As tax season is now upon us, the number one question is raised: how is cryptocurrency taxed?, it is worth reviewing some common tips and tricks concerning your cryptocurrency holdings and reporting obligations.
(1) How is cryptocurrency taxed?
Since the IRS sounded off on the subject way back in 2014 (an eternity in crypto years!), Bitcoin and other “virtual assets” have been treated as property. What this means is that any “sale or exchange” of your virtual assets will give rise to a taxable event, that is, any time you sell or use your crypto (including to trade or swap for another crypto) you have a taxable event. A “taxable event” means that you must calculate gain or loss on the transaction and report that on your tax returns.
(2) What about a 1031 exchange? If I trade one crypto asset for another, I don’t have to declare that transaction until I trade it in for fiat right?
Wrong. The law changed, and you may no longer consider exchanges of personal property (crypto is personal property) as tax-deferred exchanges under Section 1031 of the Internal Revenue Code. So, the taxation on cryptocurrency applies to situations where, say, you owned Bitcoin and you swapped it for Ether. Even though there was no “cashing out” to fiat currency (say, United States dollars), you have still realized either a gain or loss on that transaction. What’s nice, however (in this example) is that you have a fair market value “basis” in your new crypto, here, ETH. Put another way, the value from which you measure any further gain in your ETH (pretend the market just keeps going up) will be calculated based on the date you did the swap.
An example: You owned Bitcoin, for which you paid $1,000 (work with me here), on January 1, 2021. Bitcoin rises to $1,500 over the next month. You swap your Bitcoin for ETH on February 1, 2021 – you receive $1,500 in ETH for your Bitcoin. Result? You have $500 in capital gain (either short or long term) AND you have a “basis” of $1,500 in your ETH. Fine. You hold your ETH for another month, and it is worth $2,000, at which point you swap it for Solana. What happens? Again, a gain of $500.00 (the
difference from when you initially swapped it from Bitcoin and the date you swapped it for SOL). New basis in your Solana = $2,000.00.
(3) What happens under the cryptocurrency laws if I am using a decentralized exchange (DEX). Do I still have to report my activity?
Yes, as much of a drag as that may be. At present, not even the centralized exchanges are issuing 1099s, but, in my opinion they soon will. Further, not many people know that in the tax law it’s the taxpayer that has the obligation to report, and the burden of proving the right to any deductions. In other words, it is not enough to think “well, they’ll never find out”, or “it’s not reported to anyone”. You don’t want to face penalties and interest for failing to report all of your crypto tax activity.
(4) What about my gains from DeFi (Decentralized Finance)? I made a return on coins I had staked. How is that treated under the cryptocurrency tax laws?
While this is a gray area with no specific guidance on point, it is likely that your staking rewards are taxable as ordinary income, valued on the day you received the reward. This is, to put it simply, a bit of a nightmare when it comes to reporting. Some people receive rewards on their staked crypto multiple times a day, day after day! Despite the challenges, there are some helpful software packages and services that can help you calculate these types of events.