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How Cryptocurrency Taxes Work: What You Should Know

It's tax season and advisors who have clients who sold cryptocurrency in 2020 will likely get lots of questions. Tax laws can be complicated and confusing.

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How Cryptocurrency Taxes Work: What You Should Know

Here are the facts:

Is cryptocurrency taxable? Since 2014 the IRS considers cryptocurrency property and not a virtual currency. This means that transactions can be taxable gains or losses.

What is cryptocurrency capital gain or loss. This is similar to a stock trade. The price at which you sell the cryptocurrency is less than the cost basis.

Let's say you purchase one Ethereum coin at $2,500. The value of your Ethereum coin rises to $3,000. Your Ethereum coin can be exchanged for $3,500 worth of another cryptocurrency. You will gain $1,000 in capital.

Because you only held the Ethereum coin for less that a year, this is a short-term gain. Your taxes will be at the normal income tax rates. The transaction would have been subject to tax as a long-term capital gains, at a maximum rate 23.8%, if you held it for more than a year.

Your total losses can be subtracted from your total gains each year to reduce gains and taxes. You can also deduct $3,000 net losses from your regular income. You can carry losses over this amount into the future.

How can you report a transaction to your tax return? Many cryptocurrency exchanges will send you a 1099B which lists the cost basis, net gains and losses for your transactions. This information will allow you to fill out Schedule D as well as Form 8949 for the 1040 return. If the exchange doesn't issue a 1099B, you will need to track it using your own records.

This could easily become complicated. Let's say you spend $100,000 on crypto. You then sell the cryptocurrency to purchase a Tesla, other cryptocurrencies, fast-food, clothes, etc. These are all likely to be taxable transactions.

Are there any new rules? The $1.2 trillion infrastructure bill by President Biden includes provisions that require exchanges to report cryptocurrency transactions by 2023 and include them in 1099-B forms. It is hoped that the tax revenue will reach $28 billion over the next ten years.

Additionally, the bill will require that exchanges report information on crypto sellers in transactions exceeding $10,000. This provision will take effect in 2024.

Clients should be concerned about the IRS. The IRS is becoming more aggressive in its enforcement of the 2021 Form 1040. The IRS has already been successful in obtaining client data from exchanges.

You could face penalties, interest, and even jail time if you fail to properly report your crypto gains.

What about wash sale? The wash rule prohibits short-term stock trading in order to take tax losses. The IRS will not allow you to deduct any stock that you have sold at a loss, but which you then buy back quickly. To buy back the exact same stock or security, you must wait at least 30 calendar days.

The wash rule was exempted from cryptocurrency transactions because of a loophole. According to pending legislation, this could change in 2022.


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