How is Tax Liability for Virtual Currency Calculated?
When specific instances known as “taxable events,” occur, the IRS will require you to pay taxes on your virtual currency.
In the eyes of the IRS, virtual currency is treated as property. This means that tax principles applicable to transactions involving property also apply to virtual currency. See Internal Revenue Service Notice 2014-21.
Virtual currency is a digital representation of value, in a form other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.
Some virtual currencies are convertible, which means that they have an equivalent value in real currency or act as a substitute for real currency.
The IRS uses the term “virtual currency” to describe the various types of convertible virtual currency that are used as a medium of exchange, such as digital currency, cryptocurrency, and NFTs.
Regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as virtual currency for federal income tax purposes.
Simply possessing virtual currency doesn’t make you liable for taxes, however. Rather, there are specific instances, known as “taxable events,” that when they occur, require you to pay taxes on your virtual currency.
These taxable events include:
- Trading virtual currency for fiat currency, otherwise known as “cashing out”.
- Trading one form of virtual currency for another, such as trading Bitcoin or using cryptocurrency to purchase NFTs.
- Trading one type of cryptocurrency coin for another, such as trading Bitcoin for Solana. Taxpayers who make coin-to-coin trades may mistakenly assume there is no tax liability because they did not receive any actual funds.
- Spending virtual currency to procure goods or services.
- Earning virtual currency as income.
By contrast, buying and holding onto virtual currency does not constitute a taxable event. Neither does transferring virtual currency from one of your wallets to another.
How Do I Pay Taxes on Something That Isn’t “Real” Money?
When reporting your cryptocurrency earnings, remember that they must be reported in United States Dollars. Even though cryptocurrency has no value as a fiat currency, it DOES have value as property.
To report your earnings, you must determine the fair market value (“FMV”) of your cryptocurrency and NFTs in dollars.
The FMV of virtual currency is simply the price a coin or NFT would sell for in fiat currency.
The IRS recommends the following formula for determining the fair market value of virtual currency:
Fair Market Value - Cost Basis = Capital Gain/Loss
If a particular cryptocurrency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars at the exchange rate.
If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain.
The taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency.
Taxpayers who receive cryptocurrency as payment for goods or services must calculate the fair market value of the cryptocurrency as of the date it was received.
Cryptocurrency miners must utilize the date of verification to determine fair market value.
Keep in mind that you need to report the value at the time of acquisition or disposition, NOT the fair market value when filing your taxes.
Since values frequently fluctuate, the IRS will consult available records surrounding the date of purchase or sale to determine if you properly assessed the fair market value of your cryptocurrency.
It is advised that you hold onto documentation that supports why and how you arrived at your calculated value, in case of audit.
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How Much Do I Owe in Taxes?
Virtual currency is subject to capital gains tax. A capital gains tax is a tax that is assessed on the sale of an asset, such as a house, stocks and bonds, or virtual currency.
When you sell an asset, the difference between its sale price and its original purchase price is known as a “capital gain” or a “capital loss.”
If the difference is positive, meaning you sold an asset for more than you purchased it for, it is a capital gain. If the difference is negative, meaning you sold an asset for less than its purchase price, it is considered a capital loss.
There are two categories of capital gains:
- short-term, or
If you retain your virtual currency for one year or less before selling or exchanging the virtual currency, you will have a short-term capital gain or loss.
If you retain your virtual currency for more than one year before selling or exchanging it, you will have a long-term capital gain or loss.
The period during which you held the virtual currency, commonly known as the “holding period”, begins on the day after you acquired the virtual currency and ends on the day you sell or exchange the virtual currency. See Internal Revenue Service Topic. No. 409.
Capital gains tax rates will be determined by calculating how long your virtual currency was held for.
If the holding period was less than one year, the sale will be subject to short-term capital gains tax rates. If your virtual currency was held for longer than one year, it will be subject to long-term capital gains tax rates.
It is important to note that cryptocurrency exchanges DO NOT have the ability to properly calculate your capital gains or losses, primarily because many users utilize more than one exchange.
To properly calculate your gains and losses, it is imperative that you develop your own tracking method.
Additionally, when you transfer cryptocurrency into or out of an exchange, that particular exchange loses the ability to provide you with an accurate report detailing the cost basis and fair market value of your cryptocurrencies, both of which are mandatory components for tax reporting.
Taxpayers who mine cryptocurrency as a trade or profession must report their earnings as self-employment income AND pay the respective self-employment income tax.
However, miners may deduct reasonable expenses, such as equipment and internet expenditures, to offset their tax liability. See Internal Revenue Service Notice 2014-21
Occasionally, cryptocurrency will undergo something known as a “hard fork” or “airdrop.” A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the original distributed ledger.
This may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger, much like how one embryo can sometimes separate into two.
If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency, you don’t have taxable income. Id.
An “airdrop” is a transfer of cryptocurrency into user wallets, usually for bare-minimum rates or for free. Airdrops are often sent out to random cryptocurrency wallet holders as a means of attracting followers, gaining internet popularity, or advertisement.
It is entirely possible that you may wake up one day having received an airdrop.
Cryptocurrency received from an airdrop is taxed as income. The recipient will incur tax liability on fair market value of the airdrop.
If you sell, trade, or otherwise dispose of your airdropped coins in the future, you will incur capital gains or losses depending on how much you sell your cryptocurrency for.
When you receive cryptocurrency from an airdrop following a hard fork, you will have ordinary income equal to the fair market value of the new cryptocurrency when it is received.
You will have taxable income in the tax year you receive that cryptocurrency.
Thank you in advance for reading “The Ultimate Guide to Bitcoin, NFTs and Virtual Currency Taxation.” It was a labor of love and our law firm welcomes all questions, comments, concerns, and feedback that you may have about this free resource.