The IRS is famously vague about crypto tax rules, but still aggressive when taxpayers guess wrong on anything from capital gains on thousands of transactions to funds frozen on FTX.
The time to give Uncle Sam his cut of your crypto is rapidly approaching — and just as in years past, there are still a lot of unanswered questions and gray areas to approach with caution if you're in the U.S.
And, if you've made more than a few small trades, with professional help.
There are a couple of reasons for this — the two biggest being that the process of figuring out how much you owe in crypto taxes can be enormously complex, and that the Internal Revenue Service has been getting more and more serious about cryptocurrencies.
How serious? The very first question on this year's Form 1040 — located just below your name and address, and above whether you can claim the standard deduction — is whether you've owned digital assets. It reads:
At any time during 2022, did you: (a) receive as a reward, award, or compensation; or (b) sell, exchange, gift, or otherwise dispose of a digital asset or a financial interest in a digital asset?
And if you think that somehow the pseudonymity of Bitcoin and other cryptocurrencies will shield you, be aware that the IRS requires centralized exchanges turn over client data by filing a 1099-K form for anyone who made more than 200 transactions and $20,000 worth of trades during the year.
What Does the IRS Want?
Despite that, "the IRS has still issued very little guidance about cryptocurrency taxes," Andrew Gordon, managing partner of crypto-focused Gordon Law Group, told CoinMarketCap. "It's not always as unclear as people think it is because usually there is some way to apply the tax code to the facts, but there's a lot of legal gray area."
That said, some aspects of crypto don't fit in very well, Sharon Yip, a CPA and co-founder of Polygon Advisory Group, told CoinMarketCap.
"People are still not sure about what the proper tax treatment is for complicated transactions such as liquidity pools, yield farming, rebase tokens, [and] self paying loans," she said.
That will only get worse, Yip added, noting that "new and complicated crypto products and activities are being created at a fast pace, especially in the DeFi and NFT areas."
Despite that, Gordon, an attorney and certified public accountant who has been focused on crypto taxes since 2014, warned:
"We've seen the IRS come after crypto users very aggressively over the past five years, even when there are a ton of unanswered questions."
A large part of this uncertainty is down to Congress rather than the IRS, according to Pat Larsen, co-founder and CEO of crypto accounting software firm ZenLedger.
"Generally a large issue such as 'what is the tax and regulatory framework for cryptocurrency' is supposed to be addressed by legislators," leaving the IRS and other regulators to enforce those laws, Larsen told CoinMarketCap. "This has not happened in crypto in the U.S. yet."
With that in mind, here's a look at some of the key things crypto holders need to know — and things they need to know they don't know — heading into tax season.
1. How Much Do I Owe?
The first and most important of the settled issues is that the IRS generally considers cryptocurrencies to be property for tax purposes.
That means that most crypto-related activities are subject to capital gains taxes. Which is a far bigger problem than it sounds.
"It can get very complex because every time you spend, swap, trade, or convert crypto and NFTs, that's a taxable event," Gordon said. "You may be 'spending' a small fraction of a token, but you need to know the cost basis and acquisition date for that fraction."
The cost basis is the price at which you bought that particular token or fraction of a token, and is compared to the price for which it is sold to determine a capital gain or loss.
The acquisition date matters because it determines the tax rate you'll be paying. Long-term gains are those held for more than one year, and are taxed at 0%, 15% or 20%, depending on income. Short-term gains, however, are taxed at seven brackets starting at 10% and climbing to 37%.
So whenever possible, you'll want to spend the oldest crypto in your wallet, or HODL it a bit longer.
"One important tip everyone should know is that you need to report crypto even if you lost money," Gordon said. "A lot of investors don't realize that."
Besides tracking capital losses to offset capital gains, he added, they can be used to offset up to $3,000 in ordinary income.
2. How Do I Calculate My Gains and Losses?
There are four methods of calculating the cost basis of your crypto transactions. These are:
- First in, first out (FIFO): This assumes the digital assets you bought first are the ones sold first. While this can lead to bigger gains, it is also more likely to qualify as a long-term gain.
- Last in, first out (LIFO): Under this method, the most recently purchased tokens are the first ones sold, minimizing gains.
- Highest in, first out (HIFO): The most expensive assets are the first ones sold. This would, in theory, minimize realized gains and maximize losses, but may also be more likely to kick in short-term gain rates.
- Specific ID: With good enough record keeping, you can determine which actual asset was used in a transaction, and its cost basis and acquisition date.
