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Cryptocurrencies have been in the headlines recently as Bitcoin prices reached all-time highs in 2021. They're also beginning to be a bigger part of the financial portfolios of consumers, investors and large companies alike. And, more merchants may be willing to accept your cryptocurrencies as payment for goods and services in the coming years.
Before you dive into cryptocurrencies feet first, however, you want to understand the tax implications of buying, selling and using them. Even if you don't receive any tax forms, the IRS requires you to report your cryptocurrency gains or losses.
What You Have to Report on Your Tax Return
The IRS considers cryptocurrencies—and there are many, not just Bitcoin—as a type of virtual currency. However, it taxes these virtual currencies as property. In general, you want to remember that:
- You may need to report your gains if you sold a cryptocurrency, exchanged cryptocurrencies or used cryptocurrency to purchase goods or services.
- You can deduct your losses if you sold or spent cryptocurrency that lost value.
- You can take a charitable contribution deduction if you donate your cryptocurrency to an eligible nonprofit.
- The Form 1040 (the federal annual tax return form) now asks whether you've received, sold, sent, exchanged or otherwise acquired a virtual currency. However, you don't need to answer yes if the only transactions were purchases of virtual currency with real currency.
To determine how much you'll need to report in gains or losses, you first need to know the value of the cryptocurrency in U.S. dollars when you first bought or acquired it. The value, inclusive of any fees you paid, is known as your cost basis. You'll compare this to the price when you sell or spend it to figure out your tax liability.
For example, if you bought a Bitcoin for $10,000 after fees and sold it for $15,000, you had $5,000 in gains—that's what you'll pay taxes on. These gains will be reported on Form 8949 and summarized on Schedule D in your tax return.
On the other hand, if you bought Bitcoin for $10,000 after fees and sold it for $5,000, you lost $5,000. You can deduct the losses to offset capital gains. If you have more losses than gains, you can deduct up to $3,000 from your taxable income ($1,500 if you're married and filing separately) and carry over the additional losses to the next year.
The IRS offers further clarification on virtual currencies in an FAQ that it periodically updates.
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How Do Capital Gains Taxes Work?
If you're buying and selling cryptocurrencies, you'll pay capital gains taxes on the profits. However, the tax rate depends on your taxable income and whether you held on to the cryptocurrency for at least a year.
When you buy and sell cryptocurrencies within a year, the short-term gains are taxed as ordinary income. However, if you hold on to your cryptocurrency for a year or more, you'll pay long-term capital gains—which may be beneficial. (The same capital gains rules and rates apply to other investments, such as stocks.)
The income limits and tax rates can depend on your filing status, and may change from one year to the next. Here are the tax rates for single taxpayers for the 2021 tax year.
| 2021 Capital Gains Tax Rates for Single Filers | |||
|---|---|---|---|
| Sold Within One Year | Sold After One Year | ||
| Taxable Income | Short-Term Capital Gains Tax Rate | Taxable Income | Long-Term Capital Gains Tax Rate |
| $0 to $9,950 | 10% | $0 to $40,400 | 0% |
| $9,951 to $40,525 | 12% | $40,401 to $445,850 | 15% |
| $40,526 to $86,375 | 22% | $445,851 or higher | 20% |
| $86,376 to $164,925 | 24% | ||
| $164,926 to $209,425 | 32% | ||
| $209,426 to $523,600 | 35% | ||
| $523,601 or higher | 37% | ||
In some situations, your cryptocurrency earnings will be considered ordinary income, such as when you "mine" Bitcoin by using computers to process cryptocurrency transactions and collect a Bitcoin reward for doing so. In this case, your Bitcoin earnings are taxed based on your marginal rate and total income.
If a company or client pays you in crypto, it's as though they're paying you in dollars and you'll need to determine the cryptocurrency's dollar value on the day you received the payment. In either case, you may need to report the income as self-employment earnings, which also means you can deduct associated business expenses from your gains.
What if You Don't Report Your Cryptocurrency Transactions?
Cryptocurrency exchanges won't necessarily send tax forms to you or the IRS. However, you still need to self-report your cryptocurrency transactions.
Some exchanges will generate reports that can help you prepare your tax returns. There are also third-party tools that can help you determine what to report on your taxes.
Failing to report your cryptocurrency transactions—even if you didn't know you should—could lead to an IRS audit, penalties and interest. Intentional tax evasion may lead to criminal prosecution, which could result in up to five years in prison and a fine of up to $250,000.
And, while Bitcoin may be safe in many respects, it's not necessarily anonymous or untraceable. As part of its Operation Hidden Treasure, the IRS' Fraud Enforcement Office is training agents and working with private organizations to identify individuals attempting to fraudulently avoid reporting cryptocurrency gains.
Plan Ahead if You're Buying or Selling Cryptos
Knowing that you'll have to report cryptocurrency transactions when you file your tax return, it may be best to set up a system for tracking all your transactions as soon as possible. There are third-party platforms that let you connect multiple exchanges and virtual wallets to consolidate all your transactions in one place. You could also track by hand, if you prefer, but it can quickly become complicated.
Additionally, if you're planning on selling, exchanging or using cryptocurrency, consider how long you've held onto it. If you're nearing the one-year mark and will benefit from a lower capital gains tax rate, it might make sense to wait.