What events in cryptocurrencies count as taxable and non-taxable? How can you calculate taxes on your digital assets? Read to find out more.
Cryptocurrency trading has emerged as one of the most popular sources of passive income over the past couple of years. Experts believe that the impending lockdowns due to COVID-19 have boosted cryptocurrency investments as more people want to make some extra money off the volatility of the crypto market. According to the latest reports, in January more than 106 million people used cryptocurrencies and the numbers are rising. Cryptocurrency has always been associated with the younger generation, but there has been a strong indication that more clients aged above 55 are now investing in this virtual currency.
Tax Implications for Digital Assets
Cryptocurrencies have now been accepted as a medium of exchange for daily transactions. In 2019, IRS (Internal Revenue Service), a US-based government agency responsible for income tax collection decided to include cryptocurrency transactions in Form 1040. According to the form, there will be tax implications on cryptocurrency transactions. Buyers, sellers, and traders must keep a record of their cryptocurrency transactions and report them properly. However, if crypto users try to evade taxes or fail to pay their taxes in due time, he/she might be penalized or even prosecuted in court.
So, the most pertinent question is how is cryptocurrency taxed? What are the factors to consider before calculating your crypto taxes? Let's see what we can learn from the U.S.
Understanding Taxable Event
The IRS has stated that virtual currencies like cryptocurrencies will be treated as property like a stock, bond, or any other asset, and crypto holders have to pay taxes like they pay income taxes on any other asset. Buying crypto assets and selling them with profits will be considered a taxable event. E.g., you buy cryptocurrencies for 10,000 U.S. dollars and sell them for $40,000. Then the profit of $30,000 is capital gains and is taxable.
Taxable Events in Cryptocurrencies
1) The nature of your investment: Before calculating your tax return, you must understand the nature of your investment. Does it depend on how you are holding your cryptocurrencies? Are you frequently selling cryptocurrencies? Then the profits from the sale will be considered as business income and will be taxed accordingly. Similarly, if it is being used as an investment, then the profits will be considered as capital gains. Based on this, you can file your tax liability. If you use cryptocurrencies for making payments for goods and services like a salary payment, then the tax liability will be calculated on the cost basis on the day of payment.
2) Duration of holding cryptocurrencies: The tax liability also depends on the duration of holding cryptocurrencies. If a taxpayer holds cryptocurrencies for more than 3 years, taxes will be calculated on long-term capital gains. If it is less than 3 years, it will be taxed on short-term capital gains.
3) Cryptocurrency mining: Incomes generated from crypto mining are considered a taxable event. The tax will be levied on the fair market value i.e., the cost basis or the price at which you mined the cryptocurrency. While calculating the taxable value, you may deduct operating costs like the resources or equipment cost. This deduction depends on the nature of mining. If you have a mining business, then you can make these deductions from the tax bill. However, if you are an individual miner, you are not eligible for these concessions.
4) Cryptocurrency exchange: Earlier conversions of cryptocurrency like Bitcoins to Ethereum were considered as “like-kind transfer” by section 1031 and taxations on these conversions were ruled out by IRS. However, in June 2021, IRS stated that these conversions can no longer be considered as like-kind transfers and are taxable income.
5) Donations and inheritance of cryptocurrencies: Crypto donations are considered the same as cash donations and are exempted from tax. Donations up to $15,000 are exempted from taxes. Recipients do not have to pay any taxes, however, if they decide to sell them, taxes will be liable on the fair market value of cryptocurrencies. Taxes will be levied on inherited crypto assets.
6) Airdrops and hard forks: If you have received cryptocurrencies through other sources like airdrops, forks, or through crypto giveaways, then it is considered as taxable income.
Non-Taxable Events in Cryptocurrencies
Charitable donations are exempted from tax under 501(c)(3) in the US Internal Revenue Code.
Cryptocurrency gifts. The person gifting is exempted from tax payment if the gift does not exceed $15,000. The person receiving the gift is not liable to pay any taxes. However, if he decides to sell the gift, it will be taxable.
Buying crypto coins using fiat money are exempted from tax when they are bought at prices less than the fair market value.
Transferring funds from one crypto wallet to another wallet.
How are Cryptocurrencies Taxed?
The amount of cryptocurrency tax and the nature of taxation depends on several factors such as:
The country where you reside: The nature of taxation depends on the tax authorities of that country. Countries like Malaysia, Germany, and Singapore offer liberal tax rules. In 2018, Portugal has exempted cryptocurrencies from income tax and is one of the favorite destinations for crypto enthusiasts.
Salaries: Employees or freelancers receiving salaries in cryptocurrencies are liable to pay income tax.
Income brackets: The tax liability depends on the income brackets. Incomes below a certain threshold are exempted from tax liability.
Calculating Cryptocurrency Taxes
To know how much is your tax liability, one needs to first calculate your capital gains and losses. Say, for example, Tom, a crypto buyer purchases 1 BTC for $10,000. Here, $10,000 is the cost basis. Next year he sells it for $20,000. Then, his capital gains are $10,000 (Sale price minus cost basis).
In the same year, he incurred a loss on his crypto assets worth $14,000. Tom can offset his losses with his crypto gains. So, his net loss becomes $4,000 (losses minus the capital gains). He has reduced his income tax liability to $4,000. This year, he can pay $3000 as taxes and carry forward $1000 to next year.
According to USA 2020 tax rules on crypto assets:
Short-term gains: Any crypto asset that has been held for less than one year is subject to taxation depending on the income bracket.
Long-term gains: The tax rates are much lower when you hold crypto-assets for more than a year. It can be 0 to 20% depending on the total income.
FIFO and LIFO Method of Tax Calculation
Tax can be calculated in the FIFO (first-in-first-out) or LIFO (last-in-first-out) method. Most countries follow the FIFO method. LIFO is used as an alternative method of tax calculation in the U.S.
Here is an example:
On January 1, 2021: 1 BTC was purchased for $100.
On January 23, 2021: 1 BTC was purchased for $200.
On February 2, 2021: 1 BTC was traded for $500.
In the FIFO method, the capital gain is calculated on an initial cost basis.
Capital gains in FIFO method= $500-$100= $400
In the LIFO method, the later price is considered. Here it is $200.
So, capital gains in the LIFO method= $500-$200=$300.
Check out these calculators that's designed to be accountant friendly. We foresee there will be more in the future as countries try to learn from U.S.
In some countries, if you fail to pay your crypto taxes on time, your crypto funds may be confiscated, penalized, or you may even have to serve jail time. According to IRS in the U.S., crypto enthusiasts will need to start keeping a proper record of trading, calculate their capital gains, and tax events. Calculating taxes can be time-consuming and complicated. Taxpayers can use crypto tax calculators or use professional help to calculate how much they owe for crypto taxes.