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Cryptocurrency: The IRS is Watching You!

Whether you own cryptocurrency or not, everyone should know the tax rules surrounding this type of property as it becomes more popular. If you have one take away regarding cryptocurrency, it should be this: Remember that Uncle Sam is watching you!

Here’s what you need to know about the IRS and cryptocurrency:

Background

The IRS generally considers cryptocurrency—also referred to as virtual currency or digital currency—to be property, just like stocks and bonds for federal income tax purposes.

Therefore, if you sell cryptocurrency at a gain, it is subject to capital gains tax. Similarly, you may claim a capital loss on the sale or other disposition of cryptocurrency. But that’s not all: Anytime you exchange cryptocurrency for actual currency, goods or services, the IRS says it’s a taxable event.

Say that you hold Bitcoin for longer than one year and then sell it at a gain. The gain is taxable up to 20%. High-income taxpayers may also need to pay a 3.8% surtax on the cryptocurrency gain. Accordingly, you can use a loss from a cryptocurrency sale to offset capital gains plus up to $3,000 of ordinary income. Any excess is carried over to the following tax year.

The IRS Is Watching You!

Cryptocurrency transactions often flew under the radar, but the IRS is now paying much closer attention. Here’s how the IRS is stepping up enforcement efforts:

  • Answer a Form 1040 question. The IRS is so concerned about cryptocurrency transactions being reported that they have a cryptocurrency question on Page 1 of your tax return, just below your name. Before filling out any part of your tax return, the IRS wants you to answer a question about whether you received, sold, exchanged, or otherwise disposed of any financial interest in any virtual currency.
  • Brokers must report transactions. After 7 years of gently prodding taxpayers to self-report cryptocurrency transactions, Congress has given the green light for the IRS to obtain cost basis and sales proceeds information for all crypto transactions directly from brokers (such as CoinBase, Electrum or Mycelium) or other individuals who regularly provide digital asset transfer services on behalf of other people. Similar to the reporting of stocks and bonds, taxpayers will receive a Form 1099-B from brokers that list all crypto transactions. These new reporting rules are effective beginning January 1, 2023.
  • Expanded $10,000 reporting requirement. Businesses that accept virtual currency as payment may be required to report transactions above $10,000 to the IRS beginning January 1, 2023. In an interesting twist, cryptocurrency and other digital assets would be considered cash for purposes of the $10,000 reporting requirement, while the IRS will continue to treat cryptocurrency as real property (and not cash) for tax compliance purposes.

What you need to do

Here are some suggestions for tracking and reporting your cryptocurrency transactions on your tax return:

  • Keep up-to-date records. Consider tracking each transaction as they occur throughout the year. You may also want to keep your own transaction ledger as a way to double-check the accuracy of your broker’s statements.
  • Set aside money to pay taxes. Consider saving a certain percentage of each cryptocurrency transaction you sell at a gain for taxes you may need to pay.
  • Be aware before you dive into cryptocurrency. As you can see, being involved in cryptocurrency may not be for everyone. Wild swings in valuation are common. Reporting requirements are complicated.

The Hidden Tax Consequences of Cryptocurrency

You may recognize the name Bitcoin and maybe even Ethereum, but what about Litecoin, Dogecoin or Ripple?

These are just some of the more than 4,500 cryptocurrencies available today. There are hidden tax complications, however, associated with every cryptocurrency transaction. Here’s what you need to know.

  • Every transaction has a tax consequence. The IRS treats cryptocurrency as investment property, like stock, and taxes every transaction as a capital gain or loss. When you pay for something in the traditional manner with U.S. dollars, the IRS doesn’t care what the value of the dollar is at the time of the transaction. For virtual currency purposes, however, the value matters. For example, assume you buy Bitcoin for $10 and two months later the market value of that Bitcoin grows to $15 and you spend that $15 worth of Bitcoin to buy something, you’ll have a $5 taxable short-term gain that needs to be reported on your tax return. If you spend a lot of cryptocurrency, tracking the gains and losses can be very complicated.
  • Big gains mean big taxes, but big losses may be limited. In classic IRS form, there is no cap on the amount of taxes you might owe in a single year for gains on the value of cryptocurrencies you sell, while losses might take many years to recoup because of the annual $3,000 loss limit against income. Adding to the complexity, virtual currencies have dramatic valuation changes…much more so than most traditional investment securities. So, you will need to budget appropriately for the taxes you’ll owe whenever you use or sell cryptocurrencies.
  • Cryptocurrency puts you on the IRS’s radar. Being relatively new, virtual currency has caused the IRS to become very concerned about potential mistakes and fraud related to how cryptocurrency is reported on tax returns. The IRS is so concerned about you not reporting cryptocurrency activity that the very first question of your tax return, right beneath where you put your name and address, asks if you took part in any virtual currency transactions over the past year.
  • You are responsible for bookkeeping. With the IRS watching so closely, it’s important to be accurate with your recordkeeping so you can properly report all virtual currency gains and losses on your tax return and substantiate all your transactions in the event of an audit.