Guide to IRS Rules on Taxation of Cryptocurrency Transactions

Simplifying Cryptocurrency Tax Law: IRS Rules and Tax Implications

With the introduction of Bitcoin in 2009, more than 10,000 variants of crypto assets appeared as payment instruments. The rapid development of Crypto and its pseudomonas nature poses challenges for the country's tax system. Despite being a decentralized currency, the government has recognized it as a medium of exchange, a store of value, and a unit of account. It can be substituted for real money, making it liable to taxation. Here, we will examine how the government recognizes cryptocurrency tax in the USA.

Key Highlights

  •  The IRS considers digital assets as property that is subject to taxable law.

  •  When you sell a cryptocurrency, you pay capital gain taxes.

  •  When you sell a cryptocurrency and make a profit, it is treated as capital gains on the profit, the same as in shares.

  •  When you use Cryptocurrency to buy goods or services, you pay taxes on the increased value between the price you paid for the Cryptocurrency and its value when you spend it. 

  •  Using Cryptocurrency as a payment for goods or services is treated as your business income.

  •  When you mine a cryptocurrency, the value of your Crypto at the time of mining is counted as your income, which is subject to tax.

Cryptocurrency Tax in the USA

In the United States, the Internal Revenue Service treats Cryptocurrency as a property subject to capital gains applicable to profit generated from trading or disposing of it. It is applied to long-term and short-term capital gain, which means the investors are liable for different durations of taxation for holding their Cryptocurrency.

  • For example-  Any profit made within one year after buying the Cryptocurrency is treated under the short-term capital gain tax rate. On the other hand, the profit realized after holding the asset for more than one year is subject to a long-term capital gain tax rate. Also, cryptocurrency investors must report any cryptocurrency income or capital gain earned during a tax year.

  • For long-term capital gain, you pay 0% to 20%; for short-term capital gain, you pay 10% to 37%, depending on your income level.

As we have already understood, the IRS treats Cryptocurrency as property, which also means it is subject to capital gain tax rules. Buying something, Cryptocurrency is considered a sale because you are selling a portion of your holding to cover the purchase cost. This means using cryptocurrencies for shopping can be a taxable event.

  • For example, if you use one bitcoin to buy a car worth $45000,  and the value of Bitcoin is about $40000 when you acquire it, you have gained $5000 on this transaction. Conversely, if the original value of Bitcoin is $50000, the transaction would result in a loss of $5000. You can use this loss to offset capital gains or taxable income in the same year.

Under the current law, the Crypto owner must report all their transactions to the IRS. As traditional financial institutions provide you with a 1099 form, cryptocurrency exchange does not issue it. Therefore, every individual must diligently keep receipts and confirmations for every purchase and sale of their Cryptocurrency. It is tax evasion if you intentionally or unintentionally underreport your income. Get guidance from a tax advisor if you need help properly reporting cryptocurrency transactions.

IRS Rules and Cryptocurrency Taxes

The IRS has released Form 1040 2022, including the dedicated Digital assets section. The section contains questions from last year's tax return. "At any time during 2022, did you (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?".

The most recent guidance of the IRS underscores that Crypto brokers, including centralized and decentralized exchanges,  payment processors, and even some online wallets, are required to issue the new form 1099 DA  to the users and the IRS. If the proposal progresses,  businesses viewed as Crypto brokers will also be required to begin issuing 1099 DA forms from January 2026 to report on users' gains and losses from the 2025 financial year.

How Do You Report Your Cryptocurrency to the IRS?

It is an individual's responsibility to keep track of their gains and losses. Make sure to stay on the right side of the rules and keep all your records. You need to keep records of the fair market value of your Crypto when you mine, swap it, and sell it.

1- Report Capital Gains or Losses from Cryptocurrency

You must report sales and other capital transactions and calculate capital gains and losses as per IRS and instructions in Form 8949- Sales and Other Dispositions of Capital Assets. Summarise your capital gains and deductible capital losses on Form 1040, Schedule S, Capital gains and losses.

2- Report Ordinary Income from Cryptocurrency.

