Investing in cryptocurrencies is never easy. Although the bitcoin price hit unimaginable levels just a few months ago, this year has been a different story. With fears of global government crackdowns running rampant, nearly all digital tokens crumbled. The virtual markets are again showing signs of life, however, which is the good news. The bad? We have to talk about cryptocurrency taxes.
The recent Senate hearing on cryptocurrencies and their underlying blockchain technology highlighted the importance of staying abreast of the news. These digital markets are entering into uncharted territory, and governing bodies have no cohesive strategy to address the issue. Some governments, like China, prefer draconian laws and fierce enforcement. Others, like our government, have seemingly adopted a wait-and-see approach.
What they’re not waiting on, though, is enforcement on “blockchain scams,” or activities that undercut existing securities laws. For instance, the Securities and Exchange Commission has initial coin offerings (ICOs) in its crosshairs. Their argument is that ICOs are nothing more than regular initial public offerings (IPOs) dressed-up in the blockchain; thus, ICOs should register with the SEC, just like any other IPO.
That reasoning has significant implications for cryptocurrency taxes. From what I understand, our government has no interest in banning cryptocurrencies. What they do want, however, is their cut. In other words, don’t try to cheat Uncle Sam by obfuscating your financial windfall with blockchain talk. Play by the rules like everyone else, and everything will be fine.
Admittedly, this is a complicated process with many ambiguities. To get a clear picture, please consult a licensed tax expert. For the rest of us, here is your unofficial guide to cryptocurrency taxes!
Guide to Cryptocurrency Taxes: Why You Want to Pay
In 2009 when bitcoin first launched, no one knew what it was. Essentially, an end-user could have free reign and do whatever they want. Of course, the proper legal and ethical thing to do with any financially profitable activity is to report it to the IRS. But since the IRS didn’t know what they were looking for, cryptocurrency taxes were a moot point.
That “see no evil, hear no evil” policy changed with Silk Road, the dark web’s version of Amazon.com, Inc. (NASDAQ:AMZN). Through Silk Road, criminals could purchase narcotics and fake passports. They could also hire illegal services, such as computer hacking or even a hitman.
For lengthy periods of time, the Silk Road operated in anonymity because they used an undetectable currency: bitcoin. Indeed, most people’s introduction to the digital token was invariably through a negative light.
The eventual crackdown on Silk Road was critical for two reasons. Number one, all enforcement agencies know what bitcoin is, even if they can’t quite explain it. Number two, and more importantly, the government established that they don’t care about bitcoin, per say; all they care about is that you’re not using bitcoin as a conduit for illegal activities.
By illegal activities, the biggest one is not paying cryptocurrency taxes! Again, be smart, and play by the rules.
Guide to Cryptocurrency Taxes: Don’t Play Games!
Inevitably, whenever the issue of cryptocurrency taxes come up, hardnosed proponents will mock sound wisdom. They’ll cling to the blockchain’s decentralized platform as proof that cryptocurrencies belong to no one nation, but rather, “the people.”
You know what? They’re right! But as any good marriage counselor will tell you, a big difference exists between being right and being married. Regarding cryptocurrency taxes, you could be right and still end up wearing an orange jumpsuit.
You can rest assured that the IRS has profoundly extensive arguments ready should you wish to duke it out. Two years ago, I warned against using frivolous arguments to avoid paying Uncle Sam. It didn’t work for the actor Wesley Snipes, and I assure you that it won’t work for avoiding cryptocurrency taxes.
The bottom line is that this maligned organization has won every single frivolous argument case. Let that point sink in.
Next, consider the fact that you must pay taxes on income-generating activities, or on financial windfalls. The medium does not matter. Attempting to skirt the rules here could lead to nasty legal problems.
Guide to Cryptocurrency Taxes: Consequences of Not Paying
We all know what the consequences of not paying our taxes are. If the infraction is small, or the result of an honest mistake, the IRS will harshly penalize you financially. If the infraction is large and especially deliberate, you will end up in a penal institute.
