Investors in cryptocurrencies may be sitting on big profits. Bitcoin and Ethereum, the two largest cryptos, are up 100% and 470% this year, respectively. Solana, another major coin, is ahead 13,300%, while the “joke” token Dogecoin has gained 49,000%.
While the profits may have enriched crypto owners, taxes may be coming due soon, and the situation isn’t clear cut. The government taxes crypto like any other investment—in other words, it’s considered an asset, like a stock, and not a currency. So, selling can incur significant capital-gains taxes, especially if you’ve owned coins for a year or less. And if you’ve earned interest by lending or “staking” tokens, that interest is taxable, just like interest from a bond or bank account. Indeed, crypto taxation can be complicated, depending on how investors trade, use, and manage their holdings.
One thing is clear: Washington views crypto as a large and growing new source of tax revenue. Congress included several tax-reporting requirements for brokerages and businesses in the infrastructure bill that President Joe Biden recently signed. The government expects to raise $28 billion over 10 years by tracking and taxing crypto transactions. Digital wallets, used for holding crypto assets, along with decentralized platforms for lending and trading cryptos, may have to report tax information to brokerages that may then issue tax forms with more transaction records. Starting in 2024, anyone receiving more than $10,000 in crypto for a product or service will have to report identifying details about the sender of the crypto, just as they would a cash transaction over that amount.
The government also aims to crack down on taxpayers who may underreport gains. Taxpayers must now check a box on their return, declaring whether they’ve transacted or had a “financial interest” in a virtual currency. Taxpayers face potential penalties or prosecution if they willfully neglect to report all of their income or profits off crypto.
In some ways, it shouldn’t be hard to comply with Internal Revenue Service rules. At the most basic level, crypto is subject to capital-gains tax on net profits from a sale. Short-term capital gains are taxed as ordinary income, which applies to crypto sold within a year of purchase. Long-term capital gains rates range from 0% to 15% to 20%, depending on income levels, and may include an additional 3.8% surcharge for filers with more than $200,000 in modified adjusted gross income or investment gains.
As a capital asset, crypto losses can offset gains in investments like stocks or real estate. If you booked short-term trading losses in crypto, for instance, they could offset short-term gains in stocks, or vice versa.
Yet investors may have to do their own accounting, since many digital-asset exchanges don’t issue standard 1099-B forms. Those forms record the cost basis of transactions and net gains or losses from sales. Without them, taxpayers may need to use software or consult a tax preparer to figure out what they owe.
Coinbase Global (ticker: COIN), one of the largest exchanges, plans to issue a 1099-MISC form for users with more than $600 in “fee income and rewards” from activities like staking their holdings in return for an interest rate. But investors will be on their own to calculate gains or losses from crypto sales, since Coinbase isn’t supplying 1099-B forms. Coinbase said in a statement that it isn’t issuing the form “as it is not required by the IRS for this upcoming tax season.” The company says it plans to provide gain/loss reporting next year.
Gemini—another big exchange—plans to issue 1099-K forms for customers with more than 200 transactions and gross sale proceeds above $20,000. But the forms show gross proceeds, without a cost basis. Other brokerages make things a little easier. Robinhood Markets (HOOD) plans to issue crypto capital-gains and cost-basis info on consolidated 1099-B forms, and use 1099-MISC forms for other income. PayPal (PYPL) and Square (SQ) both plan to issue 1099-B forms for the 2021 tax year.
More complications arise, given the varied ways that investors buy, hold, and exchange their crypto holdings. Investors can use a digital wallet and other nonbrokerage accounts that enable them to hold and trade their crypto outside a major exchange. Digital wallets like Metamask, which has 21 million users, allow investors to transfer holdings from an account with an exchange and hold it separately. Investors can then shift cryptos to a decentralized-finance or DeFi, platform, and earn interest by lending their tokens to liquidity pools or staking their assets to help secure a blockchain network. Traders also swap tokens on automated trading platforms like Uniswap, which consist of “smart contracts” between buyers and sellers. None of these entities issue tax forms, partly because there isn’t a company keeping tabs on trading, gains, or losses.
