Executive Summary
If you have invested in cryptocurrencies, DeFi, or NFTs, there’s a good chance you may have to pay taxes.
In this guide, we will take a comprehensive look at the present state of cryptocurrency taxes in the US, focusing on taxable and non-taxable events across a wide array of crypto investments and transactions.
Understanding the Tax Obligations of Crypto Investors
The IRS issued its first cryptocurrency taxation guidelines in 2014. But not until 2019 did the IRS start explicitly asking taxpayers to report their crypto investments on their income tax returns.
However, a central premise of cryptocurrency taxation has remained unchanged since 2014 – specifically, that cryptocurrencies and other blockchain-based digital assets are treated as property, not currency, to file taxes. Any transactions involving cryptocurrencies that create a gain for the owner are thus taxable by law in the United States.
In other words, if you profit by selling your crypto investments, you must report it as a capital gain and pay tax on it. (Conversely, if you lose money on your investments, you may be able to deduct as a capital loss.)
Can the IRS Even Track Crypto?
There is a prevailing, mistaken sentiment that crypto owners are anonymous to everyone, including the IRS. But this is not true. The IRS can track and analyze an individual’s crypto wallet holdings through disclosures from centralized exchanges or through data analysis of blockchains. If the IRS wants to know who owns a digital asset, they can most likely find out.
As an investor and taxpayer, you must report any digital asset transactions in the fiscal year on your Form 1040 when you file your taxes.
Additionally, centralized crypto exchanges are legally required to file form 1099-K to inform the IRS about investors who make trades worth more than $20,000 yearly or have more than 200 transactions annually.
The IRS has taken steps in recent years to find ways to connect crypto wallets to their owners. Some wallets allow you to link your credit or debit card. Sometimes, you may share your non-custodial wallet address with a centralized exchange. In either case, trained IRS agents can use plenty of breadcrumbs to connect active cryptocurrency wallets to a tax evader. Given the high tax evasion cost, the risk is not worth taking. In short: pay your taxes.
What Is the Relationship Between Capital Gains and Cryptocurrency Taxes
Capital gains tax is levied on any profits you make from selling or disposing of capital assets. Real estate, stocks, gold, and are all examples of capital assets. So is cryptocurrency, and capital gains are calculated the same in your crypto investments as they are for their traditional counterparts.
For example, let’s say you buy bitcoin for $20,000, then hold it until the price increases by 25%. When you sell the bitcoin for $25,000, the $5,000 profit is subject to capital gains tax.
The long-term capital gains tax applies to assets held for a year or longer. Thus, many investors who buy and hold crypto for the long term – as we practice here at Bitcoin Market Journal – are subject to long-term capital gains tax.
In the US, the tax rate for long-term capital gains tends to be lower than the individual income tax. If you hold the crypto for less than a year before selling it, the gains are considered short-term capital gains taxed at your standard income tax rate. Holding crypto for over a year before making any sale/trade can significantly reduce your tax burden. (Another reason to HODL.)
As of this writing, the capital gains tax rate is 0%, 15%, or 20%, depending on your overall taxable income.
Bitcoins vs. Altcoins: What’s Taxable?
For tax calculations, there is no distinction between bitcoin, Ethereum, and any other type of cryptocurrency. Whether they are proof of work or proof of stake, altcoins, or stablecoins, they all follow the same tax rules.
What matters more is whether your investing activities are considered “taxable events.” Certain transactions are considered taxable events, which carry specific requirements and obligations compared to non-taxable events.
Non-Taxable Events for Crypto Investments
Some non-taxable events in crypto investing include:
- Buying and Holding Crypto: If you purchase some tokens with your money and hold them in a wallet, it does not qualify as a taxable event. You don’t have to report it to the IRS. But don’t forget to keep good records, as the purchase cost will determine your future tax burden.
- Transferring Crypto Between Wallets: Moving the tokens you hold from one wallet to another does not constitute a taxable event, assuming you own both wallets. A good example is transferring your tokens from a software/custodial wallet to a non-custodial wallet like the Ledger Nano or Trezor.
Taxable Events for Crypto Investments
There are many more situations where a crypto transaction is considered to be taxable by the IRS:
- Selling Crypto: If you sell your bitcoin, or any other cryptocurrency, at a profit in exchange for fiat currency like US dollars, the transaction is taxable. Your tax burden depends on how much you got from the sale – if it is lower than what you initially paid for the crypto, you can write it off as a capital loss, up to a maximum of $3,000 per year.
- Trading Crypto: If you exchange your crypto for another token at a profit, that is also taxable. Here is an example – you buy BTC worth $1000. You exchange it at a later date and get ETH worth $1500. In this transaction, you gained $500 profit, making it a taxable event.
- Getting Paid in Crypto: If your employer pays you a salary in bitcoin or any other currency, it is considered taxable income. Similarly, if a customer pays you for goods/services in crypto, that is earned income, a taxable event. Note that this is taxed at ordinary income rates, not capital gains rates.
- Mining Crypto: If you earn income from mining BTC, it is treated as ordinary income and should be reported in your tax returns. It doesn’t matter whether you hold the tokens or sell them immediately. Receiving mining rewards is always considered ordinary income.
Both individual hobbyist miners and business entities have to pay income tax on mining rewards, albeit in different ways. For individuals, that means reporting on your Form 1040 Schedule 1, while businesses have to report it on Schedule C.
What’s Taxable in DeFi Investment?
Decentralized finance is a new frontier in cryptocurrencies and blockchain investment. Exploding in popularity in 2021, DeFi offers more efficient alternatives to traditional financial services. It has become more popular over that time, attracting over $178 billion in capital at its peak.
