Crypto tax season is fast approaching. With so many investors entering the crypto market the past year, that means dealing with a new asset class on their taxes. And even for seasoned investors, the regulatory landscape changes all the time. Here’s what you need to know about filing crypto taxes for 2020.
The U.S. Internal Revenue Service (IRS) in 2014 decided bitcoin and other cryptocurrencies should be treated as “property”, meaning they qualify for capital gains treatment similar to traditional assets like stocks and bonds. There are, however, some instances where certain activities involving digital assets are treated as income and therefore subject to income tax.
What crypto actions are taxable events in the United States?
Capital gains tax events involving cryptocurrencies include:
- Selling cryptocurrency for fiat (U.S. dollar, British pound sterling, Japanese yen, etc.)
- Using cryptocurrency to purchase goods and services.
- Trading or swapping one crypto asset for another, either on an exchange or directly peer-to-peer.
Income tax events include:
- Receiving cryptocurrency from an airdrop
- Any crypto interest earnings from decentralized finance (DeFi) lending
- Crypto mining income from block rewards and transaction fees
- Crypto earned from liquidity pools and staking
- Receiving cryptocurrency as a means of payment for carrying out work, including bug bounties
It’s worth noting that any losses incurred from trading can be used to offset your capital gains as well as deduct up to $3,000 off your normal income tax depending on how long you’ve held the assets for (see below). Any additional losses can be carried forward to the next tax year. You do, however, have to show a loss across all assets in a particular class to qualify for a capital gains reduction.
Bob owns a selection of crypto assets and company stocks. His company stocks performed well over the year and Bob made a $10,000 profit, which he cashed out and is subject to capital gains tax. Bob’s crypto assets, however, performed badly, and he lost $14,000. So he decided to cash out.
Because Bob had a net loss across all of his capital assets (crypto and stocks) he’s able to completely offset the capital gains owed for his $10,000 profit to zero, plus use the remaining $4,000 to reduce his ordinary income tax by the maximum amount of $3,000 and carry the remaining $1,000 over to the following year.
How much tax will you pay?
In the United States, how much capital gains tax you owe for your crypto activity depends on how long you’ve held your assets and in which income tax bracket you are.
This is divided into two parts:
- Short-term capital gains: Any gains or losses made from a crypto asset held less than a year are taxed at the same rate as whatever income tax bracket you’re in. A full list of tax brackets for 2020-21 can be found here. Any losses can be used to offset income tax by a maximum of $3,000. Any further losses can be carried forward as mentioned above.
- Long-term capital gains: Any gains or losses made from a crypto asset held for longer than a year incurs a much lower 0%, 15% or 20% tax depending on individual or combined marital income.
Losses from exchange hacks or theft
The significant changes to tax law from December 2017 confused many crypto investors who had been subject to scams, hacks or other ways to lose crypto investments.
The amended law limits personal casualty losses to a “federally declared disaster.”
Many crypto investors and accountants mistakenly thought this limitation would apply to their crypto investments. However, this is not the case, according to the legal team at CryptoTaxAudit.
Crypto investment losses are not “personal casualty losses.” Instead, they are classified as investment losses under tax code 165(c)(ii) because they are “transactions entered into for profit, though not connected with a trade or business.”
As a result, all crypto losses in scams, thefts, or accidents are complete tax losses. These losses can be claimed on form 8949 as $0 proceeds transactions. This means that if you bought one bitcoin for $15,000 and it was stolen through an exchange hack, you would be able to report a loss of $15,000.
Deducting Ponzi scam losses
Ponzi scam losses can be treated as itemized deductions and are not subject to the $3,000 capital loss limitation. The amount invested in the scam can be deducted from your taxable income. This treatment is also known as the "Bernie Madoff deduction," named after the former chairman of the Nasdaq stock market, Bernard Madoff, who was convicted for running one of the biggest financial fraud operations in history. The key requirement is that someone must have been indicted for the loss to qualify as a Ponzi deduction.
How to prepare for crypto tax season
Now that you know how your crypto assets are taxed, here’s what you need to do in order to prepare, file and pay your taxes:
- Keep a record of all your cryptocurrency activity: The IRS requires all crypto users to keep an accurate record of all cryptocurrency purchases and sales, including airdrops, lending interest and all other activities mentioned above under capital gains and income tax events. Most leading crypto exchanges and platforms have built-in tax reporting features that automatically generate reports for you. However, there are also third-party services that offer to do all the leg work for you (see below).
- Calculate your gains and losses: Once you have your full transaction report, you can use a number of services or tax calculators to work out what you owe or do it manually depending on how many trades you’ve made in the year. The amount is found by finding the difference between the price at which you sold and the cost basis (the original price you paid).
- Fill in Form 8949 and add it to Form Schedule D: Form 8949 is the specific tax form for reporting crypto capital gains and losses. The Schedule D form is the main tax form for reporting overall capital gains and losses. Any cryptocurrency earned as an income needs to be added to Schedule 1 Form 1040, and self-employed earnings from crypto need to be added to Schedule C.
- Submit forms and pay any tax owed.
Crypto tax services for U.S. citizens
The following platforms offer a range of crypto tax services and can take care of the entire process for you:
If you have a particularly complex crypto tax situation, it’s advisable to seek the help of a professional tax accountant.
This article is for informational purposes only and should not be construed as tax or accounting advice. Always seek professional guidance from a tax accountant when assessing your individual tax situation.