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In 2014, the IRS initiated cryptocurrency taxation guidelines, marking the onset of regulatory oversight. Notably, it wasn’t until 2019 that the IRS mandated the reporting of cryptocurrency investments on income tax returns. Since 2014, a core principle has endured: cryptocurrencies and blockchain-based digital assets are considered property, not currency, for U.S. tax purposes. Consequently, any profitable cryptocurrency transactions are subject to U.S. taxation and treated as capital income, while losses may potentially qualify for capital loss deductions.
Can the IRS Track Crypto Transactions?
Contrary to common belief, cryptocurrency owners aren’t entirely anonymous to the IRS. The IRS can track and analyze cryptocurrency holdings, leveraging data from exchanges and blockchain analysis. To comply with tax laws, it’s crucial to report all digital asset transactions on your Form 1040 each fiscal year.
Centralized exchanges are required to submit Form 1099-K to the IRS for investors with trades exceeding $20,000 annually or over 200 transactions. In recent years, the IRS has intensified efforts to link crypto wallets with owners, aided by wallet linking options and user disclosures to exchanges.
Attempting tax evasion carries significant risks. In summary, it’s advisable to fulfill your tax obligations.
The Relationship Between Capital Gains and Cryptocurrency Taxation
Capital gains tax is relevant to cryptocurrency profits, akin to real estate and stocks. For example, buying bitcoin at $20,000 and selling it at $25,000 yields a $5,000 profit subject to this tax.
Tax rates hinge on the ownership duration. Holding for over a year qualifies for lower long-term rates, while assets held for under a year face standard income tax rates. In the U.S., rates range from 0% to 20%, based on taxable income. Longer crypto holdings can reduce tax liabilities.
Taxation of Bitcoins and Altcoins
The following are considered non-taxable events for cryptocurrency investment:
- Acquiring and Holding Crypto: Buying tokens with your own funds and holding them in a wallet is not a taxable event. There is no need to report it to the IRS, but maintaining accurate purchase records is crucial for future tax considerations.
- Transferring Crypto Between Personal Wallets: Moving your owned tokens from one wallet to another you possess doesn’t create a tax liability. For instance, transferring tokens from a software or custodial wallet to a non-custodial wallet like Ledger Nano or Trezor is tax-free.
The following are considered taxable events for cryptocurrency investment:
- Crypto Sale Profit: Selling cryptocurrency for profit in exchange for fiat like US dollars is a taxable event, with your tax liability based on your profit. If the proceeds are lower than your initial investment, you can claim it as a capital loss, up to a yearly limit of $3,000.
- Crypto Trading Profit: Making a profit from crypto-to-crypto trading is also taxable. For example, if you buy Bitcoin (BTC) for $1,000 and later exchange it for Ethereum (ETH) worth $1,500, the $500 profit is subject to taxation.
- Crypto Income from Work: When your employer pays you with cryptocurrency as part of your salary or if you receive crypto from customers for goods or services, it’s taxable income. This income is taxed at ordinary income rates, not capital gains rates.
- Crypto Mining Income: Earning income through cryptocurrency mining, specifically Bitcoin (BTC), is treated as ordinary income and must be reported in your tax returns, regardless of whether you keep or sell the mined tokens. Mining rewards are consistently considered ordinary income for tax purposes.
Tax Considerations in a DeFi Investment:
DeFi is an innovative sector in the crypto and blockchain domain, gaining prominence in 2021 with over $178 billion in capital. As of 2023, DeFi exchanges aren’t obliged to report to the IRS, but in 2024, they will under the Infrastructure and Investment Jobs Act. The IRS lacks comprehensive guidelines for DeFi transactions, necessitating investor caution in the following activities:
- Crypto Loans: Borrowing a DeFi loan doesn’t trigger additional taxes, but using crypto to repay these loans can be taxable, possibly as a capital gain or loss. Lenders of DeFi loans are subject to taxes, akin to other lending activities. Profits from loan repayments and capital gains from selling collateral are taxable.
- Liquidity Pools, Staking, and Yield Farming: Earnings from depositing tokens into liquidity pools are taxable when received from third parties. Pair-based staking in Automated Market Maker (AMM) protocols are taxable, whereas single-sided staking isn’t, although interest income should be reported.
- Yield Farming: Income generated through yield farming is subject to income tax. If you accumulate capital gains by holding rewards, they must be separately reported for capital gains tax purposes.
- Governance/Utility Tokens: In most decentralized crypto projects, participants receive governance tokens that confer voting rights and influence over protocol decisions when specific criteria are met. These tokens have distinct tax considerations.
As the DeFi landscape evolves and regulatory clarity emerges, staying informed and seeking professional tax advice is essential for DeFi investors.
How Nonfungible Tokens Are Taxed
Non-Taxable NFT Events:
Creating NFTs: Minting or crafting an NFT on the blockchain does not generate a taxable event. While the NFT may possess value, it remains unrealized by the creator, and reporting the minting process is unnecessary.
Taxable NFT Events:
- Selling NFTs: When a creator or investor successfully sells an NFT and receives proceeds, typically in ETH, it constitutes a taxable event. The seller must report this event and fulfill the corresponding income tax obligations. In this context, NFTs are treated as non-capital assets, and any gains are categorized as ordinary income. However, when someone uses crypto to purchase an NFT, it transforms into a capital asset.
- Purchasing NFTs: Buyers do not directly pay taxes when acquiring NFTs. Nevertheless, they may realize capital gains or losses on the ETH utilized for the transaction. The tax treatment (short-term or long-term capital gains) hinges on the duration they held the ETH before its use in the NFT purchase.
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