How Does the IRS View Cryptocurrency Capital Gains?

Blockchain attorney Dr. Nick Oberheiden

Attorney Nick Oberheiden
Cryptocurrency Capital Gains and the IRS Team Lead
Blockchain attorney Alina Veneziano

Attorney Alina Veneziano
Cryptocurrency Capital Gains and the IRS Team Lead

Background: 2014–2018 IRS Efforts on Crypto

Cryptocurrencies have become increasingly popular. The IRS wasn’t always at par with the growing popularity of cryptos until 2014, when the agency issued a statement stating that virtual currencies will be treated as property in federal income tax matters. The agency also stated that capital gains tax rules apply to cryptocurrencies.

However, despite issuing guidance in 2014, less than 1,000 US taxpayers filed returns on their cryptocurrency dealing between 2013 and 2015. While 2016 to 2018 had more crypto filings, it still wasn’t as expected, considering the number of cryptocurrency users, transactions, and crypto market turnover during this period.

2019–2020 IRS Efforts

In 2019, the IRS stepped up cryptocurrency enforcement efforts by sending 10,000+ letters to US taxpayers it suspected had failed to comply and report their virtual income in their returns. That same year, the IRS asked taxpayers explicitly if they had made profits from their cryptocurrency dealings.

The agency amended the Schedule 1 form to require taxpayers to answer if they had sold, sent, received, exchanged, or gained financial interest in virtual currencies. The following year, the agency ramped up efforts by adding a question about virtual currencies to Form 1040, the form used for filing income tax returns. This milestone signified the IRS’ increased seriousness about enforcing capital gains tax for cryptocurrencies.

The IRS Take: Cryptocurrencies Are Property

The IRS treats virtual currencies or cryptos like Bitcoin as property. As a result, they attract taxes as real property. For instance, if you purchase $2,000 worth of Bitcoin and later sell for $10,000, you get $8,000 in taxable capital gains. Capital gains are straightforward and easy to compute, provided a taxpayer maintains accurate and updated records of crypto transactions.

However, there are other cryptocurrency transactions that are treated as taxable events. For instance, US taxpayers should report exchanges, sales, and any other dispositions involving virtual currencies. This applies even if the cryptocurrency account is held outside the US.

What Happens When You Buy One Crypto Using Another?

If you exchange Ethereum for Bitcoin, the IRS assumes you liquidated Ethereum into US dollars and used the dollars to buy Bitcoin. Assuming you had $50,000 worth of Bitcoin and the value increases to $80,000, then you exchange your Bitcoin for Ethereum, the Bitcoin value increased (by $30,000) before you purchased Ethereum. Such a scenario qualifies as a taxable event because capital gains were realized. As a result, you would be expected to pay tax on the $30,000 capital gains.

What Happens When I Use Crypto for Retail Transactions?

Many retailers have been accepting cryptocurrency payments for years. While most of these retailers happen to be in the tech space, there are many mainstream businesses that have been accepting cryptocurrency payments.

A perfect example would be KFC Canada, which launched a marketing campaign in 2018 that allowed customers to pay for $20 worth of fried chicken using Bitcoin. While this promotional offer was limited, it paved the way for other businesses to accept cryptocurrency payments.

Most importantly, any retail transactions in cryptocurrency have tax implications. The IRS considers retail transactions involving crypto to be taxable events. As is the case with buying one cryptocurrency with another, the IRS assumes you liquidated your crypto holdings into dollars before using those dollars to buy goods or services. Increases in the crypto holdings value before a transaction translates to capital gains realized during a retail transaction.

Therefore, when using crypto for direct retail transactions, you should maintain accurate transaction records and record the value of your crypto holdings when transacting. This information is crucial for reporting capital gains accurately regarding retail transactions.

What Happens to Losses?

Losses suffered when trading crypto can be recovered. The offset isn’t limited to cryptocurrency gains only but to capital gains generally from any other assets. For instance, if you own cryptocurrencies and stocks and your stock portfolio does well in a certain year, prompting you to sell the stocks and cash out, the resulting profit is considered capital gains. If your cryptocurrency portfolio does poorly, and you sell at a loss, that loss (say $5,000) can be deducted from the capital gains tax you owe from selling your stocks.

Summary: The IRS’ View on Cryptocurrencies

To comply with your tax obligations as a US taxpayer and file accurate returns, you must understand how the IRS treats cryptocurrencies. Understanding the IRS’ take avoids serious problems like unexpected tax liability.

You must be proactive about your cryptocurrency transactions by first keeping accurate transaction records. It’s advisable to record all crypto purchases, exchanges, sales, lending interest, airdrops, retail transactions, and everything else that can qualify as a taxable event.

Keeping accurate records isn’t as hard as you would think. Most cryptocurrency exchanges feature built-in tax tools that can generate transaction history automatically. Even if your exchange doesn’t have such features, you can keep accurate records yourself.

Armed with an accurate cryptocurrency transaction report for a given year, it’s easy to compute your tax liability accurately. Alternatively, you can utilize the services of experts of use tax calculators. Tax professionals or CPAs come highly recommended for complex tax matters as these are the best-suited professionals for computing cryptocurrency tax liabilities. Most importantly, you need help from other experts like attorneys if your face legal issues for failing to file accurate returns, among other reported tax legal problems.

Contact the attorneys of blockchainlawyer.com if you have questions about cryptocurrencies and IRS.