What Is Cryptocurrency? How Does Crypto Impact Taxes?

Even though cryptocurrency has existed for over ten years, its popularity has quickly skyrocketed in the past year. If you have recently made investments in crypto, you might still have questions about its precise definition: “what exactly is cryptocurrency?”

Before tax season arrives, it is advisable to have a fundamental knowledge of the cryptocurrency you have purchased, whether to diversify your portfolio or simply out of curiosity. Additionally, it is important to be aware of certain essential aspects of cryptocurrency taxes.

This post will discuss the definition of cryptocurrency, the fundamental concepts, and the essential information about cryptocurrency taxes. It will also provide a detailed overview of the tax implications associated with different types of transactions.

What is cryptocurrency and how does it work?

Cryptocurrencies are decentralized digital or virtual currencies that are present across various computer systems globally. Unlike other forms of investment, they do not have a centralized storage or issuance controlled by any central authority, which makes them attractive to certain individuals looking to invest in crypto.

The decentralization of virtual currency highlights several important aspects of cryptocurrencies. Firstly, they are purposely designed to ensure tamperproof nature through cryptography, which enciphers transaction details exchanged between individuals.

Here’s how cryptocurrency works

For tax purposes, it is essential to understand two terms that are significant in tracking transactions: the “blockchain” serves as the usual platform for these operations.

• On-chain transactions are transactions stored on the blockchain.
• Off-chain transactions are not stored on the blockchain

Bitcoin, Litecoin, Ethereum, and Dogecoin are just a few of the cryptocurrencies that exist.

How does cryptocurrency gain value?

Put simply, the matter at hand revolves around supply and demand. When the demand goes up, the currency’s value will rise accordingly. Conversely, a decrease in demand will lead to a decline in value as well.

However, it is worth noting that the worth of your individual assets may fluctuate due to changes in supply and demand.

How do cryptocurrency transaction fees play into it?

Although fees and taxes may not be the main factor influencing your investment decisions, it is important to consider that they can affect your overall profitability. The specific fees you incur will differ depending on the type of currency you are dealing with.

When it comes to the tax implications, you can trust H&R Block to provide you with the necessary information about the essentials you need to be aware of. So, let’s delve into it!

Do you need assistance in preparing your cryptocurrency taxes? Whether you collaborate with an H&R Block tax professional or opt for H&R Block Online Premium, we are available to support you!

Cryptocurrency taxes

Investing in cryptocurrency, like any other asset, carries tax responsibilities. However, as previously mentioned, cryptocurrency possesses distinctive attributes that distinguish it from other forms of investment. It could be argued that cryptocurrency taxes adhere to a unique rhythm of their own.

Cryptocurrency vs. stocks

Comparing something to what it is not can often provide a clearer understanding. For example, by analyzing stock assets, one can grasp the crucial tax distinctions between individual taxation of cryptocurrency and stocks in the United States, as outlined in the table below.

How is cryptocurrency taxed?

This is the perfect moment to use the phrase “it depends.” We will now analyze the different situations: purchasing, trading, giving as a gift, receiving payment with cryptocurrency, and selling it.

To start off, it would be prudent to clarify a few terms beforehand.

• Basis – The amount of investment in a particular property.
• Long-term vs. short-term capital gains – When you sell a capital asset for more than you purchased it, it’s called a capital gain. The type of gain is determined by how long you hold that asset. Short-term is under one year; long-term is over one year.

Purchasing cryptocurrency

Purchasing crypto has no tax consequences, but it is important to keep track of your purchase price to avoid unnecessary tax payments in the future. The significance of on-chain and off-chain transactions becomes relevant in this regard.

If you buy cryptocurrency in a:

• on-chain transaction , the exchange will value it in U.S. dollars as of the time and day the transaction takes place based on the amount recorded on the block chain.
• off-chain transaction , you must determine the fair market value at the time and date the transaction occurred as if it were recorded on the blockchain. You can use a cryptocurrency or blockchain explorer to determine this value, and it will be accepted by the IRS.

