Oct 6, 20215 min read

The Tax Burden of Cryptocurrency

Cryptocurrency interest has steadily grown over the past few years. On any given day of the week, some cryptocurrency seems to be making headlines either for its massive gains, or its devastating losses. The volatile cycle of crypto investing has brought significant attention to digital coins. Whether you are invested in Bitcoin, Ethereum, Litecoin, Dogecoin, or the hundreds of other cryptocurrency options, one fact remains: all of these coins are seen as investible assets in the eyes of the IRS. As a result, many people are setting themselves up for large tax bills without realizing it by buying and selling digital currencies.

Where Does the IRS Discuss Virtual Currency, and What Do They Say About It?

In 2014 the IRS issued Notice 2014-21 which clarified tax treatment by stating “Virtual currency is treated as property for U.S. federal tax purposes.” To make the point even more clear, Notice 2014-21 goes on to state “General tax principals that apply to property transactions apply to transactions using virtual currency.”

In addition to buying and selling cryptocurrency, the IRS outlines further rules for several normal cryptocurrency events:

Mining Virtual Currency

Before Coinbase, Robinhood and other brokers allowed trading of cryptocurrencies, the original way to obtain these “coins” was through mining. Miners purchase expensive computer systems and use their computing power to mine bitcoin. These miners also help to secure transactions by providing Proof of Work. Under Notice 2014-21, miners should be recognizing taxable income every time they receive a block reward of virtual currency for successfully mining a new block of cryptocurrency. This income is taxed at a taxpayer’ ordinary income tax rate, ranging anywhere from 0-37%. In addition, this income would also be subject to the self-employment tax which amounts to an additional 15.3% on the first $142,800 of earnings.

Buying and Selling Goods with Virtual Currency

Many retailers are allowing goods to be bought and sold directly with cryptocurrencies such as bitcoin. If you purchase goods using cryptocurrency, the IRS has made it clear that the transaction is taxed as if you bought and sold the bitcoin for cash, and then purchased your goods or services.

Capital Gains on Sale of Cryptocurrency

Capital gains are assessed on all assets that are held for investment and sold for a higher price than what you paid, and capital losses are credited when you sell for less than what you paid. For example, if you bought 1 share of Stock A for $100, and after 6 months Stock A was sold for $150, you realized a $50 gain. Subsequently, if Stock A is sold for $50 after 6 months, you would have a $50 loss.

As previously mentioned, all virtual currencies are treated as investible assets, subject to the same gain and loss rules as stocks and bonds. Below we will discuss the two types of tax that you may be subject to when selling virtual currencies.

The type of tax you pay on the sale of cryptocurrency will depend on your holding period. For any asset that was sold and held for less than 366 days, you will be need to pay ordinary income tax (0-37% depending on income) on any gain realized. Depending on income levels, you may also be subject to the 3.8% Net Investment Income Tax (NIIT). That means short-term capital gains can cost the investor over 40% of the gain in taxes.

Assets that are sold after being held for longer than one year will capture long-term capital gains tax rates on the gains. The long-term capital gains are taxed at 0%, 15%, or 20% depending on your total income. As with short-term capital gains, long-term gains are also subject to the 3.8% NIIT for high income earners.

The Future of Capital Gains Taxes

In September, the House Ways and Means Committee proposed a tax overhaul that would shift the taxation of investment assets from what we discussed above. While these changes are less drastic than the ones that President Biden first proposed, the tax increase is significant, and will still be felt by many taxpayers.

One of the first changes proposed would be to increase the top tax bracket from 37% to 39.6%. For eligible taxpayers, this would mean that short term gains would see an additional tax increase of 2.6%. Combined with the 3.8% NIIT, this would mean that short term gains could be taxed as high as 43.4%.

Although long term gains would still receive a beneficial tax treatment, they will increase from 20% to 25%. Adding the NIIT of 3.8% to that number means higher-income tax payers will pay up to 28.8% on their long-term capital gains.

Knowing the present and potential future tax rates on assets such as cryptocurrency is an important component of any investment decision; as deciding whether to sell now or later may have an impact on how much of that gain gets paid to the IRS. The volatile nature of cryptocurrency holdings can lead to outrageous gains and losses. If you had purchased one Bitcoin in 2014 when it was valued around $350, that same coin would be worth over $40,000 today. Unfortunately, many people do not properly prepare for the $11,500 tax bill that could be due to the IRS for this transaction.

If you have any questions related to cryptocurrency transactions or any other question related to tax or cryptocurrency, click below to set up a time to speak with one of our team members.

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