You must report your ordinary income from Cryptocurrency on Form 1040, U.S. Individual Tax Return, Form 1040-SS, Form 1040-NR, or Form 1040, Schedule 1, Additional Income and Adjustments to Income.

Tax Liabilities for Crypto Investors Who Don't Sell

The tax situation is relatively straightforward when you buy and decide to hold. It means you don’t need to report your Crypto when you purchase on your tax return if you have sold. But other events oblique you for tax liabilities.  

  1. When you earn Crypto as payment for goods and services. 

  2. When you receive Crypto from mining and airdrops.

  3. When you receive Crypto from trading and swapping.

  4. When you earn interest on your Crypto by lending.

  5. When you receive new coins from a hard fork, the new coin is taxable.

Way to Minimise Crypto Tax Liability

Cryptocurrency is seen as an exciting investment option for money. Still, many prefer to avoid entering this segment due to its tax liability and paying hefty tax bills. However, there are ways to minimize Crypto tax liability or reduce your Crypto taxes and keep making more profit on your investment.

1- Prefer Long-term Investment:

Investing long-term is the simplest way to save on Crypto taxes. Therefore,  plan when it comes to Crypto taxes. Carefully understand the tax implications on your investment and take steps to minimize your tax liability. You can save a considerable amount on taxes by investing over the long term.

2- Consider Some Donations:

You can donate your currency to charity to save some on crypto taxes.   Keep in mind you are donating your Cryptocurrency to a qualified charitable organization. By doing so, you can receive a tax deduction on the fair market value of your Cryptocurrency at the time of the donation.

3- Use Self-Directed IRA:

A self-directed IRA is a retirement account that helps you invest in a wide range of a set, including Cryptocurrency. You can use a self-directed IRA to invest in cryptocurrencies deferred from taxes. This can be a great way to save taxes and build your retirement fund.

4- Use Previous Crypto Losses:

If some of your investments run in red, you can use them to offset gains. This can help you introduce your overall tax bill. However, it is also essential to understand that you can only use losses to offset gains in the same tax year. 

Does the IRS Audit Crypto Transactions?

If the IRS suspects underreporting cryptocurrency taxes, they will act by initiating an audit or sending a warning letter to the potential unpaid taxpayer. The IRS has been actively addressing non-complaints in the light of cryptocurrency transactions. In 2019, the IRS sent out more than 10000 tax notices to non-compliant taxpayers. IRS is putting more effort into Crypto traders and investors who are under-reporting their gains; however, it will also focus on those traders who are over-reporting losses to lower their tax bill.

List of Crypto Tax-Free Countries

El Salvador became the first country to legalize Bitcoin and recognize it as a currency. However, only some countries can legalize Bitcoin due to its decentralized nature. Still, as cryptocurrencies are gaining popularity, most countries consider them a tax-free asset. Here is the list of those countries where Crypto is tax-free (to some extent).

  • Portugal

  • Puerto Rico

  • United Arab Emirates

  • Switzerland

  • Singapore

  • Bermuda

  • Belarus 

  • Slovenia

  • Germany

  • Costa Rica

Final Words

Major fluctuations in the value of cryptocurrency trigger questions in the minds of crypto traders and investors about how Cryptocurrency is taxed. To avoid legal issues, it is vital to understand how the IRS treats cryptocurrency and how Cryptocurrency is taxed in the USA. IRS considers digital assets as property that is subject to taxable law.

FAQs

Is swapping Crypto taxable?
Yes, swapping one Cryptocurrency for another is treated as a taxable event by the IRS because it involves the disposal of crypto assets. Any gain from swapping is subject to either short-term or long-term capital gains depending on the duration you have held the original Crypto.

Do I need to report Crypto if I didn’t sell?
If you only purchase Crypto and don't sell, swap, spend, or otherwise earn Crypto, you do not need to report it to the IRS. IRS is only interested in gains, losses, and income from Crypto. If you gain or lose through swapping, you need to report.

How much tax do you pay on crypto gains?
On short-term capital gain, you pay up to 30% tax; on long-term gain, you pay up to 20% tax, depending on your gains.

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Noah Willaims 28 Nov, 2023

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