If you are unsure about the published value, you will have to consider the fair market value of the property or services traded in order to calculate the value of the cryptocurrency you received.

When you make a purchase with cryptocurrency, you can include the transaction fees in your cost basis. When you sell your crypto in the future, the taxable gain will be reduced by the same amount, ultimately decreasing the capital gains tax owed.

Converting cryptocurrency into real estate.

If you trade property for cryptocurrency, you will face immediate tax implications in the same tax year. Subtracting the fair market value of the received property from the basis of the crypto you swapped will determine whether you have incurred a capital gain or loss.

I will provide an illustration as follows:

• Anjali pays $10,000 for cryptocurrency and holds it for 10 months as it grows in value.
• She then exchanges $12,000 of her cryptocurrency to pay for a piece of land (unimproved land for tax purposes).
• The difference between $12,000 (the exchange price) and $10,000 (her basis) is a $2,000 short-term capital gain (It’s a short-term capital because it’s under one-year).

Trading cryptocurrency in return for goods or services.

You will be subject to taxation on the fair market value of the entire cryptocurrency amount, akin to ordinary income, when you trade cryptocurrency for goods or services.

Allow me to provide an illustration:

Elias, who is not engaged in computer repair business, receives $50 worth of cryptocurrency from Zach to fix a computer.

• Elias will recognize $50 of ordinary income for the cryptocurrency he received.
• Zach purchased the cryptocurrency he paid to Elias for $20 as an investment four years back. Zach will recognize $30 of long-term capital gain.

Please be aware that self-employed individuals are required to pay self-employment tax on the cryptocurrency received for goods or services, in addition to considering it as ordinary income.

Giving cryptocurrency as a gift.

Receiving cryptocurrency as a gift does not result in immediate income tax implications, and the basis and holding period of the gift may match that of the giver. However, it is important to note that if the value of the cryptocurrency exceeds the annual and lifetime exclusion amounts, gift tax and generation skipping tax may apply to such crypto gifts.

Receiving payment in cryptocurrency.

Do you get paid in cryptocurrency? Your employer must consider the fair market value of the crypto you receive as they would with other wages. This means it will be liable for Social Security tax, Medicare tax, Federal Unemployment Tax Act taxes, and federal income tax withholding. State tax rules may also apply, depending on where you live.

Crypto is being sold.

If you decide to sell your cryptocurrency, you will be required to pay taxes on any profits made from the sale. As already stated, a profit or capital gain occurs when an asset is sold for a higher price than its purchase price.

If you are curious about the tax deductibility of cryptocurrency fees, it is important to note that although there is no dedicated deduction for them, you have the option to subtract any transaction fees incurred during the sale of cryptocurrency from your total proceeds.

I will provide an illustration:

• Carolina pays $15,000 for cryptocurrency and holds it for two-years as it grows in value.
• She then sells $17,000 of her cryptocurrency and has fees of $500. She can subtract the fees from her proceeds ($16,500)
• The difference between $16,500 and $15,000 (her basis) is a $1,500 long-term capital gain (It’s a long-term capital because it’s over one-year).

What is the tax rate on cryptocurrency?

The tax rate for cryptocurrency varies from 0% to 37% based on the duration of currency ownership and the circumstances of cryptocurrency acquisition.

• Ordinary income rates are between 10% and 37% depending on your income tax bracket.
• Short-term capital gain rates are between 10% and 37% depending on your income tax bracket.
• Long-term capital gain rates are between 0% and 20% depending on where your income level is in a special bracket for long-term capital gains.

How does the Infrastructure Investment and Jobs Act affect cryptocurrency taxes?

The tax reporting requirements for cryptocurrency underwent changes with the passing of the Infrastructure Investment and Jobs Act in late 2021.

Beginning in 2023, exchanges are obligated to send the IRS Form 1099-B, which reports the sale of cryptocurrencies to both the IRS and the taxpayer. Consequently, if you decide to sell crypto in 2023, the exchange must deliver Form 1099-B to you by the end of January in 2024.

Afterward, you will utilize the 1099-B to document your transactions on your personal 1040 tax form. To understand the current process of reporting, refer to the following section.

