As of now, the world of cryptocurrency is under scrutiny from those who believe in its future and those who are skeptical of it, and this is true if you own cryptocurrency or are planning to create a digital portfolio. Governments aren’t oblivious about them either; they initially considered the emergence of cryptocurrencies a threat and considered banning them. However, they soon realized what they were doing and did not take that step.
Now, instead of shunning crypto trading, Uncle Sam and other governments want a piece of the pie in the form of DeFi taxes. In this article, we will look at this taxation and understand the need to pay taxes on cryptocurrencies and other complications connected to it.
Special Note: This guide is primarily for American citizens. Not a US citizen? Check out these helpful crypto tax guides for other countries!
Do You Pay Taxes on Cryptocurrency – A Quick Overview
Yes, the period of regulation-free cryptocurrency earnings is over, and now, measures are being introduced to tax earnings from varying cryptocurrency activities like staking, farming, and price fluctuations. The IRS has introduced several measures to enforce crypto tax compliance, categorizing all earnings from cryptocurrency as capital gains. Their approach is to consider those earnings like those made from trading stocks.
Taxing crypto earnings might not be the most exciting part of crypto investing; however, you need to know how taxes are applied to cryptocurrencies if you are investing in them. While cryptocurrencies are still new, the IRS is working hard to enforce crypto tax compliance.
As mentioned above, it doesn’t matter how you profit from crypto trading or what you do with it. The crypto asset becomes taxable, and the tax applies even if you make a transaction and do not hold the asset anymore. Failure to report taxes on crypto, whether intentional or not, could cause the IRS to send you an estimated tax payable. If you don’t pay taxes on virtual currencies, you could end up having to pay hefty penalties later on down the line… Like if you’re sipping on martinis in the Bahamas in your new yacht in 2030.
Today, we will explain the intricacies of crypto taxes, the different crypto tax rate brackets, and other important details.
Do You Pay Taxes On Cryptocurrency?
According to IRS Notice 2014-16, the general use of any virtual currency—be it Bitcoin, $CAKE, Solana, or a hot-off-the-press farming cryptocurrency, can incur a tax liability on you. The IRS classifies cryptocurrency as property, which means activities like transfer/trading crypto are all taxable in the IRS’ eyes.
These taxes are deferred when you purchase a cryptocurrency. Hence, you won’t have to pay any taxes at the time of buying. It would simply incur a liability on you that will be realized when you do anything with the currency classified as gains.
Taxable activities include but aren’t limited to:
- Selling crypto on a profit
- Trading one currency for another. In this case, trading also includes turning your cryptocurrency into a Liquidity Pool (LP) token for yield farming. Again, you will only have to pay taxes later on when you recognize a gain
- Mining cryptocurrency
- Disposing of cryptocurrency
For simplicity’s sake, let’s say you have a portfolio of $10,000 consisting of a diversified range of virtual currencies, and non-fungible tokens. Over a month, you manage to turn it into $15,000 and decide that the portfolio has crossed your risk threshold. It’s time to pull out.
You will have to report the profit earned, i.e., $5,000 as a capital gain and pay the relevant tax amount.
Now, suppose you decide to stable up after the token’s value drops to $5,000 only (a loss of 50%) and suffer a loss. In this case, you can deduct a certain sum against your taxable income. Crypto losses are tax-deductible but only up to $3,000.
So, in a way, the IRS does give you a ‘benefit’ against reporting your cryptocurrency. However, this benefit wouldn’t have been necessary if the amount wasn’t taxable in the first place, as many Telegram groups, forums, etc. complain about.
After all, this was supposed to be DeFi… right?
IRS Measures – How to Report Taxes on Crypto
So, how does the IRS know that you have invested in crypto? If you’ve done your taxes recently, you may have noticed a question on Form 1040 (US Individual Income Tax Return) asking if you have made any transactions using a virtual currency during the year. This scenario might make you think this is like asking a child if they have candy; if they say yes, you want a piece, and if they say no, you wouldn’t know!
However, in reality, the situation is more complex.
The IRS can check your transactions against their sources to identify if there are any virtual currency transactions. And if you’ve onboarded your fiat dollars using a popular exchange like Gemini or Coinbase… it’s likely the gov’ will find out sooner or later. Think of it as a grownup checking the child’s pocket for candy.
It’s in your best interest to stay transparent. Failure to report virtual currencies can lead to hefty fines… and if the value is significant, you may even have to do some jail time!
Do Crypto Exchanges Report to the IRS?