That’s all standard stuff. But I genuinely believe that this tax year, the IRS will be extra vicious toward cryptocurrency taxes. We’ve all seen “bitcoin millionaire” memes and had a good laugh. But on the other end of the spectrum, the IRS has also seen those memes, and they’re not happy.
The zealous tax agency has been hounding cryptocurrency exchange Coinbase to release all its customer data, a ridiculous privacy violation. Naturally, Coinbase pushed back in their bitter legal dispute. Late last year, a federal court in California ordered the popular exchange to hand over customer data for anyone who transacted $20,000 or more in digital tokens.
The IRS feels that they lost control and credibility over the entire blockchain issue. They’re going to send a message that they’re not screwing around. You may expect harsher-than-normal penalties if caught, so please take this as fair warning.
Guide to Cryptocurrency Taxes: What Is the Legal Definition of Bitcoin?
People have different definitions of bitcoin. To some, it’s mankind’s single greatest invention. For others, it’s vapor, something that’s here today and gone tomorrow. Still, others believe that it can lay the foundation of future financial transactions if handled responsibly.
This is all fine and dandy. But to the IRS, bitcoin is property. The IRS acknowledges that cryptocurrencies have characteristics of legal tender. For instance, DISH Network Corp (NASDAQ:DISH) accepts bitcoin payments for their satellite TV and internet services. But because cryptocurrencies aren’t recognized as sovereign money, they’re not legal tender.
On the other side of the coin, the SEC acknowledges that bitcoin acts like a security. As I previously mentioned regarding the Senate hearing, the SEC would prefer cryptocurrencies be classified as securities. That would immediately place legal controls and restrictions on ICOs.
However, until we receive further official clarification, you are obligated to report any capital gains or losses as property transactions.
Guide to Cryptocurrency Taxes: To “hodl” or Not to “hodl”
Because cryptocurrencies are taxed just like property (in most cases), it’s almost always preferable to hold your digital tokens for longer than one year. At that point, you’ll pay the long-term capital gains tax rate. For most folks, that should be 15%.
This relatively reasonable rate incentivizes cryptocurrency investors to “hodl,” or hold on for dear life. If we were talking about a house or a classic car, I would agree. To hodl would be the best course of action. Not “hodling” would incur short-term capital gains rates, which are very unreasonable.
But hold on! Because the bitcoin price is extremely volatile, the same principles don’t necessarily apply. For instance, if you bought bitcoin early in 2017 like I suggested, you had choices to make. At the record high, the difference between your purchase price and selling price was approximately $19,000. Assuming the highest short-term rate of 39.6%, your impact would be $7,524.
That sucks. But what sucks even more was hodling into 2018. If you panicked and sold at the low, you would extract $6,000 minus the long-term capital gains rate.
It’s simple math: hodling didn’t work in this case.
Guide to Cryptocurrency Taxes: What about Mining?
Reading the SEC’s arguments that cryptocurrencies should be classified as securities fascinated me. In many respects, they are right: blockchain participants treat bitcoin as a security. The old saying goes, if it walks like a duck, and quacks like a duck, it must be a duck!
I’m almost tempted to side with the SEC on this issue, except for one nagging detail. Using Nvidia Corporation’s (NASDAQ:NVDA) or Advanced Micro Devices, Inc.’s (NASDAQ:AMD) advanced processors, people can “mine” cryptocurrencies. This lone, but incredibly significant difference makes digital tokens completely unprecedented.
Therefore, I’m not sure if the SEC will ever get its wish. Some market observers have compared the mining reward system to dividends. Really? I receive dividends from owning Sony Corp (ADR) (NYSE:SNE). To my knowledge, I’ve never once solved a mathematical problem to get more SNE stock.
Even though this mining issue deserves its own classification, the IRS has other ideas. The agency considers successful mining rewards as taxable income. You must report the fair market value of that digital token on the date it was mined.
I have major problems with this definition. But for now, make the best of it. Consider getting a business license in your city as a sole proprietor. Then, under IRS form Schedule C, deduct your utility costs incurred for your mining “business.”
Fair play is fair play.