Tax form for cryptocurrency

You may come across two different types of tax forms for your taxes.

You received tax forms.

• Forms 1099: Depending on your activity and the exchange you use, you may receive either Form 1099-K or Form 1099-B to report your crypto transactions.
• Forms 1099- NEC: You may receive Form 1099-NEC if you are an independent contractor paid in cryptocurrency for performing services.
• Forms W- 2: If your employer pays you in a cryptocurrency, you will receive a Form W-2.

The tax forms that you are required to fill out:

• Form 8949: You may need to complete Form 8949 to report any capital gains or losses. Be sure to use information from the Form 1099-B you received. If you receive a Form 1099-K, be sure to report both your basis and your gains and losses for your cryptocurrency transactions on Form 8949.
• Form 1040:
  • If you did have capital gains or losses, you’ll also record them on your Form 1040/Schedule D.
  • If you received wages in cryptocurrency, you’ll record that amount as wages on your 1040.
  • If you were paid for services in cryptocurrency, you’ll record that amount as either other income on Sch 1 or income on Schedule C.
  • Additionally, a checkbox on Form 1040 will require you to state yes or no to the following question: “At any time during 2021, did you receive, sell, send, exchange, or otherwise acquire any financial interest in virtual currency?”

US Crypto Tax Guide 2023

Are you curious about how crypto tax operates and what the IRS’s rules for crypto tax are? The IRS has provided explicit instructions on how cryptocurrency is taxed. Both Capital Gains Tax and Income Tax are applicable to Bitcoin and other cryptocurrencies. In our comprehensive guide on crypto tax in the US, we will explain everything you should be aware of, including the taxation of crypto, the rate of tax for crypto, capital gains tax for crypto, and income tax for crypto. All of this will be covered in anticipation of the tax deadline on April 18th.

Do you have to pay taxes on Bitcoin and crypto?

In the US, tax on gains and income from cryptocurrency is required to be paid. The IRS has stated that depending on the nature of the transaction, crypto could be liable for either Income Tax or Capital Gains Tax.

How much is crypto taxed in the USA?

The tax rate on short-term capital gains and crypto income can be as high as 37%, while long-term capital gains can be taxed at a rate ranging from 0% to 20%. It should be noted, however, that NFTs considered collectibles might be subject to a 28% tax. The tax amount on crypto in the United States is variable and dependent on factors such as income, the particular transaction, and the duration of asset ownership.

Is any crypto tax free?

Not all crypto transactions in the USA are subject to taxation – that’s the good news we’ll begin with.

There will be no tax on crypto in the cases when:

• Buying crypto with fiat currency.
• HODLing crypto.
• Moving crypto between your own wallets.
• Gifting crypto – provided you haven’t reached the lifetime gift limit.
• Donating crypto to charity is tax deductible – although you may need a qualified appraisal if you’re donating more than $5,000.
• Creating an NFT.

Can the IRS track crypto?

Yes, the IRS has the ability to monitor cryptocurrency transactions. Therefore, if you are wondering whether or not you are required to pay taxes on your cryptocurrency profits and if the IRS is aware of your cryptocurrency holdings, you should cease questioning immediately.

This is the method through which the IRS obtains information about your cryptocurrency activities.

• All major crypto exchanges must now complete KYC (Know Your Customer) checks.
• Exchanges process banking information where they accept fiat payments in exchange for crypto.
• Many exchanges also have records of crypto addresses you’ve withdrawn funds to – so they can identify custodial wallets too.
• Many exchanges are sending 1099 forms to the IRS and users.
• The IRS has won cases against Coinbase, Kraken, and Poloniex, forcing them to share customer data.

Our blogs provide further information on topics such as 1099 forms, Coinbase and its relationship with the IRS, John Doe Summons, and the methods employed by the IRS to monitor crypto activity.

How is crypto taxed in the US?

Individuals may be subject to either Income Tax or Capital Gains Tax as there are two possible taxes that could be applicable due to the classification of Bitcoin and other cryptocurrencies as property in terms of taxation.

