By: Steven Gamboa
Over the past decade, cryptocurrency has revolutionized the finance world as it transformed from a textbook concept into a global virtual currency valued at over $1.3 trillion. The introduction of this virtual currency has raised concerns amongst individuals regarding income reporting guidelines and possible tax implications associated with cryptocurrency transactions. Since it can be a complex topic to comprehend, the summary below outlines what cryptocurrency is and various issues that could potentially impact your upcoming tax return filing.
Cryptocurrency is a virtual currency generally used to exchange goods and services and is slowly moving towards becoming an accepted payment method across multiple online platforms. Cryptocurrency is also commonly used as an investment tool, similar to stock portfolios, in which individuals purchase currencies – also known as tokens – that are eventually disposed or traded for other tokens resulting in either a taxable gain or loss for the seller. Cryptocurrency has gained notoriety due to its extremely volatile and at times unpredictable market performance which can rapidly accumulate significant losses without the proper guidance. Bitcoin, the most popular cryptocurrency at the time of this article, serves as a prime example of the risks associated with cryptocurrency trading since it has lost nearly half of its value after reaching an all-time high in April of 2021.
Cryptocurrency Tracking Challenges
Currently, one of the main challenges associated with cryptocurrency is the difficulty of accurate record keeping for tax reporting purposes. Generating transaction reports is generally easy if an individual is only using one exchange platform. Accurate record keeping becomes an increasingly challenging task when trading on multiple exchange platforms. In accordance with the IRS guidance, it is the taxpayer’s responsibility to have sufficient records “to establish the positions taken on tax returns”. Certain exchange platforms such as Robinhood have started issuing Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, to report the proceeds of an individual’s crypto transactions on their platform, as well as the cost basis when available. The cost basis will not be reported on Form 1099-B if the individual traded on multiple exchange platforms. To support the crypto activity reported on their tax return, some taxpayers have opted for tracking their crypto transactions on Microsoft Excel Sheets which can prove to be a tedious task. Therefore, to facilitate the tracking of cryptocurrency cost basis across multiple exchange platforms, paid software programs which generate crypto activity reports such as CoinTracker and Delta have been introduced for more accurate tax reporting.
Taxation of Cryptocurrency Gains
In 2014, the IRS ruled that cryptocurrency must be treated as a capital asset for tax reporting purposes. Therefore, cryptocurrency gains are taxed using capital gains tax rates which are the same tax rates imposed on investment profits such as stocks, bonds, and certain real estate property.
Cryptocurrency Tax Rates: Short-Term vs Long-Term
Income and losses arising from cryptocurrency are reported on the individual’s personal income tax return for the year during which a transaction was finalized. Since cryptocurrency profits are taxed in accordance with capital gain tax rates, the holding period of the tokens will dictate the tax treatment of each transaction.
For example, profits arising from tokens held for less than one year are classified as short-term capital gains. Short-term capital gains are considered ordinary income; therefore, they are taxed according to an individual’s tax bracket which is the same tax rate applied to regular wages/salary earnings.
The following tax rates apply to short-term capital gains realized in 2021 according to an individual’s filing status and taxable income reported on their tax return:
|2021 Short-Term Capital Gains Rates|
|Tax Rate||Single||Married Filing Joint||Married Filing Separately||Head of Household|
|10%||Up to $9,950||Up to $19,900||Up to $9,950||Up to $14,200|
|12%||$9,951 to $40,525||$19,901 to $81,050||$9,951 to $40,525||$14,201 to $54,200|
|22%||$40,526 to $86,375||$81,051 to $172,750||$40,526 to $86,375||$54,201 to $86,350|
|24%||$86,376 to $164,925||$172,751 to $329,850||$86,376 to $164,925||$86,351 to $164,900|
|32%||$164,926 to $209,425||$329,851 to $418,850||$164,926 to $209,425||$164,901 to $209,400|
|35%||$209,426 to $523,600||$418,851 to $628,300||$209,426 to $314,150||$209,401 to $523,600|
|37%||Over $523,600||Over $628,300||Over $314,150||Over $523,601|
On the other hand, profits arising from tokens held for one year or longer are considered long-term capital gains which receive a much more favorable tax treatment than ordinary income.
The following tax rates ranging from 0% to 20% apply to long-term capital gains realized in 2021 according to an individual’s filing status and the taxable income reported on their tax return:
|2021 Long-Term Capital Gains Rates|
|Filing Status||0% Rate||15% Rate||20% Rate|
|Single||Up to $40,400||$40,401 to $445,850||Over $445,850|
|Married Filing Joint||Up to $80,800||$80,801 to $501,600||Over $501,600|
|Married Filing Separately||Up to $40,400||$40,401 to $250,800||Over $250,800|
|Head of Household||Up to $54,100||$54,101 to $473,750||Over $473,750|
Reporting Cryptocurrency Activity
Gains and losses originating from cryptocurrency are reported on Form 1040, Individual Income Tax Return, using Schedule D. Schedule D is typically used by taxpayers to report the sale of capital assets such as their home, car, and stocks. Form 8949 is also utilized to reconcile capital gains and losses and to separate each transaction in accordance with its designated holding period.
Individual taxpayers are allowed up to a $3,000 deduction from their taxable income if cryptocurrency losses exceed the gains.
Cryptocurrency “Wash Sale” Loophole
Although crypto activity is reported using the same method as stock sales for tax purposes, the IRS classifies cryptocurrency as “property” instead of a stock or security. A wash sale occurs when a security is sold at a loss and either the same security or “substantially identical” securities are repurchased within a 30-day period. Under wash sale rules, the losses realized from stocks and securities during the 30-day period would be entirely disallowed. The classification difference might seem small at first glance; however, it results in a much more favorable tax treatment for cryptocurrency since wash sale rules only apply to stocks and securities. For example, it may be advantageous to sell your cryptocurrency for a loss during volatile periods to lock in a realized loss and then immediately repurchase the cryptocurrency. By utilizing this strategy, we are able to utilize these losses to offset other capital gains in our portfolio and possibly reduce ordinary income by up to $3,000. Capital losses arising from cryptocurrency transactions cannot be disallowed and can be utilized to lower an individual’s overall tax liability by offsetting capital gains originating from other stocks and security transactions.