With cryptocurrencies skyrocketing in recent years, the IRS is coming for crypto users and investors who haven’t paid their taxes.
Cryptocurrency has become mainstream and gained popularity over the years. As of August 2021, there are more than 6,000 types of virtual currency – a huge increase since 2013.
With the increasing acceptance of cryptocurrencies as forms of payment, the Internal Revenue Service (IRS) sharpens its focus on crypto transactions. The IRS launched its Operation Hidden Treasure to look at blockchains for unreported crypto income.
As such, people who trade digital currencies but failed to report their use or trading of virtual currency or have been ignoring their tax obligations may find themselves the target of the IRS.
Experts in the industry share that this could create some unwelcome tax bills especially for those who conduct multiple transactions each year. It can also be difficult for digital currency traders to keep track of what’s owed on their gains.
There’s a cryptocurrency tax, so if you’ve been lenient on your crypto taxes, it’s the right time to clean up your act. Not doing so could lead to future tax problems, especially if you have unreported profits on Bitcoin, Ethereum, or other cryptos.
This article will guide you to better understand how cryptocurrency is taxed and if you have to pay taxes on cryptocurrency.
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What Is Cryptocurrency?
Cryptocurrency, also known as virtual currency, is digital and decentralized money based on blockchain technology.
It can be used to buy goods and services, transferred, traded, saved for future use, be given as a gift, or held for investment.
The first, most popular, and widely used cryptocurrency is Bitcoin.
Generally, the IRS treats cryptocurrency as “property”, similar to stocks, gold, or other investments. This means that a virtual currency will assess capital gains when it’s sold at a profit.
For instance, if you bought your Bitcoin and then exchanged or sold it, you have to pay taxes for that gain.
Many retailers and businesses accept cryptocurrencies as payment to minimize transaction fees charged by credit card and payment processing companies.
As cryptocurrencies are wholly digital, there isn’t any physical coin or bill connected to them. And unlike conventional currencies which are backed by a central bank or financial institutions, cryptocurrencies aren’t regulated.
Instead, virtual currencies are recorded in a digitized public ledger called a “blockchain.”
Cryptocurrencies are relatively secured in the sense that they are backed by blockchain technology. But they don’t have the same level of protection as standard currencies.
Though cryptocurrencies are unregulated and come with risk factors, all transactions are recorded on a decentralized ledger. And each transaction in the blockchain comes with a digital verification process to prevent fraud.
IRS is Cracking Down Cryptocurrency Transactions
IRS chief Charles Rettig shared how the country is losing about a trillion dollars every year in unpaid taxes.
With the huge “tax gap” between taxes paid and taxes owed, the federal government is also determined to crack down on tax evaders. This is in line with the government’s need to raise money for its economic agenda.
As the U.S. Government, Federal Reserve, and SEC call for more virtual currency regulations, the IRS issues guidance on the tax treatment of certain cryptocurrency transactions.
IRS is aggressively pursuing enforcement of compliance in cryptocurrency transactions.
IRS Cryptocurrency Enforcement Effort
The U.S. Treasury Department is taking a more active role in cryptocurrency regulation. In a release, the department announced that any transfer worth $10,000 or more has to be reported to the Internal Revenue Service.
Over the years, the IRS has stepped up cryptocurrency monitoring and enforcement.
Since 2014, the IRS has established guidance stating that virtual currency should be treated as property for federal tax purposes and that capital gains tax rules apply.
The IRS said that from 2013 to 2015, only about 800 to 900 taxpayers filed tax returns reporting gains from cryptocurrency.
In 2017, the IRS filed a lawsuit against one of the largest crypto exchanges, Coinbase. There’s a huge gap as Coinbase has almost 6 million customers. In response to the litigation, Coinbase turned over 13,000 names to the IRS.
As part of the crypto crackdown, the court also authorized the IRS to issue “John Doe” summonses to virtual exchange operators Kraken and Circle.
In 2019, the IRS has sent more than 10,000 letters to people who have potentially failed to report their cryptocurrency income.
