The Internal Revenue Service may be running on old-fashioned technology, but that doesn’t stop it from taking a share of your newfangled cryptocurrency winnings.
If you didn’t notice it last year — or pretended not to know — the IRS is asking you questions about whether you sell, trade, or “otherwise” dispose of any financial interest in virtual currency. It’s now high on the 1040 form — above even where you listed your salary.
How serious is the government about crypto? This month, President Biden signed an executive order increasing the possibilities of the central bank’s digital currency. And the next day – perhaps making a point about the tax implications of all this – the IRS announced that the two cryptocurrency company owners would be jailed for a combined eight years for tax evasion.
“Crypto actors,” said Texas federal prosecutors, “are obligated to pay their fair share of taxes, just like everyone else.”
It can be tricky if you jump on both feet. Are you confused by the consequences of your first gain or loss? Or maybe confused how exchanging one crypto asset for another results in a taxable event?
Thankfully, service providers are starting to emerge to help crypto enthusiasts with the pick and shovel equivalent of software.
CoinLedger is one of them. It offers specialized tools that can help track what you paid for digital assets and figure out any tax liability. We asked its chief executive, David Kemmerer, about the tax illusions (and delusions) crypto investors have as they navigate this process.
Read More in the Cryptocurrency World
This interview was condensed and edited for clarity.
Under what circumstances should you pay taxes on your cryptocurrency?
Cryptocurrencies are treated very much like stocks or equities from a tax perspective, where capital gains apply when you dispose of the cryptocurrency. If I buy that Bitcoin for 100 dollars and then sell it later for 1,000, that $900 capital gain is income that needs to be reported on my taxes.
If you earn cryptocurrency from work — and people are actually getting paid in crypto today — it is taxable income, at fair market value at the time you received it. Let’s say I do work for someone and they pay me one Bitcoin exactly on February 23rd. Well, on February 23, I made $40,000 in income. Or whatever the fair market value of Bitcoin was at the time I received it for my service.
Why does your software need to exist?
The problem unique to cryptocurrencies that do not exist for equities is that this data is fragmented across different platforms. Let’s say I use E-Trade to buy and sell Tesla shares. Everything happens in E-Trade. It’s not normal for any trader to send their Tesla stock elsewhere.
That doesn’t apply to crypto. All user transactions can be carried out in several different wallets and in several different third parties.
This software exists to be TurboTax for cryptocurrency investors. We integrate with all the various crypto economy platforms. All that data is fully normalized, and then piped through our tax engine. Then we can generate by clicking the button the required capital gain, capital loss and income report.
What do you say to cryptonewbies when they ask you about the IRS view on cryptocurrencies?
They are very concerned about the digital asset space. It is inaccurate to think that “I am using crypto, it is pseudo-anonymous, they will never know what kind of income I am making.” The IRS has the ability to see a lot going on in this space, and they are rapidly increasing their investment in being able to do that.
It’s been a big year for non-exchangeable tokens. What happened to that?
If you buy an NFT and then you sell it or somehow dispose of it, exchanging it for something, you realize a capital gain on the fluctuation of that asset.
Expand Your Cryptocurrency Vocabulary
A glossary. Cryptocurrencies have gone from being a curiosity to a viable investment, making it nearly impossible to ignore. If you’re struggling with terminology, let us help:
Bitcoins. Bitcoin is a digital token that can be sent electronically from one user to another, anywhere in the world. Bitcoin is also the name of the payment network through which this form of digital currency is stored and transferred.
Blockchain. Blockchain is a communally managed and reliable database for storing digital information. The original blockchain is the database where all Bitcoin transactions are stored, but non-currency companies and governments are also trying to use blockchain technology to store their data.
Cryptocurrencies. Since Bitcoin was first conceived in 2008, thousands of other virtual currencies, known as cryptocurrencies, have been developed. Among them are Ether, Dogecoin and Tether.
coin base. The first major cryptocurrency company to list its shares on a US stock exchange, Coinbase is a platform that allows people and companies to buy and sell a variety of digital currencies, including Bitcoin, for transaction fees.
DeFi. The development of cryptocurrencies spawned a parallel world of alternative financial services, known as Decentralized Finance, or DeFi, which allowed crypto businesses to move into the realm of traditional banking, including lending and borrowing.
NFT. “Non-exchangeable tokens,” or NFTs, are assets verified using blockchain technology, where a network of computers records transactions and provides buyers with proof of authenticity and ownership. NFT makes digital artwork unique, and therefore salable.
Web3. The name “web3” is what some technologists call the idea of a new type of internet service built using blockchain-based tokens, replacing centralized enterprise platforms with open protocols and decentralized community-managed networks.
DAO. A decentralized autonomous organization, or DAO, is an organizational structure built on blockchain technology that is often described as a crypto cooperative. DAOs are formed for the same purpose, such as investing in startups, managing stablecoins, or buying NFTs.
What types of crypto transactions generate the largest volume of entries into your software?
The most common is spot market trading — buy, sell — directly on a centralized cryptocurrency platform like Coinbase.
What about the fees that crypto traders sometimes charge when they buy or sell digital assets on other exchanges or platforms? Can it reduce your taxable profit?
So let’s say I buy Bitcoin on Coinbase. Coinbase charges me, say, a 3 percent fee. That fee can be added to the base of the asset I purchased. If I bought $100 worth of Bitcoin but I also paid this $3 fee, now my base in that Bitcoin is actually $103. When I turned around and sold it, it was profitable for me: I didn’t make much profit, because my base was higher.
What are the questions you hear most often?
A lot of people ask, “Hey, this is only taxable after I cashed in to fiat, right?” And the truth is, “No.”
When you dispose of an asset, regardless of whether or not you actually return it to US dollars, you may still be subject to a tax bill.
So even if I use my Bitcoins to buy other cryptocurrencies like Ether, can I still be taxed on the gains I see on my initial investment? Let’s say you bought Ethereum on Coinbase for $1,000, and you held it for a few months and it ripped — it’s $2,000 now. You sell them to buy stable coins, or Bitcoins. If by the time you bought it for $1,000, you had realized a capital gain of $1,000
How about avoiding taxes? Is there already a tax attorney who specializes in cryptoshelters — or whatever it is in the blockchain world?
There are many tax attorneys who have carved a niche into the world of digital assets. And many of those people can definitely help from a tax planning and tax avoidance perspective. Nobody we work with helps with tax evasion — it’s illegal. But there are many smart people who can help you reduce your taxes through proper planning.
Do you know the overall level of tax compliance?
In our survey, we found that more than 50 percent of crypto investors report their digital asset activity on their taxes. And we will see the number continue to increase drastically in the years to come.