The IRS requires crypto exchanges operating in the US to file a 1099-K (Third Party Network Transactions) for each client with more than 200 transactions, and their trading volume exceeds $20,000 during the year. Since 2016, the IRS has issued numerous summon orders to crypto exchanges to identify investors whose transaction volume exceeds this threshold.
How Much Tax on Crypto Gains–Cryptocurrency Tax Rates
Cryptocurrency tax rates have been kept similar to income tax rates to make things easier and more transparent. The rate at which you pay depends on:
- Your total income during the year
- Whether you are a filer or not
- Your marital status
- Position in the family and
- For how long you have owned a virtual currency before disposing of it. This provision is similar to capital gains, i.e., if you have owned the currency for less than 365 days, you will have to pay short-term gains tax. Owning the currency for 366 days or more would make you eligible for long-term gains tax.
For the tax-year 2021 (ending 30th June 2022), income would be taxed as ordinary income. Here is a table to help you understand the slab rate.
|Tax Rate||Single||Married||Head of Household|
Long-term capital gains are taxed as follows.
|Tax Rate||Single||Married||Head of Household|
The tables above show that crypto taxes on long-term capital gains are less than on short-term gains. For example, if you purchased Dogecoin in 2019 and decide to sell it now, you will have held it long enough for it to be classified as a long-term capital gain. However, if you purchase it today and sell it tomorrow, you will pay a higher tax rate.
How to Report Crypto Gains or Losses for Tax?
In Form 1040, you tell the IRS whether or not you made a virtual transaction in the past year. However, to report crypto gains and losses, you will need to file Form 8949 (Sales and Other Dispositions of Capital Assets). It will inquire about several elements of your gains and losses, so make sure you are logged into your wallet when filling.
For example, you will need to report the exact:
- Name of the currency you are reporting against
- Date of acquisition, even if you got it through a farm or were rewarded from staking.
- Date you sold/traded/otherwise disposed of the currency
- How much you get the currency for
- Sale value
- How much you gained/lost
You will need to report this for every taxable crypto event… So if you’ve traded hundreds or even thousands of crypto assets recently, you might be in for a hard time.
DeFi Taxes & Stocks – The Similarities
As mentioned above, cryptocurrencies are taxed just like stocks or other types of property. You’ll need to pay tax on gains while crypto losses are tax-deductible. Converting cryptocurrency into fiat is taxable, just like pulling out of the stock market. And most importantly, the tax rates for crypto gains are the same as the capital gains tax you’ll have to pay for gains on the stock exchange.
Another similarity is the long- and short-term gain tax liability and how you report it all. You need to keep your tax burden to a minimum. You can do that by:
- Holding on to your crypto investments for at least 365 days before selling or otherwise making a transaction with them.
- Harvest on tax loss, i.e., if you have had gains and losses during the year, make sure you use the loss to offset your taxable gains.
- Then there are the virtual currency IRAs, allowing you to make tax-deductible contributions for future use, just like with fiat.
Transactions with Cryptocurrency – Understanding Tax Implications
Making a transaction with your cryptocurrency is a fancy way of saying that you have traded virtual currency. Instead of getting another currency in return, though, you’ll be getting a product or service, but the transaction will be taxable.
When you make a transaction, you will be essentially paying tax on the capital gains earned between the time you bought the currency and the time you are making the transaction. The IRS won’t be concerned as much with what you used the currency for as it would be interested in the fair value of the coin at the time of exchange.
This means that you will be paying tax on capital gain or loss. From your end, the IRS won’t be worrying about whether you paid value-added tax or not.
There is a Bit of A Relief, Though
While cryptocurrency taxes can be a pain, to say the least, crypto losses are tax-deductible, which should relieve filers. You can deduct capital losses on any virtual currency, just like in stocks or bonds, i.e., reduce your taxable income by the loss amount up to $3,000.
Unfortunately, this $3,000 is nothing for you if your portfolio is too large. The price fluctuations coupled with the risk of DeFi exploits can add up to become a very painful issue – much more than $3,000. Consider the Layer.Farm DeFi project loss or the numerous other DeFi exploits over the years.
If you have losses on virtual currency, declare them as soon as you can see any gain. You have about a year to carry forward losses as well, meaning that if you got lucky in 2021 and didn’t suffer a loss, you can combine it with 2022’s $3,000 benefit to reduce your tax liability significantly.
If you’re actively trading or yield farming in a variety of projects, you would have to be very lucky, mind you, to not face a loss with crypto and DeFi.