These “soft letters” warn cryptocurrency account holders to take action on their tax returns before the audit happens. It reminds recipients to act in good faith, check their returns, and ensure that cryptocurrencies were accurately reported.
In May 2020, IRS issued a Statement of Work seeking cryptocurrency third-party experts to audit taxpayers’ virtual currency transactions.
This statement of work implies contractors to “ingest all data provided by the IRS, as well as any attendant or related data the contractor collects through their systems.” The contractor must also analyze blockchain data and application programming interface keys obtained from virtual currency exchanges.
Thus, the IRS has also committed to issuing rules to clarify how virtual currencies should be taxed and how to do that under the current regulations.
Understanding Cryptocurrency Tax Basics
Under the current IRS Guidance, the 2020 version of IRS Form 1040, if you have received, sold, sent, exchanged, or otherwise acquired – at any time during the year – any financial interest in any virtual currency, you must attach a full crypto tax report to your return.
How Much Do I Owe in Crypto Taxes?
The good news is, owning a cryptocurrency doesn’t create a tax liability instantly.
Instead, you only owe taxes if you spend or sell it and gain a profit. And your tax is based on the IRS cryptocurrency tax rate.
This means that the capital gains and losses you incur when buying, selling, and trading cryptocurrencies have to be reported on your tax return.
You don’t owe any taxes on the transaction if you sell or spend your cryptocurrency at a loss.
For instance, if you purchased $10,000 Bitcoin and sold it for $15,000, your taxable gain would be $5,000. But if you sold your Bitcoin for only $8,000, you’d owe nothing in taxes.
And if all you did was hold, you also won’t owe taxes on your crypto – but the IRS still wants to know this.
Take Note: Cryptocurrency taxes also depend on your tax bracket, how long you’ve held your cryptocurrency, and how you got and used it.
Understanding Tax Treatment of Virtual Currency Transactions
IRS guidance in Notice 2014-21 sets a ruling that virtual currency should be treated as property for federal income tax purposes.
Cryptocurrency Payments to Employees and Independent Contractor
Thus, businesses accepting cryptocurrencies as payment for transactions must report gross income based on the fair market value (FMV) of the virtual currency when it was received – which is measured in equivalent U.S. dollars.
When cryptocurrency is used to pay wages to employees, the wages are taxable to the employees. This is subject to federal income tax withholding, FICA tax, and FUTA tax; and should be reported in the employees’ W-2 forms.
When cryptocurrency is used as payment to independent contractors or service providers, the payment is also subject to self-employment tax for the contractor. You are to report this on Form 1099-NEC provided that payment amounts to $600 or more during the year. The rules for self-employment tax apply and payers must issue 1099-MISC forms.
Thus, any taxpayer who receives virtual currency as payment for goods or services is required to include the FMV of the cryptocurrency in his reported taxable income.
There’s also a tax gain or loss due to the appreciation or decline of the cryptocurrency value during the time you held it before paying employees or independent contractors.
When you receive virtual currency as payment for goods or services, you have to determine the FMV of the currency based on the transaction date, measured in U.S. dollars. From there, you can calculate your taxable income or gain.
Based on what the IRS states:
“A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received.”
You can check the IRS for additional information on reporting virtual currency income in more specific cases.
Understand that virtual transactions have real-life tax implications. The important thing you can do now is to get ready with your taxes.
Start planning to simplify your virtual currency tax filing. Gather your reports and figure out what you owe.
Connect with a Tax Lawyer
Given the emerging nature of cryptocurrency, it will remain to be part of the mainstream virtual marketplace. Taxation will be a complex undertaking and is expected to evolve as more regulations are introduced. Also, the scrutiny surrounding tax reporting will continue to intensify.
If you’re engaged in cryptocurrency in any form or are expecting to do so soon, you need to understand how it impacts your tax liability.
If you need assistance in reporting virtual currency, whether as an individual or for a business, experienced tax attorneys can help.
Consider working with a tax professional who has experience analyzing tax codes related to virtual currencies.
We look forward to helping you.