What is the tax rate on cryptocurrency transactions in 2021?

Let’s start with the obvious: You must report any cryptocurrency transactions.

Just because the U.S. government does not back cryptocurrencies, that does not mean the IRS and subject do not regulate them to taxation. In fact, as of the 2019 tax year, every federal taxpayer must now state on their 1040 form whether they have received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency.

However, an update to the original guidance on that new question has confused taxpayers and tax professionals alike. To make matters worse, understanding exactly how to report your crypto transactions is not always easy.

How is cryptocurrency taxed?

In guidance issued initially in 2014 and expanded upon in 2019, the IRS intended to treat virtual currency as property, not as currency, for federal tax purposes. As of the time of this writing, that guidance still applies.

(Readers should note that new guidance or regulations could happen subsequent to this writing, and I may not immediately update this post. Reach out to us to get the latest.)

Because the IRS considers any cryptocurrency held as a capital asset to be property, tax principles that apply to a property will generally apply to cryptocurrency transactions, too. That means any gain or loss from the sale or exchange or your virtual currency will be subject to capital gains tax rates.

If you possessed your cryptocurrency for a year or less before selling or exchanging it, the digital asset is taxable as short-term gains; the federal tax rate for this is the same as the rate for income and can range from 10% to 37%, depending on your taxable income bracket.

On the other hand, let’s say you held onto your currency for over a year. In that case, your profits from selling or exchanging it are taxable as a long-term capital gain, and the tax rate will usually range from 0% to 20%, depending on your income.

Selling cryptocurrency for “fiat” currency (government-issued currency not backed by a commodity such as gold), using it to buy goods or services, or trading one crypto asset for another are all capital gain tax events.

The IRS considers other types of taxable events, however, as income tax events. These events are generally taxed according to your personal income tax bracket and can include:

  • Earning crypto interest from decentralized finance
  • Receiving crypto through an airdrop
  • Receiving crypto payment for carrying out a task
  • Earning crypto from staking and liquidity pools
  • Earning crypto mining income from transaction fees and block rewards

 

One more thing is important to know: For tax purposes, you must report transactions using virtual currency in U.S. dollars. You will need to determine the Fair Market Value (FMV) of your currency as of the date of the transaction.

Fair Market Value is the amount of money an asset would sell for on the open market. When it comes to virtual currencies, the sale price is usually converted to U.S. dollars according to the exchange rate.

What changes have been proposed?

The bipartisan infrastructure bill currently under consideration in the House of Representatives includes a provision introducing new reporting requirements related to cryptocurrency transactions.

Intended as an offset to help fund the infrastructure bill, this new provision would create an estimated $28 million in revenue by increasing tax compliance among cryptocurrency traders.

Under current law, crypto exchanges and others involved in facilitating digital currency transactions are exempt from certain reporting requirements. For example, they are not required to report their customers’ losses and gains, as a traditional broker would be. As a result, the IRS often does not know about a given taxpayer’s income from cryptocurrency, and gains are often significantly under-reported.

The proposed new rule would expand the definition of the word “broker” to include “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.”

The result? Digital asset traders would be required to report the names, addresses, and gross proceeds associated with their transactions.

Crypto advocates have objected to this provision, claiming the language is too broad. They have suggested revising the language to exclude virtual currency miners and software developers, who do not usually have customers. They, therefore, typically do not have access to the information needed to comply.

The debate over these points is ongoing, and we must wait and see what form any new regulations on the cryptocurrency industry may take once passed into law. But one thing seems clear: Sooner or later, the IRS will crack down on unpaid cryptocurrency taxes.

What might the proposed cryptocurrency rule change mean for taxpayers?

While crypto tax cheats may have the most to fear if the proposed changes become law, even those who aren’t aware of any unpaid taxes may experience the impact. After all, as I mentioned earlier, the IRS doesn’t necessarily make it easy to report your virtual currency transactions accurately.

As previously discussed, Form 1040 now includes a question asking the taxpayer whether they purchased or acquired virtual currency during the tax year. Yet, the updated guidance issued this year states that if your only transactions “were purchases of virtual currency with real currency, you are not required to answer yes to the Form 1040 question.”

Far from yielding clarity, this guidance left even tax practitioners scratching their heads. Taken along with how limited the existing IRS guidance on the topic is and how many questions remain unanswered, you understand that reporting errors may happen.

What does that mean? Although you may not have intended to hide taxable crypto income from the government, you may have inadvertently under-reported.

In the event of new regulations, such as those under debate, becoming law, they will likely require exchanges to issue 1099-B forms detailing gains and losses to their customers. If so, the burden in terms of calculation may not fall too heavily on the taxpayer.

It’s possible, of course, that the current proposals will not end up as law. Nevertheless, if you expect to earn gains on cryptocurrency in the years to come, you should also expect to pay more taxes on those gains.

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