3. Can I Do It By Hand?
"The process of calculating capital gains and losses for individuals with a high volume of trades can be incredibly complex and sometimes near impossible to do on your own, depending on your trading history," Larsen said. He added:
"Every transaction on-chain and off-chain from day one of your trading history must be accounted for and priced in your country's fiat currency."
That's where tax software like ZenLedger comes in, importing data from multiple wallets and exchanges to determine profits and losses, he added.
Even with good software, the process can include manually verifying some transactions — particularly complex ones or those flagged as missing — or adding transactions from platforms that don't offer downloadable data.
Frequent traders, Gordon said, "might have thousands of transactions to look at. Usually that's when people call us."
4. What Do I Have to Report?
Straight buying and selling crypto isn't the only thing that the IRS wants to know about.
One notable capital gains taxable action is trading one digital asset for another — for example buying dogecoin with ether, the Kraken exchange said in a recent blog. This includes stablecoins and NFTs.
Another is selling or using digital assets to pay directly for goods or services. This has become an issue in using cryptocurrencies like Bitcoin for day-to-day purchases, payment processors acknowledge, as even buying a can of Coke would trigger a capital gain. Several of the crypto regulation bills proposed last year included a purchase threshold of $50 to $200, below which capital gains would not be triggered.
Then there's crypto created in a hard fork — such as when Bitcoin holdings were duplicated on the Bitcoin Cash blockchain.
And, selling any digital asset for fiat, including metaverse items or "land" must be reported.
Then there are sources of taxable income that must be declared. These include:
- Interest, yield or rewards from staking and crypto lending is taxable — whether it comes from centralized or decentralized finance (DeFi)
- Earnings from DeFi liquidity pools on DeFi platforms like Uniswap or Compound
- Block rewards from mining
- Airdropped tokens
- Referral rewards
- Crypto received from play-to-earn games like Axie Infinity
- Earnings from projects build on metaverse "land"
- Token rewards earned for watching ads on the Brave browser
- Sales on NFTs (of course) but also any creator royalties from their resale
5. What Don't I Have to Report?
Things that do not trigger capital gains include:
- Buying crypto with fiat currency
- Transferring assets between your own wallets
- Depositing crypto as collateral for DeFi loans
- Minting NFTs
- Gifting or donating crypto, subject to certain conditions and limitations
Kraken added that locking up digital assets in staking contracts does not trigger capital gains, although any earnings gained from that does, which is kind of splitting hairs.
6. No More Harvesting?
One crypto capital gains strategy that may be coming to an end, Larsen said, is tax loss harvesting. That means selling crypto holdings that have lost value to realize the loss and offset capital gains made elsewhere, and then buying it back to preserve your portfolio's desired holdings.
In the securities industry, the wash sale rule applies for 30 days.
Under newly proposed rules, he said, "the wash sale rule would apply to crypto, therefore removing the current ability to sell and immediately buy back."
7. NFT Rules Changing?
On March 21, the IRS and the U.S. Treasury published a notice announcing their intention to treat many non-fungible tokens as collectibles — which "are generally taxed at different rates than securities or income," Larsen said.
Those rates are generally less advantageous than the capital gains on other assets, the agency said.
While it seeks comments on the new rules, the IRS notice advised using a "look-through analysis."
Meaning that if the item held in the NFT is a collectible, so is the NFT. The agency gives the example of an NFT certifying ownership rights to a gem. As gems are collectables, so is the NFT.
"If an NFT has a visual component — like unique or serialized artwork — then it likely will be a collectible," Larsen said. The same would not be true for NFTs giving titles to metaverse "land" plots.
8. I Had Funds on FTX or Celsius. Now What?
One of the toughest questions to answer is what people who had funds frozen and lost on bankrupt platforms like Sam Bankman-Fried's FTX exchange or the crypto lender Celsius should do.
Tough enough that Gordon said "we're advising most clients to file an extension and wait to see if the IRS will issue any guidance about this specific situation, because it's affecting a lot of taxpayers."
The problem is that while lost funds and assets may provide a capital loss, with the bankruptcies still playing out, it isn't at all clear how much affected customers will get back or when they will get it.
"If you do end up getting any of your money back from Celsius, FTX, or BlockFi, then it will be ordinary income at the time of receipt," Gordon said. He added:
"There could be negative consequences to claiming a loss now. It's an aggressive stance to take."
This already played out with clients of the famously hacked and bankrupted Mt Gox exchange, Larsen said.