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How Are Cryptocurrencies Taxed?

There’s no such thing as a free lunch. We’ve all heard the cliché. And repeated it. And ignored it more than once.

But who would have thought this bit of wisdom would apply to Bitcoin? As Bitcoin and the rest of the cryptocurrency market keep reaching record highs, the Internal Revenue Service (IRS) is taking notice. For those who own cryptocurrency, like Bitcoin or Ethereum, it’s important to know if and how your tax liability will be affected whether you’re buying, selling, or mining digital currency.

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Cryptocurrency Made Less Cryptic

Forget dollar bills randomly stuffed in your pants pocket. Put away your ‘loose change jar’ for collecting leftover pennies, nickels, and dimes. Simply put, cryptocurrency doesn’t include any physical tokens of monetary value; rather, it’s a decentralized, digital store of value and medium of exchange. And one other thing that’s important to know: Cryptocurrencies lack any centralized governmental oversight.

Cryptocurrency relies on encrypted, distributed ledgers (blockchain technology) to record and verify all transactions, much like a handwritten, updated checkbook keeps track of every  transaction. First launched in 2009, Bitcoin was the only player in the game. Today, there are thousands of other cryptocurrencies in circulation, including Bitcoin Cash, Ripple, Dogeoin, and Litecoin.

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Taxes Take A Bite Out Of Bitcoin                                             

In a 2014 ruling, the IRS determined that cryptocurrency should be treated as a capital asset (think stocks and bonds) and not as a currency such as dollars or euros. Capital assets are taxed whenever they are sold at a profit. The bottom line:  When you make a purchase using cryptocurrency, and the amount of crypto you spend has gained in value over what you originally paid for it, your spending incurs capital gains taxes.

For example:

Say you buy $20 worth of Bitcoin and it rises in value to $200. If you use the bitcoin to buy something worth $200, you’ll owe capital gains taxes on the $180 in profit you’ve realized since you initially bought the Bitcoin. It may seem as if you spent rather than sold  the Bitcoin, but to the IRS, they’re one and the same.

According to Jon Feldhammer, tax partner at Baker Botts, “[Cryptocurrency] started having trading volumes in the tens of millions of dollars each day, and it was clear the IRS was missing out on a significant tax revenue source.“

You only owe taxes on cryptocurrency if you spend or sell it and realize a profit. If you sell or spend your crypto at a loss, you won’t owe any taxes on that specific transaction.

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What You Need To Know About Taxes On Crypto

The amount you owe in cryptocurrency taxes depends on how long you’ve held your cryptocurrency and your annual income.

  • If you’ve owned your coins for less than one year before spending or selling them, any profits would be short-term capital gains, taxed at your normal income tax rate.
  • If you’ve held your crypto for a year or more, any profit would be long-term capital gains, taxed at a lower rate, determined by your annual income.
  • If you earn cryptocurrency by mining it or receive it as a promotion or as payment for goods or services, it counts as part of your regular taxable income. You’ll be responsible for taxes at your regular tax rate on the entire value of the crypto on the first day you receive it.
  • If you hold cryptocurrency from mining it or receiving it as a promotion or payment and spend or sell them later at a higher value than when you first received them, you’ll be responsible for short- or long-term capital gains taxes on the profits.

The taxes you owe on cryptocurrency depends on two things: how you obtained it and how you use it.

“Mining” refers to using computers to solve complicated equations and record data on the blockchain; you may receive payment in new crypto tokens in exchange for this work. The entire value of cryptocurrency obtained by mining is subject to taxation.

Cryptocurrency obtained through a marketing promotion or an airdrop is considered taxable income. If it’s received as payment for goods or services, it counts as taxable income, just like cash.

If you sell crypto for more than you originally paid for it, you owe taxes on the gain just as you would with stocks or mutual funds. If you convert or exchange crypto, you owe taxes on any gains you earn in the transaction.

Feldhammer suggests that those with crypto learn about the new taxation rules pertaining to the currency, and  take the tax regulations seriously. “Taxpayers are required to report their crypto transactions on their tax returns,” he says. “The IRS is cracking down on this.”