You’ve probably heard of cryptocurrencies like Bitcoin, Dogecoin, Ethereum, Litecoin, or any other of the plentiful options. Many people are under the impression that these currencies are legal money, but they’re actually like gold; they are property. And you must also pay tax when you dispose of gold and make money on it.
The IRS asks a crypto-related question on the first page of the 1040 form; the question asks if you have received, sent, exchanged, or got rid of any financial interest in virtual currency. This question must be answered, even if you have no clue what cryptocurrency is. There is no option to leave this question blank.
How Does the IRS Learn About Your Activity?
Exchange platforms such as Coinbase, Crypto.com, and Uphold – amongst others – will eventually issue 1099 forms for all crypto activities. When they do, you will receive tax forms for the years between 2018 and 2021. If you’ve never reported your capital gains on your tax returns, you would have to pay penalties and interest on top of the tax – and those can be huge.
Non-privacy-oriented blockchains also keep public records of every crypto transaction. The IRS needs just one transaction to detect a person’s wallet. From there, the agency can track every transaction tied to that wallet. Rumor has it that the IRS has put together a list of enough crypto audits to last the next six years. And why not? The IRS wouldn’t let the amount of money cryptocurrency makes pass by without some scrutiny.
When Should You Answer No on the 1040 Form?
The IRS is only interested in cryptocurrency transactions that have netted taxable income or loss. They are not very concerned with any passive cryptocurrency holdings. For instance, if you bought Ethereum but have done nothing with it, received crypto as a gift, or moved crypto from one wallet to another, you can answer No to the question on your 1040.
Keep in mind that wallet-to-wallet crypto transfers are not taxed. In some cases, however, it is hard to prove that it was just a transfer. You will need to connect all the wallets to a single crypto reconciliation software to prove there was a non-taxable transaction.
When Should You Answer Yes on the 1040 Form?
If you used crypto to buy or sell goods or services, mined new crypto, or turned crypto into money or another crypto, you must answer Yes to the crypto question. These activities are considered taxable income or loss, and, even if you buy something small with cryptocurrency, it’s still identified as a taxable transaction.
How to Correct Your Answer on the Form?
· If you meant to answer No but chose Yes, there is no need to file an amended tax return.
· If you chose No when Yes was necessary and failed to report your cryptocurrency transactions, file an amended tax return right away. Failure to do so means the IRS could send you a letter demanding you pay the taxes due, plus penalties and interest.
Accounting for Payments in Crypto
Bookkeeping for payments using cryptocurrency is one of the greatest challenges I’ve come across. When a person gets paid in crypto, that payment equals the fair market value of crypto at the time of payment. Let’s say, for example, a client paid you one Ethereum for your work. You do some quick research and find that, at the time of the payment, Ethereum cost $3,000. This is now how much income you show on your tax return. But what happens if you turn around and sell this Ethereum three days later, and, at the time of sale, your Ethereum rose to $3,100? In this case, there is a capital gain of $100 ($3,100 minus $3,000). Capital gain is not ordinary gain, so it goes on a different tax form along with your sold stocks.
What if you paid someone with crypto and want to deduct this payment on your tax return? Again, you’ll be deducting the fair market value of Ethereum at the moment of your payment. If Ethereum was $3,000 when you sent it to your vendor, that is what you would deduct on your tax return. What happens, however, if that Ethereum that you just sent originally cost you $2,000? You bought it for $2,000 and sent it to the vendor when it was worth $3,000. Again, you would need to account for this capital gain of $1,000 on a different tax form.
Accounting for crypto payments becomes a painful chore when there are a lot of transactions. Fortunately, there are several reconciliation software that do most of the work for you. They may not be that precise yet, but they do most of the work. Ultimately, you’ll reconcile your crypto payments yourself in Excel.
Tax Planning Benefits of Crypto
So, are there any good sides to crypto? After all, it fluctuates, accounting for it is difficult, and the IRS is on the hunt for it. Well, there is such a thing as tax harvesting. Since the IRS thinks of crypto as property and not stocks, you can harvest** crypto losses** without wash-sale limitations. The wash-sale rule prevents you from recognizing a loss on a sold stock if you bought the same stock immediately after disposing of it. With crypto, you can sell it, capture the capital loss, and immediately buy back the same amount of crypto. This is useful during years of big capital gains. For example, you sold a house and made some capital gains on it. At the same time, you also have crypto you bought when it was high. You wait till the crypto drops and sell it at a loss, but then immediately buy it back. You keep the same amount of cryptocurrency, and you also recognize the capital loss, which will now offset your capital gain on the house. Say you made $200K on the house and then offset it with $50K of crypto losses, then you’d only have to pay tax on $150K of capital gains while keeping the same amount of crypto in your wallets. Pretty sleek, right?
I am passionate about crypto. It is useful, and it is here to stay.
If you have questions about cryptocurrency, you can reach me at 760-652-9161. I can help you wade through the confusion and prevent you from making any costly mistakes.
Your San Diego CPA,
Daria