The popularity of cryptocurrency is currently justified. The technology behind it has the potential to change the way we do business and conduct transactions. But just like any other type of investment asset, cryptocurrencies are also subject to certain tax laws that need to be considered anytime you buy or sell them.
Crypto and taxes are on a collision course.
Cryptocurrency is a new asset class that’s not widely understood by the general public yet. However, it’s already on its way of becoming mainstream. Just like any other asset class, cryptocurrency can be purchased with cash or borrowed money; depending on how you acquire your coins – whether through mining or buying them from an exchange – will determine how much profits you make upon selling them back into fiat currency (USDs).
Crypto to crypto trades can trigger a taxable event.
If you’re trading cryptocurrencies, the IRS treats your crypto to crypto trades as a taxable event. This applies even if the coins being traded are not sold and remain in your wallet. This is because the IRS treats crypto to crypto trades as barter transactions. Barter transactions are taxed at fair market value, which means you must pay capital gains tax on any gains realized from these trades.
However, this is different from selling crypto for cash or another cryptocurrency and then purchasing another coin with that money—those types of trades are not taxable events if they were done for personal use rather than investment purposes.
To avoid paying taxes on these types of barter transactions with other cryptocurrencies:
- Don’t trade between two cryptocurrencies that have already been taxed when purchased; and
- Never sell one cryptocurrency and then purchase another without first converting it back into fiat currency
Airdrops and hard forks are taxable events.
The IRS has ruled that airdrops and hard forks are taxable events. This means that if you receive airdropped tokens or participate in an airdrop, you will have to pay tax on them. The same goes for hard-forked coins that give you new coins from the split. This is true even if those tokens become worthless or if the airdrop was just a marketing ploy by the company.
If you’ve been holding onto airdropped tokens for any length of time and want to sell them, make sure to keep track of all your transactions and record their value at the time they were received (not how much they’re currently worth). You should also keep records of any sales or exchanges you make along the way so that you can prove how much tax you owe.
Sending crypto to another wallet can be taxable.
If you have a personal purpose for sending crypto to another person, there should be no issues with the IRS—just make sure they know what they are doing as far as their tax returns go. However, if you are sending cryptocurrency from one wallet to another in order for business purposes and both parties are aware of this at the time of transfer, then it could count as a sale and trigger capital gains tax liability.
Crypto mining income is treated as ordinary income.
If you’re mining cryptocurrency, know that the income is treated as ordinary income. On profits from crypto mining, self-employment tax and federal income tax must be paid. Your state taxes also follow the same rules.
Keep your cryptocurrency gains out of the tax net.
There are several methods that you can use to avoid paying taxes on your cryptocurrency gains. These include:
Tax-loss harvesting
Tax-loss harvesting is a strategy to minimize the impact of taxes on your investments.
Essentially, tax-loss harvesting entails selling losing investments and reinvesting the proceeds in shares of similarly positioned investments that have lost value. Your taxable income should be decreased in order to have a lower tax liability.
The 1031 exchange method
The 1031 exchange method works by swapping one type of property for another, which allows you to defer taxes on the capital gains. The IRS allows you to defer paying capital gains taxes when you make an exchange of real estate that is investment property.
If you are planning to sell your crypto for cash, you can use this method to reduce your tax liability on the gains from selling your crypto.
HODLing
HODLing is the act of holding on to an investment for as long as possible. The idea is that by holding on to your crypto, long-term capital gains are taxed at a lower rate than short-term profits.
As you can see, it’s not as simple as just holding onto your coins—you need to be careful about how you trade them and what transactions trigger a taxable event for both capital gains and ordinary income.