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The entire cryptocurrency industry has made astronomical gains over the past year, permeating into new industries and minting millionaires. The spotlight on the budding crypto industry has brought attention from many investors, detractors, and the IRS.
Crypto is a relatively new industry, and as such, the tax rules surrounding it are foreign to most people, but the rules become far clearer with a little research.
Cryptocurrency tax is filed under capital gains or income tax. This rule puts it in the same purview as other investments like stocks and real estate. It means that you only owe the IRS tax if you make a profit on the cryptocurrency or trade it for another item.
Wrapping your head around cryptocurrency and how it’s taxed can be difficult. The good news is that it doesn't have to be, and this article will cover cryptocurrency and how it's taxed to help you easily file your taxes and stay out of sight of the IRS.
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What Are Crypto Taxes?
In the United States, cryptocurrency is usually taxed similarly to other investments like real estate under ‘capital gains tax.' This tax extends to various other financial instruments, most popularly; stocks, bonds, real estate, and jewelry.
Crypto tax is tax due on any cryptocurrency taxable event. Crypto tax mainly comes in the form of capital gains tax which is taxed on any profit or loss you make, and income tax which is taxed when you get paid crypto for providing a good or service.
This provision implies that most of your crypto tax will go to your gains and not your holds. For example, if you buy one unit of BTC at $50,000 and sell it off at the same price, you won’t be taxed because you have made no net gain on it.
The other way in which crypto can be taxed is as income tax. This tax comes from staking, mining, and interest gained from lending. Each type of tax has its positives, negatives, and nuances, which must all be considered when filing your crypto tax returns.
Crypto Tax 101: How Each Type of Crypto Tax Works
Capital Gains Tax
As stated previously, capital gains majorly cover investment instruments. If you've dabbled in stocks, bonds, or real estate, then you’ll have a rough idea of how capital gains tax works.
The main thing to understand about capital gains tax is that it mainly functions on differences.
Here, the tax you owe the government is usually dependent on what you gain or lose while trading and not on what you hold. If you buy crypto and sell at the same price, it shouldn't reflect on your tax returns.
However, any gain you make while trading must be written down and taxed depending on the ongoing tax rates. The positive side of this is that you can also file them as a loss when you make losses and get a deduction on your net taxable income for the period.
A key factor to understanding how crypto tax works in terms of capital gains is to properly understand the term "taxable event." A taxable event is simply anything you do that results in you owing tax to the government.
Understanding this means that we can reduce the majority of crypto tax related to capital gains to two things; buying and selling.
The reduction means that you only incur taxes when you buy or sell your cryptocurrency, not just by holding it. The nuance in this is that if, for example, you buy Bitcoin at its market value and hold it over a few years, making significant gains, you owe nothing until you sell that Bitcoin.
Once you sell the crypto, this counts as the taxable event for this scenario because that’s when the profit is realized. So, as long as your diamond hands stay strong, you don't owe any tax on that trade.
Some confusion can arise here, and many people have some trouble wrapping their minds around the amount of nuance involved. A major thing to note is that any form of selling for profit will incur a tax and not just a reverse trade.
If you bought a BTC/USDT pair and traded the Bitcoin you bought for ETH at the end of the trade instead of converting back to USDT, it still counts as a taxable event if the BTC price has risen since you bought it.
With this, it becomes apparent that holding your crypto for long periods will reduce the frequency of tax returns you have to pay for. The advantage of holding for long periods becomes even more apparent when you consider that capital gains also distinguish between short and long-term holdings.
Short and Long Term Holds
Having 'diamond hands' (holding investments for long periods) is a term used in the online investing community to identify people with strong nerves and is generally a positive thing.
When it comes to taxing your crypto, having diamond hands also seems to be highly positive.
Since trading crypto is filed under capital gains tax, it is subject to "short and long term gains." This rule is a blessing in disguise for people used to holding crypto long-term.
The main point is that anything held for over a year counts as a long-term hold and is subject to lower tax rates than assets held for a shorter than a year.
This provision makes it more attractive to investors to hold long-term, potentially increasing their profits. The downside is that holding long-term isn’t always a feasible option.
Market volatility, a sudden need for your invested money, and a host of other reasons can mean that most people usually do not hold any crypto for that long.
Also, the longer you hold, the higher your profit but conversely, the higher your profit, the higher the amount of tax you’ll have to pay. Short-term holds take up the other side of the coin and are subject to the relevant tax rates.
One final thing to note about the capital gains tax due on crypto is that depending on your income bracket, you might not owe anything, to begin with.
