the name, cryptocurrency is treated like an asset, not currency. In a sense, Bitcoin is taxed much more like a share of stock rather than a foreign exchange transaction.
With those basic precepts in mind, the taxation of crypto would seem relatively straightforward. However upon closer inspection, there is still a vast nebula of tax pitfalls which await unsuspecting miners and traders. Let’s delve in deeper.
2.Know your limits
Coinbase received a great deal of attention recently when issuing form 1099-K to more than 13,000 users. Specifically, users who conducted more than 200 trades valued at more than $20,000 should have already received a copy of their 1099-K. Coinbase was also required to furnish a copy of this form to the IRS. Critically, even users who did not receive a 1099-K are still required to report and pay taxes on their crypto activity, regardless of the number or value of trades. In other words, selling even a single coin in 2017 is counted as a taxable event.
Amounts reported on form 1099-K are “gross” amounts, not net. The form only shows the total amount of transactions that passed through a trader’s exchange account during 2017. In order to determine tax liability, a trader must first establish their cost basis in the cryptoasset. A taxpayer must also report their so-called basis to the IRS using form 8949. For example, if a coin was worth $2000 when it was acquired but later sold for $6000, the taxable gain is only $4000. Assuming the coin was held for at least one year, a trader is eligible for so called “long-term” tax treatment at a lower rate. If the coin was held for less than a year, “ordinary” tax rates would apply.
Here are some other high-level takeaways in line with current cryptotax thinking:
When cryptoassets are held for at least one year, capital gains treatment comes into play, potentially lessening the blow for buy-and-hold traders. For crypto daytraders, this provision is of no benefit.
When cryptotraders qualify for capital gains treatment, they are permitted to net gains and losses together, including non-cryptoassets and offsetting up to $3,000 of their non-capital, ordinary income.
Exchanging cryptocurrency for goods or services above $600 triggers another provision, requiring the participant to issue a form 1099-MISC to the person on the other side of the transaction. Further complications arise in cross-border dealings which are particularly sticky.
Certain services, like Bitcoin.tax, have sprung up to fill this niche, but they only answer part of the question. They fail to adequately address the qualifications behind exemptions for “like-kind” exchanges which may provide some relief to traders who converted Bitcoin to Ethereum and vice versa. That provision was eliminated with the passage of the Tax Cuts and Jobs Act but is still worth considering for the 2017 tax year.
3. Understand the different rules for trading and mining
What’s more, cryptominers are responsible for paying taxes on their mining activity. For this population segment, matters are even worse still: first, the mere act of mining incurs a tax liability equal to the fair value, in USD, at the date of mining. Additionally, miners are required to compute and pay the maligned “self-employment tax,” which consists of FICA, FUTA, and OASDI – that’s an additional 18% on top of their ordinary income tax rate which could potentially be as high as 39.6% last year. For those keeping score at home, miners could potentially be on the hook at a 50% effective tax rate when all is said and done.
Miners are permitted to make business deductions for the cost of mining equipment, but those deductions are likely a rounding error when compared to the income (and tax liability) generated by their mining activity. While these amounts may not be immediately traceable by the IRS, any attempt to exchange cryptocurrency for USD and remit funds to a US-based checking account will create the paper trail that’s necessary to establish custody of ownership and open the door for underpayment penalties down the road.
4. Bring on professional help
This flurry of interest has only served to amplify the uncertainty and disseminate misinformation regarding the proper tax treatment of cryptoassets. In a recent article, Forbes even went so far as to suggest that cryptotraders file requests for extensions rather than rush to self-prepare a return and risk underreporting to the IRS. While some miners and traders will no doubt attempt to hide their assets thinking they can escape scrutiny, more savvy members of the cryptocommunity are taking proactive steps.
While the 2017 tax year is likely the primary focus for a traders and miners, it’s important to remember that transactions as far back as 2014 are considered taxable. This opens a Pandora’s Box and could potentially mean filing (and paying) amended returns for earlier tax years, depending on when a trader first acquired cryptocurrency. A qualified tax professional can help address this issue and offer a menu of options unique to a trader’s specific facts and circumstances. Other options include exploring netting strategies using non-cryptoassets such as stocks and bonds.
In summary, the taxation of crypto assets is not new and is here to stay. In future years, high-profile cases of crypto tax evasion will give rise to court rulings which will further clarify the treatment of Bitcoin and its brethren.
But the message today is simple: pay your taxes. Those who attempt to escape the long arms of the IRS do so at their own peril. After all, no one wants to be made an example of.