Guide to Cryptocurrency Taxes: Payments in Bitcoin
As I previously noted, DISH Network accepts bitcoin for payment, but they’re not the only businesses doing so. An increasing number of establishments are drawn into the blockchain craze. Thus, it’s natural to wonder if a loophole exists to prevent paying taxes by transacting in cryptocurrencies.
Sorry, but the IRS has already plugged this potential loophole long ago. Generally speaking, you will have to report payments using bitcoin or other cryptocurrencies. The IRS provides a guidance that transaction values of $600 or more must be reported.
That indicates that for small purchases, the IRS either doesn’t care or doesn’t have the resources to hunt minutiae.
Even so, I wouldn’t bother making any payments in bitcoin. For smaller transactions, the medium is extremely frustrating due to the extraordinarily high bitcoin price. Smaller denominated cryptocurrencies aren’t a reliable solution either, since they’re not as readily accepted.
For large purchases such as a house, you’d have to report that anyways to the IRS. Thus, unless I was a fugitive, I don’t see any true benefits of using cryptocurrencies as de-facto legal tender.
Guide to Cryptocurrency Taxes: Crypto Day-trading
Without a doubt, several blockchain proponents actively day-trade cryptocurrencies. In fact, the blockchain is the perfect medium for day-trading, as the digital markets never close.
Where the fun starts to fade is when you consider cryptocurrency taxes. As I discussed earlier, the SEC wants bitcoin and other alternative cryptos, or altcoins, to be classified as securities. The IRS has other ideas, and digital tokens are currently property.
So does that mean crypto day-traders are safe from disclosing their activities?
The IRS lists three specific criteria that determine whether you are a trader:
- You must seek to profit from daily market movements in the prices of securities and not from dividends, interest or capital appreciation
- Your activity must be substantial
- You must carry on the activity with continuity and regularity
While crypto day-traders meet the latter two criteria, they technically do not meet the first. That is, crypto day-traders do not trade securities, but property.
Will such an argument hold up in a court case? I genuinely have no idea. What further complicates the issue is that treating cryptocurrencies as securities necessarily involves other laws and guidelines.
My best idea in this ambiguous situation is to act in good faith. If you’ve made a profit (or loss) on your trading activities, you should report it.
Guide to Cryptocurrency Taxes: What about Altcoins?
If you’ve read this far, it should be clear to you that the IRS has attempted to close as many crypto loopholes as possible. Still, it’s fair to ask if the tax agency will treat altcoins the same way as bitcoin.
The short answer is yes, although the comprehensive answer is more nuanced (isn’t it always?). The IRS specifically singles out convertible virtual currencies. According to their words, a convertible digital token “has an equivalent value in real currency, or that acts as a substitute for real currency.”
Using this definition, bitcoin is just one of several convertible cryptocurrencies. I believe what the IRS is saying is that if your token is traded in an exchange somewhere, it’s convertible.
But do non-convertible cryptocurrencies exist? They do, but that coin must operate within a closed system: it cannot be traded or exchanged for other cryptocurrencies, and of course, for fiat currencies.
Where things might get a little tricky is convertibility difficulty. If the altcoin in question is primarily traded in a semi-closed system and is not readily exchangeable for other assets, is it a convertible cryptocurrency?
Again, I don’t know, but I’m sure this will be a future discussion point.
Guide to Cryptocurrency Taxes: Make Records Great Again!
I don’t know too many people who enjoy preparing their taxes. Just the thought of filing document after document is enough to make most people sick. But if you really turned in a fortune with the sharply rising bitcoin price, do yourself a favor: make records great again!
Long story short, if you made a $1,000 profit, the IRS probably won’t waste its breath on you. But if you made $1,000,000, you’re going to get audited. You could have dotted every “i” and crossed every “t.” You could have Pope Francis notarize your returns.
But believe me, if you made that much money, you’re going to be doing some ‘splaining.
The thinking process here is that the IRS wants to make sure you’re not being “pseudo-honest.” In other words, are you declaring the first million in the hopes they won’t search for the second, unreported million?
Yes, the unwarranted accusations stink. But who said the IRS was noble?
Josh Enomoto is not a licensed tax professional, and this article should not be considered tax advice. As of this writing, he is long bitcoin and SNE.