Cryptocurrency has moved from the realm of shadowy internet message boards to front stage financial news. Crypto and NFTs are just as much a part of news network discussions as the stock market is -stealing headlines, talking time and pageviews from its more traditional predecessors. However, along with the increased attention to those new financial vehicles comes updated tax considerations. Below is a primer for cryptocurrency tax considerations, and is by no means a full discussion:
I have been mining cryptocurrency and have started to receive coins from this activity – is this taxable?
Yes – IRS Notice 2014-21 states that successfully “mining” cryptocurrency will create income for the taxpayer. The amount of gross income includible to the taxpayer is the fair market value of the cryptocurrency at the time of receipt.
Where do I report this income on my tax return?
How to report this income is dependent on the purpose/nature of your activity. If you are pursuing this purely as a hobby, any income would be included on 1040 Schedule 1 Line 8 Other Income. These amounts are not subject to self-employment taxes however, you are unable to take deductions against this income as hobby-related expenses are not allowed. Alternatively, if your activity would be regarded as business activity, you likely will need to report the income on Schedule C. Additionally, you can take ordinary and necessary business expenses against this income – however, you may also be subject to self-employment taxes.
What happens if I later sell the cryptocurrency that I have mined?
The IRS views virtual currency as property, and as such general rules around property apply. The basis of your mined coins would be the fair market value as of the time of receipt – since you are required to include that as income as discussed above. If the property is a capital asset (think stocks for most taxpayers as an example), then capital gain or loss would result from a sale. Whether gains or losses are categorized as long-term or short-term will depend on how long you have held the coin for, similar to a sale of stock. Long-term treatment would apply if held for over a year, short-term if held for less than a year.
If the property is not a capital asset, ordinary income or losses would result. Common examples here would be items like inventory or items held for sale directly to customers are typical areas where this treatment would apply.
I did not mine any cryptocurrency, but I did purchase some this year. Do I have to pay tax on my purchase? Do I need to check that box about crypto transactions on the 1040?
If you only purchased crypto during the year and had no other transactions (sale, using it to purchase other goods/services, etc) then there are no further tax consequences for the year. Additionally, you are not required to check the box regarding crypto transactions.
When I sell cryptocurrency – does it matter which specific coin I sell? It can matter a lot! The IRS allows taxpayers to specifically identify units of virtual currency, granted that you meet documentation requirements. Those requirements are (1) the date and time each unit was acquired, (2) your basis and the fair market value of each unit at the time of acquisition (3) the date and time each unit was sold, exchanged, or otherwise disposed of, and (4) the fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit. These requirements are met by several popular wallets, and this is a great area to utilize tax planning strategies, as selling coins that you have held for over a year with a high basis would have a different tax impact than coins recently purchased with low basis. Donating virtual currency can also be a viable tax planning strategy. Please consult with an HBK Tax professional first before using this as a tax planning strategy.
What if my wallet doesn’t provide that type of documentation and I have not kept the records either?
If you do not use specific identification related to sales and exchanges, the IRS deems that you are disposing of them in chronological order – starting with your earliest unit. This would be first-in, first-out basis, or FIFO. I didn’t receive any type of 1099 or official-looking document when I made my sales – do I still need to report this on my tax return? Yes! Any income, gain or loss from virtual currency needs to be reported on your tax return, whether you received a statement or not.
What about forks?
The taxability of a fork depends on which type – soft or hard. A soft fork is a change of the protocol of the software that can be backward compatible. This can be used to implement new features for a coin = but, importantly, it is still the same coin. It is not creating a new coin. Soft forks are not a taxable event, since you are still holding the same original coin.
Hard forks are different – these are software upgrades that are not backward compatible, and all users must upgrade to the new software to continue participating. This is a permanent divergence from the original chain, which can potentially create a new coin. It is possible to have a taxable event after a hard fork, if a user ends up possessing both the original cryptocurrency and a new cryptocurrency, via either the hard fork or airdrop. Speak to an HBK tax advisor for further information.
What about staking?
Staking is essentially lending your crypto – by lending your crypto, you are helping to secure and validate a given chain. In return, you have the potential to earn more crypto, similar to an interest payment. The more crypto that you are lending, the higher your chances of earning are. The taxability of this is still waiting for further clarification. As recently as December 21, 2021 the IRS released guidance that defined a “transaction involving currency” to include “receipt of new virtual currency as a result of mining and staking activities.” However, in the case Jarrett et al v. United States, the position is being taken that any coins gained through proof of stake should be considered new property that was created by the taxpayer. The IRS declared that it was refunding money to the Jarrets as a result of this case. IRS clarification or further court cases may provide further insight as to the taxability of these transactions.
This is by no means a full deep dive into the world of cryptocurrency taxation – new vehicles, methods and transactions are being created all the time. Hopefully, this primer has helped to understand some of the basics around taxation as it relates to cryptocurrencies. As with other areas of tax, please consult with your HBK tax advisor regarding these types of transactions.