Crypto is big. In fact, the global crypto asset market capitalization recently eclipsed $2.75 trillion. As the value of cryptocurrencies such as Bitcoin and Ethereum grows, so does investor interest. But those who transact in cryptocurrencies must understand current tax implications of their transactions - not an easy feat when those tax implications are quickly developing and changing.
The IRS has been trying to keep pace with the virtual currency revolution. Evidence of this effort made its way to the “front page” of your 2021 Form 1040. “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in virtual currency?”
IRS Notice 2014-21 defines “virtual currency” as a “digital asset”, classifying it as property. Therefore, when an individual exchanges “virtual currency,” they are disposing of “property” and are taxed accordingly. The taxation of the digital asset is contingent upon the character of the income and the transaction. Comparable to stocks and bonds, income and loss will be subject to ordinary and capital gain rates. If the “digital asset” has been held for less than one year, it is classified as a short-term capital gain, and will be taxed at ordinary tax rates. Assets held for more than one year will result in a long-term capital gain tax. Gains may also be subject to an additional 3.8% net investment income tax (NIIT).
Any time cryptocurrency is disposed of in the US, investors will be taxed on any recognized profit. Disposing of cryptocurrency includes selling the asset for fiat currency, swapping cryptocurrency for cryptocurrency, spending cryptocurrency on goods and services, and gifting cryptocurrency over defined threshold ($15,000 in 2021; $16,000 in 2022). The cost basis of the digital asset is the amount paid to acquire the asset, including any transaction fees. If the price realized for the asset is greater than the cost basis in the cryptocurrency, a tax liability results. Should terms be reversed, disposal may result in a capital loss. Standard rules for offsetting capital gains and losses applies to cryptocurrencies.
For businesses who accept cryptocurrency payments in exchange for goods or services, it is considered taxable income as it cash had been received. For reporting purposes, the dollar value received for the goods is equivalent to the fair market value of the “digital currency” on the day it was received.
Cryptocurrency gains and losses may be calculated using one of three different methods: FIFO (first-in first out), LIFO (last in first out) or HIFO (highest in first out) explained below:
- HIFO (highest in, first out) – This method will sell shares with highest cost first. A higher cost basis yields a lower capital gain or higher capital loss. HIFO allows taxpayers to select the most expensive bitcoin purchased for their cost basis. To take advantage of this accounting method, investors must keep detailed records relating to each coin owned, when it was purchased, the amount it was purchased for, when it was sold, and the market value at that time to corroborate these calculations to the IRS.
- Investors failing to maintain sufficiently detailed records regarding related transactions will use FIFO or LIFO methods to calculate capital gains and losses.
Because Internal Revenue Service code is evolving quickly regarding virtual currency transactions, it is more important than ever to seek the guidance of an experienced tax advisor. Our LTax experts are keeping tabs on the evolution of IRS code as it relates to cryptocurrencies, and we will continue to share updates as available.
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