Single individuals that make less than $41,675 a year don’t owe anything in the form of capital gains as stated by the IRS. However, this complete exclusion only applies to long-term holdings.
Income tax is the tax due on payments made for goods traded and services rendered. This sort of tax is usually easier to understand as it’s not subject to as much nuance as its counterpart.
The key thing to understand when filing your tax returns is that any payment you receive in the form of crypto is filed under your income tax.
Crypto miners are also not left out of the conversation here. Mining is essentially providing a service (mining) for income (crypto), and as a result, it’s subject to income tax.
Some other activities such as staking and lending are also filed under income tax as both things involve providing services for the income you gain.
One thing that can cause some confusion is that what seems like income tax can also have sometimes incurred capital gains tax. This confusion comes from the fact that any income tax is taxed from the date you received the cryptocurrency as payment.
If you end up holding the crypto longer than that before swapping it to fiat currency, you’ll end up having to pay capital gains tax if there’s a rise in price on that crypto.
How to File Your Crypto Tax Returns
The volatility of the crypto market means that it can sometimes seem impossible to calculate the amount of tax you own. Volatility makes the market move, and there’s almost no market as volatile as cryptocurrency is.
The PnL calculator shows your profit and loss over a specific period, which you can set. This calculator removes a lot of the guesswork when it comes to calculating your capital gains tax.
Rather than going through all your trades over a particular period when you file your tax returns, you can use the PnL to determine exactly how much money you've made in profit.
Due to capital gains being taxed on profit alone, as opposed to everything involved in the trade, once you figure out the total profit you've made, all you have to do is calculate the amount of tax on it.
The easier way to go about this is to go to a third-party crypto tax software or program and have them do the work for you. One example of this is CryptoTrader which helps you track all of your taxable crypto holdings and makes filing your tax returns that much easier.
Depending on how much you've made and how averse you are to do your crypto tax filing, it might be a far better use of your time to hire a professional to do the work for you.
The crypto industry's massive boom has also created many jobs, one of which is professionals that specialize in crypto taxes.
Why You Should Pay Your Crypto Taxes
Crypto began with the dream of decentralization and anonymity through blockchain technology. While that’s largely still the same today, governments and exchanges have all figured out ways to track some transactions.
However, the anonymity provided by the blockchain leaves many people wondering whether they can get away with filing crypto taxes.
You should pay crypto taxes because it’s required by law. The increasing use of crypto in day-to-day life has led to increased scrutiny from the government, which has raised the need for accountability.
Also, not paying tax is illegal and could lead to a fine or, in extreme cases, a jail sentence.
Crypto taxes have become especially popular following the controversial 'infrastructure bill' that passed through the Senate recently and pointed the finger at crypto as a source of income for the United States.
Since then, the crypto space has seen increased scrutiny, leading to Binance enforcing mandatory KYC to use their platform.
The Infrastructure Bill & How It Affects Crypto Tax
The infrastructure bill was recently signed by President Biden and, among other things, primarily aims at improving the country. The controversy arose with the crypto community when it pointed at crypto taxes as a source of income to fund the $1.2 trillion bill.
Since then, there has been far more scrutiny than before on crypto holders, and there’s now a far greater tax requirement from exchanges in terms of tax compliance.
Exchanges will now be required to give out 1099-Bs to their customers. These are tax compliance forms historically issued by traditional brokers.
This new development means that tax evasion with crypto will soon become very difficult for traders. Centralized exchanges are now mandating KYC requirements to use their services.
The KYC makes it easier to track your transactions on and off the exchanges so that they can ensure compliance.
What is Cryptocurrency?
If you've opened a newspaper or the internet over the past year, chances are you have most likely heard something about crypto. While many people understand it, many more are still in the dark.
Cryptocurrencies are a form of decentralized finance. It was created to remove middlemen (banks and other financial institutions) from transactions.
A few more things are required to fully understand the entire cryptocurrency space, such as blockchain, DeFi, and NFTs. However, the above description will give you a general idea of what you need to know.
As much as people dislike it, paying taxes is essential to any economy and is a major source of income for any government. Regardless of the type, all financial activity is taxed, and crypto is no different.
Although it might seem difficult to track at first, having a strong understanding of capital gains and income tax will make filing your tax returns far easier.
Also, taking advantage of tax deductions for losses and long-term holds could reduce your taxes by a lot, leaving you in far more profit than you would have had otherwise.
Koinly automatically imports your transactions, finds all the market prices at the time of your trades, matches transfers between your own wallets, calculates your crypto taxes.