This poses a problem. Not reporting cryptoasset transactions is a violation of US tax law.
Reporting cryptoasset transactions to the IRS can be difficult unless you understand how those transactions are taxed.
Cryptoassets are digital representations of value that are stored using data encryption technology known as cryptography. Cryptoassets include non-fungible tokens (NFTs), utility coins, and security tokens, but the most common is cryptocurrencies.
Cryptocurrencies are digital currencies that operate independently of a central bank. Transactions in cryptocurrencies (and most other cryptoassets) are recorded and managed through an open-source, peer-to-peer network that relies on blockchain technology. Because blockchain technology makes a permanent record of each transaction, cryptoasset ownership is verifiable even without a central authority.
The first few year’s cryptocurrencies were on the market, it felt like the wild west — taxpayers had no formal tax guidance to follow. But in 2014, the IRS released Notice 2014-21 which detailed how to report the sale and exchange of virtual currency and other cryptoassets. Since then, the IRS has expanded its guidance with Revenue Ruling 2019-24 and in their website’s FAQ section. In these releases, the IRS makes it clear that cryptoassets are treated as capital property for federal tax purposes, even when they are used as currency.
Gains or losses recognized from a cryptoasset transaction will be taxable as a long-term capital gain if held greater than 12 months, or as short-term capital gain if held less than 12 months. Because cryptoasset earnings are investment income, many individuals will also be subject to a 3.8% net investment income tax.
To calculate the gain or loss from a cryptoasset transaction, you must first determine your investment’s tax basis. Tax basis is generally what you initially paid to acquire the asset. If you received a cryptoasset as payment for goods or services, your cost basis would be the fair market value of the crypto the day you acquired it.
A transaction’s gain or loss is then determined by subtracting the cost basis from the sales price. The treatment would be the same when using a cryptocurrency to pay for goods or services as part of one’s daily life.
Mining is the process of creating and validating cryptocurrency transactions on a blockchain by solving complex mathematics problems. The “miner” solving the equations is paid in cryptocurrency.
Mining cryptocurrency is considered ordinary income, earned at the fair market value of the cryptocurrency at the time it was mined. Net profits from mining may be subject to self-employment tax is the mining activity constitutes a trade or business.
As cryptoasset transactions become more common, there are a few important things to remember.
This article was featured in Crain's Cleveland Business on November 15, 2021.