Investors can lose track of their cost basis as crypto assets move from one platform to another. But the tax authorities require investors to self-report capital gains or income in order to determine profit and, of course, tax owed. If there’s a discrepancy between self-reported investment income and the proceeds reported by a brokerage, investors could get an audit notice from the IRS asking them to reconcile the figures.
“Crypto can move from wallet to wallet, and people may have no idea what their cost basis is,” says David Kemmerer, CEO of CryptoTrader.Tax, a software provider. “The IRS is getting info on who’s investing, but they’re not getting information on how much those investors may have actually made.”
New tax rules that passed in the infrastructure legislation, meanwhile, aim to close some crypto loopholes. The Treasury Department wants brokers to share cost-basis information and pass it on to the IRS so that investors can’t hide gains as they shift assets around. Digital wallets and DeFi platforms may also have to maintain tax information and turn it over to brokerages as part of a new reporting regime.
One change in effect for the 2022 tax year may close a “wash sale” loophole for crypto. The Democrats’ Build Back Better bill includes digital assets in standard wash-sale rules. The rules prevent investors from taking a tax write-off on a loss if they buy a “substantially identical” security within 30 days before or after a sale.
Investors trading Bitcoin, for instance, could now sell every time it drops below their cost, and buy more immediately after (or before) the sale, and claim a loss. If an investor did this with a stock, the loss would be disallowed under wash-sale rules. An investor could still add the loss to the cost basis, potentially lowering taxable gains if the stock bounces back. It is likely, however, that the wash-sale will apply to crypto investing in 2022.
Yet some ambiguities may make it tough to comply with the new rules. The IRS hasn’t specified what qualifies as a “substantially identical” crypto. That could be problematic, since Bitcoin and other cryptos have spinoff tokens like Bitcoin Lite, for instance. “There’s an argument to be made that Bitcoin is a different asset than Bitcoin Lite or some other spinoff,” says Tom Shea, tax principal at Ernst & Young.
Investors should also note that if they sell a crypto and then use the proceeds to make a purchase—rather than paying with the currency itself—the sale is considered a taxable event by the IRS. While apps like PayPal and Square issue tax forms with investors’ cost basis, other apps may only record the information, leaving it to investors to self-report gains.
Moreover, transactions over $10,000 in crypto may soon be reportable. If you try to buy a Tesla in Bitcoin, the IRS may consider it the equivalent of a cash transaction and require that the recipient of the crypto report it, including the name and Social Security number of the sender. Small transactions that add up to $10,000 within a 15-day period will also be reportable by the recipient of the crypto, according to Shea. The law makes it a felony not to comply, including potential prison time.
One way to keep things simple: own crypto through a security, such as a stock, exchange-traded fund, or limited-partnership fund. Several crypto funds trade like stocks over the counter, including the Grayscale Bitcoin Trust (GBTC), and Bitwise 10 Crypto Index fund (BITW), a basket of major coins. The funds are taxed like pass-through entities, with steep expenses, and may trade at premiums or discounts to underlying holdings (both are now at discounts). Grayscale issues a gross-proceeds tax form and Bitwise issues a K-1 form, rather than the more common 1099-B.
Several futures ETFs are now trading, including the ProShares Bitcoin Strategy (BITO) and Valkyrie Bitcoin StrategyValkyrie Bitcoin Strategy ETF$18.580.10(0.54%)Open$18.45Volume335.12KP/E RatioN/ADiv YieldN/AMarket CapN/A18.3818.65 (BTF). The funds should do a decent job of tracking the spot price of Bitcoin. But they aren’t low cost, imposing a drag on returns that could add up to 2.5% annually, on top of their management fees, depending on expenses associated with continually rolling over futures contracts. They may also delve into other crypto assets or derivatives to maintain exposure levels.
Owning crypto directly avoids those issues, while increasing the tax filing and reporting issues. Whether to own crypto is another matter. The one winner: accountants and software providers that can now crunch the numbers on a new asset.