We will examine both types of transactions you are making with your cryptocurrency to determine the tax you will pay.

Capital Gains Tax & crypto

In the United States, there are multiple methods available for disposing of your cryptocurrency, as it is considered a capital asset for tax purposes. It is important to note that whenever you dispose of crypto, you might be required to pay Capital Gains Tax.

• Selling crypto for fiat currency.
• Trading crypto for crypto (including stablecoins, tokens, and more!)
• Spending crypto on goods or services.

Any profit you made from disposing of something will be subject to Capital Gains Tax.

Crypto Capital Gains Tax rates

The Capital Gains Tax rate for crypto is not specifically defined, but rather determined by the general rules of Capital Gains Tax. The rate you will be charged for your crypto depends on the duration of your asset’s ownership and your earnings. If you have held the crypto for less than a year, you will be subject to the short-term Capital Gains Tax rate. Conversely, if you have held it for more than a year, you will be subject to the long-term Capital Gains Tax rate.

How to calculate crypto capital gains

What is the amount of tax that one needs to pay on gains from cryptocurrencies?

When you buy or sell cryptocurrencies, the variation in value between the time of acquisition and disposal is referred to as a capital gain or loss. This occurrence is known as a taxable event, meaning that whenever you trade, sell, or use your crypto, you will experience a capital gain or loss. If you generate profits from selling your crypto, it will result in a capital gain. Conversely, if you incur a loss from disposing of your crypto, it will lead to a capital loss.

Determining your crypto capital gain and losses is a simple process. Initially, you must determine the cost basis of your crypto. The cost basis refers to the amount you spent in acquiring your crypto asset, including any applicable transaction fees. In case you acquired the crypto without any cost, such as receiving it as a gift, you will instead consider the fair market value of the cryptocurrency asset in USD on the day of receiving it.

To determine if there is a capital gain or loss, subtract the cost basis from the asset’s value on the day of disposal.

Capital Gains Tax is payable on gains, but not on losses. However, it is beneficial to monitor losses as these can be used to offset gains. More details about this will be discussed later.

USA crypto cost basis method

Calculating your crypto taxes is a simple process once you have knowledge of how cryptocurrency is taxed, isn’t it?

At this stage, things become significantly more intricate. When dealing with several cryptocurrency investments and transactions, the situation can become quite challenging. To begin with, it is essential to determine your cost basis.

The cost base was discussed earlier and at first glance, it appears to be straightforward. Nonetheless, what occurs when there are numerous assets and transactions involved?

Consider this example – you purchased 1 BTC in 2019 at a price of $4,000. In 2020, you acquired an additional BTC for $20,000. In 2021, you sold 1 BTC for $30,000. Using the initial cost base, you achieve a tremendous capital gain of $26,000. However, if you opt for the second cost base, your capital gain stands at a highly respectable $10,000.

So, how do you determine which one to utilize? Do you review each transaction and link each private key with the transaction? While you could do that, even the aforementioned example is basic. Numerous cryptocurrency investors possess numerous assets and conduct thousands of trades annually, thus making this an arduous undertaking.

Cost basis accounting methods provide guidelines for calculating the cost basis for a specific fiscal year.

Multiple cost basis methods are permitted by the IRS, which is advantageous for American crypto investors as it can significantly affect their crypto tax bill. The IRS permits the following methods:

• First In First Out (FIFO): the first asset you bought is the first asset you sell.
• Last In First Out (LIFO): the last asset you bought is the first asset you sell.
• Highest In First Out (HIFO): the most expensive asset you bought is sold first.
• Specific Identification (Spec ID): pick the asset you sold, provided you can identify it with records.

Using different accounting methods can significantly affect the amount you owe for crypto taxes. In the example mentioned, employing the FIFO method would result in a $26,000 profit subject to Capital Gains Tax, whereas using LIFO would lead to a much lower $10,000 profit. Further information on various cost basis accounting methods can be found in our guide. It is important to note that there is no definitive correct choice, as the most suitable method depends on individual circumstances. However, selecting the right accounting method can help minimize your crypto tax payments.

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