The federal government is still in the process of formulating regulations for DeFi. For instance, DeFi exchanges are not required to report to the IRS as of 2023. Starting in 2024, these platforms will have to issue tax forms under the upcoming Infrastructure and Investment Jobs Act.
Likewise, the IRS has yet to issue detailed guidelines on many DeFi transactions and scenarios. In the meantime, investors should tread carefully when handling the tax implications of the following activities in DeFi:
- Crypto Loans: If you are a borrower of a DeFi loan, you don’t have to pay any additional taxes. However, using crypto to repay your loans can be taxable. Depending on the circumstances, you may have to report it as either a capital gain or loss.If you are the lender of a DeFi loan, taxes will apply, just like in any other lending activity. If you profit when the loan is paid back, the profit is taxed. Similarly, if you sell the loan collateral (usually a crypto token), any capital gains earned will also be subject to tax.
- Liquidity Pools, Staking, and Yield Farming: You earn rewards when you deposit your tokens into liquidity pools. Receiving such rewards from third parties is considered a taxable event.Pair-based staking, usually found in AMM protocols, is a taxable event and must be reported when you join the protocol. However, joining a single-sided staking protocol is not. But you must still report any interest income earned to the IRS.
Any income earned through yield farming will also be subject to income tax. If you enjoy any capital gains over time by holding your rewards, they will have to be reported separately for the purpose of capital gains tax payments.
- Governance Tokens/Utility Tokens: In most decentralized crypto projects, participants are awarded governance tokens when they fulfill certain criteria. These tokens give holders voting rights and the ability to have a say in the future trajectory of the protocol.
Earning or receiving governance tokens is a taxable event. They have to be reported as ordinary income based on the value of the tokens converted into dollars. The same rules also apply to any utility tokens awarded by a protocol.
How Are NFTs Taxed?
NFTs are digital assets used to represent intellectual property ownership on the blockchain, such as digitized images, videos, music, artwork, or text. As a fairly new asset class, NFTs haven’t yet received the full tax guidelines from the IRS.
While regular cryptocurrencies are taxed as a property by the IRS. However, NFTs have traits that make them resemble physical collectibles. Whether the IRS will classify them as property or collectible remains to be seen. This will have implications in the future regarding the tax rate.
Non-Taxable Events for NFTs
- Creating NFTs: The minting or creating an NFT on the blockchain does not create a taxable event. The token may hold some value, but it has yet to be realized by the creator of the NFT. There is no requirement to report the minting of an NFT.
Taxable Events for NFTs
- Selling NFTs: When a creator (or investor) completes a successful sale of an NFT and receives the proceeds (usually in ETH), it is a taxable event. The seller has to report the event and pay the relevant income taxes.The NFT, in this situation, is considered as a non-capital asset. Any gains made by the creator are considered to be ordinary gains. However, once someone has spent crypto and purchased an NFT, it becomes a capital asset.
If a buyer were to hold an NFT and then sell it later, the difference between the original purchase price and the selling price would have to be reported as either a capital gain or loss.
- Purchasing NFTs: A buyer is not required to pay taxes directly for purchasing an NFT. However, they may have realized capital gains (or losses) on the ETH used during the transaction. Depending on how long they held the ETH before using it, this will attract either short-term or long-term capital gains taxes.
Gray Areas and Controversies
Basic transactions and trades involving cryptocurrencies like bitcoin and Ethereum are fairly clear regarding the IRS rules. However, when it comes to newer asset classes like NFTs and DeFi, many things still need to be clearly defined by the IRS.
Here are some examples where tax implications have to be analyzed on a case-by-case basis:
- Wrapped Tokens: A wrapped token is a digital asset whose value is tied to another, well-established crypto. These tokens are used when people want to transfer liquidity across different blockchains. Ether is the native token used mainly on the Ethereum blockchain. Wrapped Ether (WETH) can be used across many ERC-20 compatible blockchains.Wrapped tokens are a major gray area as far as tax implications are concerned. We don’t have any clear guidelines from the IRS on this matter. While some experts consider the use of wrapped tokens as taxable, others don’t.
- Multichain Bridging: Like wrapping, multichain bridging allows users to transfer crypto liquidity across multiple blockchains. Depending on who you ask, it can be interpreted as either a taxable or non-taxable event. The IRS needs to provide more clarity on the matter.
- DeFi Rebasing: Rebasing functions are used by some crypto protocols to adjust the coin supply and thereby maintain some control over price fluctuations. In traditional markets, companies sometimes use stock splits similarly to divide shares and increase liquidity.
Stock splits are not taxable as they increase the number of shares, but the value of the holdings remains the same. If this approach is applied for DeFi rebasing, you would only incur taxes on future capital gains.
However, another approach involves considering any income from rebasing as a form of dividend payment, which would constitute regular income. However, there has yet to be a consensus on the appropriate tax treatment of rebasing.
We still need clarity regarding the tax implications in several other scenarios. It is essential to seek the services of an experienced tax professional if your crypto investments include elements from DeFi, NFT, and other emergent blockchain fields. Otherwise, you run the risk of unwittingly committing tax evasion. This serious crime carries potential fines and even jail terms depending on the magnitude of taxes owed to the federal government.
We strongly recommend you consult your tax professional if you are involved in transactions that involve any of these gray areas.
Investor Takeaway
Long-term buying and holding of your crypto investments helps avoid the taxation from frequent buying and selling.
The crypto market is headed towards an era of strict regulations and greater surveillance from agencies like the IRS. If you have any unreported investments in crypto, now is the time to look at the potential tax implications.
Consulting a tax professional is highly recommended if you invest in gray areas like NFTs, DeFi protocols, and use cases. Cryptocurrencies carry the same tax burden as any other asset class or investment. If you make a profit, be sure to pay your taxes.
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