What began in 2009 with a single virtual currency—Bitcoin—has grown to comprise some 16,000 cryptocurrencies totaling more than $2.4 trillion in assets.1 But know this: All that virtual activity has real-life tax consequences.
"If you make money on a cryptocurrency transaction and don't report the income, you could be in hot water," says Hayden Adams, CPA, CFP®, director of tax and financial planning at the Schwab Center for Financial Research.
Let's look at how cryptocurrencies are taxed—and how to avoid running afoul of the IRS.
The IRS treats cryptocurrencies as property, meaning sales are subject to capital gains tax rules. Be aware, however, that buying something with cryptocurrency also counts as a sale because you're effectively selling a portion of your holdings to cover the cost of the purchase. "People don't think of shopping as a taxable event, but it can be if you use virtual currencies," Hayden says.
Whether the transaction results in a gain or a loss is calculated by taking the difference between the fair market value of the goods or services you receive and your adjusted cost basis—that is, the amount you paid for your cryptocurrency, plus any fees.
For example, if you use one bitcoin to purchase a $45,000 car but that bitcoin was worth only $40,000 when you purchased it, the transaction would result in a $5,000 gain. Had the bitcoin originally been worth $50,000, the transaction would result in a $5,000 loss, which potentially could be used to offset capital gains or taxable income in the same calendar year.
Play it safe
Under current law, the cryptocurrency owner is responsible for reporting all transactions to the IRS. "You're not going to get a Form 1099 from the currency exchange, so it's on you to keep receipts and confirmations for every purchase and sale," Hayden says.
Moreover, if you can't prove your adjusted cost basis, you must report it as zero—meaning the entire sale will count as a gain. "Whether intentional or not, any instance of underreported income is considered tax evasion, so be sure to take it seriously," Hayden says.
If you're not sure how to report transactions properly, work with a tax advisor—and potentially file an amended return for any past missteps.
1Coinmarketcap.com, as of 12/27/2021.
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Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Digital currencies, such as Bitcoin, are highly volatile and not backed by any central bank or government. Digital currencies lack many of the regulations and consumer protections that legal-tender currencies and regulated securities have. Due to the high level of risk, investors should view Bitcoin as a purely speculative instrument.
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