Cryptocurrency and Taxes: What You Need to Know Before Filing

By
TradersDNA

The popularity of cryptocurrency continues to soar, attracting investors and traders from all walks of life. However, with the increasing adoption of digital assets comes the necessity to understand the complex tax obligations they introduce. From Bitcoin to Ethereum, many crypto investors need to be made aware of how transactions in these virtual currencies affect their taxes, leading to potential legal risks if they don’t file accurately. As tax season approaches, it’s essential to understand the implications of cryptocurrency trading on your tax return, the classifications of these assets, and the steps you can take to avoid unwanted IRS scrutiny.

Before diving into your cryptocurrency tax responsibilities, consider the guidance offered by professional services, such as Tax Law Advocates Representation. These services are invaluable for individuals who need help navigating the intricacies of the IRS’s cryptocurrency guidelines, especially if they require support with broader tax relief programs like the IRS Fresh Start Program.

Cryptocurrency and Taxes: What You Need to Know Before Filing

How Cryptocurrency is Classified for Tax Purposes

Cryptocurrency is recognized as property in the USA rather than a currency, and it is classified by the IRS, which means the taxation rules are different. When you trade cryptocurrencies or other digital assets, these transactions may be taxable as capital gains or income. For example, if you buy Bitcoin and wait for it to appreciate, then sell it, you are only required to pay taxes. However, if you receive cryptocurrency as a payment for your services, you are subject to the regular income tax.

That is why you must file each reportable event separately, as cryptocurrencies are considered property. Any activity such as buying, selling, exchanging, or using digital assets for goods and services generates a taxable event that has to be recorded and reported to the IRS. The tax rate applied depends on the type of use, as in the capital gains tax rules on stocks, where the period of holding the asset determines the rate of tax to be paid.

Due to the specificity of cryptocurrency reporting, any record of your activities should be kept in detail, including the dates of the activity, the amount of the activity, and the USD value of the cryptocurrency at the time of the activity. This information is useful when determining your profit or loss for tax purposes when preparing your tax return.

IRS Guidelines and Compliance

Recently, the IRS has become much more active in identifying and combating cryptocurrency users who fail to report their income and pay taxes. The agency now expects taxpayers to declare any activity with cryptocurrency as and when filing their tax returns. In the 1040 form, one must answer whether they have ‘received, sold, sent, exchanged, or otherwise acquired a financial interest in any virtual currency at any time during the taxable year.’ Responding ‘yes’ means you must legally include all relevant transactions on your return.

Failure to meet these standards attracts audits, fines, and, where there is intent to avoid the law, criminal charges. Sometimes, the IRS sends letters or penalties to people believed to have omitted their profits from cryptocurrency trading.

There are penalties for not reporting cryptocurrency transactions. Possible consequences are monetary sanctions and, in more severe instances, legal consequences. For example, the IRS Fresh Start program provides solutions for individuals struggling with tax payment, providing a way to seek tax relief through either an installation plan or an offer in compromise. 

Calculating Gains and Losses

Gauging a cryptocurrency sale’s capital gains and losses takes work, more so among active traders or those dealing with multiple exchanges. In most cases, the profit or the loss is arrived at by subtracting the actual purchase price of the digital currency from the selling price. If you could sell or otherwise dispose of your cryptocurrency for a higher price than you bought it, you will have to pay capital gains. On the other hand, if you sold it at a price below the purchase cost, you recorded a capital loss.

Crypto tax calculations are usually done based on one of the several cost-based methods, including the first in-first out (FIFO) method or the last in-first out (LIFO) method. The method you choose determines the gains and losses you report; therefore, selecting the most suitable method for a particular situation is prudent. Some crypto investors consult with tax advisors to know which cost-basis method leads to the lowest taxable income, especially when they frequently trade in cryptos.

Special Considerations for Crypto-to-Crypto Transactions

CryptUnlikeentional investments, entaicryptocurrency is direct swaps of cryptocurrencies without necessarily converting to traditional money. Any exchange of one digital currency for another, for example, exchanging Bitcoin for Ethereum, is considered a taxable event. The IRS regards trading one cryptocurrency for the other as if you sold the first asset at the fair market value and bought the second asset. 

Investors who have engaged in decentralized exchanges or wallets must ensure that they determine the Fair Market Value for each transaction. Despite the software applications that exist in the market that allow investors to monitor cryptocurrency transactions and calculate profits or losses, investors should ensure that they provide accurate information to avoid understating.

Conclusion

Since cryptocurrency is gradually gaining a place in the financial world, knowing how it affects your taxes is vital. The IRS also established satisfactory principles on declaring and paying taxes on the profits of the trade in cryptocurrencies; noncompliance with these rules has severe penalties. Whether it is as essential as knowing how cryptocurrency is classified or as complex as learning how crypto-to-crypto trades work, reporting is crucial to being compliant.

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