The Internal Revenue Service (IRS) arrived late to the cryptocurrency party. But it is making up for lost time.
In less than a month, the federal agency is reported to have sent out three sets of letters to holders of cryptocurrencies. The first one was an informational missive to 10,000 crypto holders, educating them about their tax liabilities with regards to the asset class. The second and third sets of letters, sent last week, meant business. The CP2000 notices, as they are called, listed tax liabilities in detail and payment deadlines.
Observers say the letters are aimed at netting institutional investors and trading firms, which milked the bull market for fat profits.
The letters may have come as a surprise to retail crypto holders. But the good news is that the federal agency has not created a new rulebook for cryptoassets. It treats cryptocurrencies as property, meaning an appreciation in their price will incur capital gains tax.
Here are some of the most commonly-asked questions about crypto taxes.
What form do I need to file my crypto taxes?
Form 8949 is used to report sales and exchange of assets. It reconciles amounts reported in 1099 forms with the IRS’ assessment of the amount owed by investors through trading.
Does the IRS have current information on all my crypto trades?
In 2016, the IRS issued a “John Doe” subpoena to North America’s biggest exchange Coinbase for customers who transferred Bitcoin on its platform between 2013 and 2015. The San Francisco-based company resisted the summons but eventually capitulated, handing over information for 13,000 of its users in 2018. Some say that the current batch of IRS letters is culled from that list. The time period for information sought by the IRS is of critical importance here because it means that investors who purchased Bitcoin in 2012 or earlier are in the clear for tax liabilities, based on the current state of affairs.
But there might be a catch as far as IRS information about crypto trades is concerned. Because cryptocurrencies can be traded across borders 24X7, the federal agency may not have access to the latest and most current information regarding crypto trades conducted by U.S – based traders. For example, the IRS may not have authority or access to the purchase and sale history for a US trader at Malta-based Binance or Chinese exchange OKEx.
How do I account for airdrops and hard forks in my tax statement?
(For those unfamiliar with these terms, an airdrop is an event in which cryptocurrencies are issued for free to traders who have registered on a platform. A cryptocurrency’s blockchain is split, resulting in two different coins, during a hard fork).
The IRS has not provided clear guidance about methods to tax hard forks or airdrops. Devin Black, product manager at Tokentax – a crypto tax software company, says there are two ways in which the firm’s clients treat cryptocurrencies.
The first one is to claim it as “other income” in their tax filing based on the fair market value or number of tokens received. The second way is to assign a zero-dollar cost basis (or, to treat the purchase price as zero for the cryptocurrencies) and pay the appropriate tax on the sale amount.
You can also assign no income or no cost basis for cryptocurrency gained through hard forks or airdrops.
How is mining treated under the current tax code? Can I claim deductions against mining equipment?
Mining cryptocurrencies is equivalent to earning income. “In essence, you are creating your own de facto business,” explains George Dimov, a New York City-based tax accountant. New cryptocurrencies generated through mining are income and their cost basis is the fair market value of the coins at the time they are generated.
As with any business, miners can claim deductions against equipment used. In the case of cryptocurrencies, this translates to mining equipment and other resources assigned to the task.
Dimov says the deductions claimed in the filing should be “reasonable”. For example, if you purchase a Bitmain Antminer and dedicate it exclusively to the purpose of mining cryptocurrencies then you can claim 100% deduction against its purchase price.
However, if you are using your own PC (or have upgraded your existing PC with high-end graphics cards to facilitate mining) then you need to prorate or bifurcate the amount of time and resources dedicated to mining crypto on your computer.
(The IRS employs similar criteria to evaluate deductions for self-employed individuals working from a home office).
Do I need specialized software to file cryptocurrency taxes?
The answer to that question depends on who you ask. “There’s really no custom tax preparation software required if you’ve only made a few trades,” says Dimov. According to him, IRS rules for filing crypto taxes are the same as for other market trades. “You can just use the sale price of your trade as cost basis and give it to your tax accountant,” he explains. Or, if you are experienced enough, fill out the form yourself.
Black from Tokentax disagrees. He says crypto taxes are “tricky” because you have to account for numerous transactions in order to conduct a trade. “The thing is, filling out an 8949 can still be a daunting task for many even with few transactions as buys and sells have to be matched up (and sometimes you have multiple sells with a single cost basis, etc), the term of sales to be calculated as short or long term, and so on,” he explains.
For example, a crypto-to-crypto conversion transaction (i.e., one in which one cryptocurrency is converted to another to facilitate purchase) incurs tax as does sale of a cryptocurrency. Such transactions are fairly common at cryptocurrency exchanges as, apart from Bitcoin and Ethereum – the world’s first- and second-most valuable cryptocurrencies, the majority of cryptocurrencies are not available directly through fiat purchases and generally require intermediate crypto conversion steps.
How much technical knowledge do I need to file my crypto taxes?
Most well-known cryptocurrency exchanges, such as Coinbase, offer details of trading history in 1099 forms for tax preparation. Traders use these forms if their trades are restricted to single or a handful of exchanges.
The complication occurs when trades are distributed across multiple cryptocurrency exchanges because not all exchanges list all coins. Creating wallets and accounts between exchanges itself requires technical skills that are over and above regular computer skills.
“Anyone who is trading cryptocurrencies is a very technical person…just to be able to open up a crypto trading account, creating wallets, and then transferring it to another exchange (that may be outside the country) requires quite a bit of work,” says Dimov.
To that extent, crypto trading software can help customers make sense of a fragmented cryptocurrency ecosystem with a global footprint. Most online crypto tax preparation software connects directly to exchanges.
One of the most common services offered by tax software is connections to different exchanges. The process to connect differs based on the type of exchange. For example, establishing a connection to Coinbase from Tokentax is fairly easy and simply requires entry of login credentials.
But connections to other exchanges, including Coinbase Pro, is a fairly technical process and requires knowledge of concepts like API keys and passphrases. Traders also need to take into account the processing time required to import data from crypto exchanges. This depends on connection speeds and volume of data.
Other methods to enter information are manual entry, CSV, or uploading tax documents (if you’ve chosen to work with a CPA provided by the service).
All of this sounds complicated. Why can’t I just let my accountant handle the software?
That might sound like a good idea. But there are a number of issues involved, says Dimov. First, there is the privacy factor. Not all crypto traders are comfortable with sharing login details with their tax specialists. Second, crypto tax preparation software may not always pull the most accurate data for your trades. In cases of discrepancy in data, it helps to have traders themselves double-check the figures.
There are so many scams and hacks in crypto. What if I lose money in an ICO scam or an exchange hack? Can I claim tax deductions in such instances?
Cryptocurrency exchange and wallet hacks are a new area for the IRS. The answer to the question above becomes even more muddled in light of President Trump’s tax reforms. Without clear guidance from the IRS, it is important to consider carefully the ramifications of classifications.
The treatment of losses occurring due to initial coin offerings (ICOs) scams is not clear within the existing framework. Typically, loss of funds in an ICO scam is generally treated as a capital loss and depends on several factors, including timing of the claim. As an example, it might make a difference if you report loss of funds through an ICO scam immediately after the offering as opposed to claiming losses after earning income from the offering.
Hacked cryptocurrency wallets may be treated as theft losses, which are itemized deductions. But the activity in those wallets is important in determining the extent of those losses. If a trader’s wallet held bitcoin for the purposes of price appreciation, then the loss might be treated as a profit activity.
However, if wallet activity shows that cryptocurrencies were used to conduct commerce-related transactions then the hack will be treated as “Other Losses.”