Big changes are afoot in 2018. Among them is the fact that Uncle Sam is no longer going to allow taxpayers to evade paying capital gains and income tax derived from cryptocurrencies.
Uncle Sam puts his foot down on cryptocurrency tax evaders
In November, the Internal Revenue Service (IRS) won a court case against popular cryptocurrency exchange Coinbase that required the exchange to hand over information on 14,355 users who'd traded in excess of $20,000 worth of bitcoin between 2013 and 2015. This information was of importance to the IRS as just 800 to 900 taxpayers per year between 2013 and 2015 had reported cryptocurrency capital gains on their federal tax return. Put plainly, investors were knowingly and willing avoiding paying their fair share of capital gains tax.
For some time, investors had the opportunity to skirt by without owing any money to Uncle Sam thanks to a little-known tax loophole called the like-kind exchange. Typically reserved for real estate transactions, the like-kind exchange (Section 1031, for those interested) allowed cryptocurrency investors to exchange one virtual token for another without paying taxes. However, this crypto tax loophole was closed with the passage of the Tax Cuts and Jobs Act in late December. Now, the like-kind exchange is strictly limited to real estate.
Long story short, the IRS is more serious than ever about cracking down on cryptocurrency tax evaders, and it has three ways of getting its fair share from virtual token users.
1. Capital gains tax from investing
The first way of taxing folks is pretty straightforward: if you buy virtual tokens and they increase in value, you'll pay either a short- or long-term capital gains tax when you sell. Keep in mind, this means paying tax on capital gains anytime you sell a virtual currency for a profit. The like-kind exchange no longer applies, as of Jan. 1, 2018.
As with any investment, the short-term is defined as holding onto an asset for 365 or fewer days, while lower long-term capital gains tax rates apply to assets held for 366 or more days. Short-term capital gains are taxed at the newly revised federal ordinary income-tax rate, which varies from a low of 10% to a peak of 37%. Meanwhile, long-term capital gains are taxed at either 0%, 15%, or 20%. Single and joint-filing taxpayers can earn up to $38,600 and $77,200, respectively, in 2018 and owe nothing in long-term capital gains taxes.
What's notable here is that digital currency investors aren't necessarily going to be provided a 1099 come tax time from cryptocurrency exchanges. This places the onus of accurate purchase and sale recordkeeping solely on the investor.
2. Capital gains tax derived from purchasing goods and services
In addition to traditional investing, the IRS also taxes virtual currencies when being used to purchase goods and services. If you've paid for anything with bitcoin, Litecoin, Zcash, Monero, Dash, Ether, or any other popular virtual coin, the IRS defines your action as having disposed of an asset. In other words, you purchased a virtual coin, and then sold it to the retailer or service in question for the agreed upon price. If the value of what you sold has increased from when you purchased the token(s) in question, you're responsible for paying capital gains tax on the difference.
The most complicated aspect of this type of transaction is that it almost entirely places the responsibility of accurate recordkeeping on the taxpayer. Even if the cryptocurrency exchange provides a 1099 showing a user's cost basis, it almost certainly wouldn't show what price the assets were sold at when a good or service was purchased.
3. Cryptocurrency mining income
Finally, the IRS also aims to tax cryptocurrency miners based in the United States.
Cryptocurrency mining describes the use of high-powered computers and servers to solve complex mathematical equations and, in the process, validate transactions on a blockchain network. Not all virtual currencies use this electricity intensive method of validating transactions, but bitcoin, Litecoin, Ethereum, and Bitcoin Cash do, among the largest virtual currencies by market cap. The first person or business to solve a group of transactions, known as a "block," is given a "block reward," which is paid out in the tokens of the virtual currency being validated.
According to the IRS, this block reward is income that you as the taxpayer need to report on your federal tax return. One option is to claim mining earnings as self-employment income. The other being that it could be filed as "other income," or essentially a hobby or secondary income stream. The decision of which method is best for miners will likely depend on their mining costs, and the ability to separate out their electric meter expenses for running mining hardware and operating any cooling systems.
Making matters worse, cryptocurrency miners can be exposed to a second round of taxation on their tokens. Aside from reporting their block reward as income, they may also have to report a capital gain when they dispose of their received virtual tokens. And, as the icing on the cake, they, too, will be responsible for accurate cost basis and sale recordkeeping.
The tax situation with cryptocurrencies is an absolute nightmare, and it's probably only going to get worse with the IRS actively policing for cryptocurrency tax evaders.