Introduction
Cryptocurrencies are treated more and more as investing instruments over time. Although the cryptocurrencies like Bitcoin were introduced as an alternative to paper currencies, these digital assets are now performing several functions that are similar to that of other asset classes such as stocks, commodities, and forex, etc.
Some many businesses and individuals have managed to earn considerable income by trading cryptocurrencies. Therefore, many governments have imposed taxes on cryptocurrency investors and other stakeholders.
Introduction to Cryptocurrency Tax
Cryptocurrencies are issued by their native blockchains that are based on Distributed Ledger Technology or DLT. For this reason, many people are investing in cryptocurrencies rather than creating positions in regulated trading options such as stocks, commodities, and forex markets among other options.
For the central governments, it is a matter of concern to make sure that they maintain their monopoly over the financial markets. To this end, government regulators have come together to impose heavy taxes on cryptocurrencies.
It is important to note that every citizen of the world has to pay some percentage of their income as taxes to the government. The system of taxes has been continued in human civilizations since ancient times when monarchies ruled the masses and there was no such thing as a democratic government.
The government can charge taxes on businesses, traders, salaried employees, exporters, manufacturers, consultants, service industry stakeholders, and just about every economic activity that is performed under their jurisdiction.
How do Crypto Taxes Work?
The reason that the government charge taxes from the citizens is to run the administrative structure of the state. Several departments in the central government structure need funding from taxes.
Therefore, the ruling government is allowed by the constitution of the country to collect taxes from its citizens. Cryptocurrencies are a decentralized financial network which means that they do not need any government interference to verify and perform transactions.
However, in the current context, many people have lost their faith in cryptocurrency enterprises. The latest event in that context is the FTX collapse. The decline of this enterprise has increased the FUD in the crypto circles.
FTX was a cryptocurrency exchange and it was hit by a bank run that revealed several instances of financial mismanagement in the country.
Therefore, many cryptocurrency investors seem to have stopped trusting unregulated cryptocurrency enterprises for conducting financial transactions.
Is It Necessary to Pay Taxes on Cryptocurrencies?
Many professional investors treat cryptocurrencies as a diversification option for their portfolios. There is a question about whether investors should pay taxes on their cryptocurrencies or campaign against them.
The fact of the matter is that the financial mechanisms of cryptocurrency enterprises are not as reliable as most people would like to believe. It is important to mention here that cryptocurrency enterprises are distinct from blockchains.
Most cryptocurrency exchanges are operational all around the world. It means that they have to work with the government of a wide array of nations to comply with the financial requirements.
Naturally, the regulatory requirements of one nation are bound to be very different from others. At the same time, there is the matter of the headquarters of a cryptocurrency exchange that can shape its overall trading policies.
The current regulatory infrastructure of the world is insufficient and outdated to accommodate cryptocurrencies.
On the other hand, some cryptocurrencies are dependent on mining farms. All PoW or Proof of Work blockchains requires real estate, energy supply, and human resources to keep operating.
Therefore, government officials also find some legal precedent to impose taxes on these cryptocurrency options. At the same time, there is also concern about cryptocurrency enterprises engaging in financial foul play such as money laundering, etc.
Therefore, many investors agree that they should impose taxes on cryptocurrencies to make sure that their legal rights are safeguarded by the governments.
Crypto Capital Gains Tax
Capital gains are taxes that are imposed on an investment position after they have been sold or dissolved. It means that as long as a consumer holds a certain investment product that has capital gains implications they would not be required by the law to pay their taxes.
On the other hand, as soon as the asset holder decides to sell their position they would be under obligation to pay taxes on their trading positions based on their realized income.
Some trading instruments that have capital gains obligations are stocks, bonds, real estate, cryptocurrencies, and other trading options.
The reason that IRS or Internal Revenue Service has also imposed Capital gains taxes on cryptocurrencies is that they treat digital assets as property. The cryptocurrency trader hailing from the USA, where IRS jurisdiction applies is where they are required to file for cryptocurrency taxes depending on the duration of their holding positions.
The people who have held their crypto portfolios for less than a year are instructed to pay 10-37% of short-term capital gains taxes.
Meanwhile, some consumers are paying capital gains taxes for more than a year and are required to pay as per long-term capital gains taxes rates of 0%, 15%, 20%, etc.
How is Cryptocurrency Taxed?
Most people might think that taxes are only implemented on cryptocurrency traders. However, some of the early attempts at regulating crypto have revealed that the state regulators have attempted to add all crypto stakeholders for taxation.
For example, the miners who are working on mining the cryptocurrencies are also added to the taxation obligations. On the other hand, the middlemen of cryptocurrency enterprises such as exchanges, swaps, liquidity pools, and others are also added to the taxation option.
At the same time, introducing taxation can also prevent cryptocurrency enterprises from engaging in financial foul play such as siphoning the funds of their clients illegally.
Furthermore, in case of legal disputes related to cryptocurrencies the investors could appeal to law enforcement agencies and pursue legal action against defaulters and threat actors.
With the presence of regulatory clarity, all cryptocurrency enterprises would be obligated by the financial regulators to perform regular financial audits.
At the same time, they would also ensure that their digital platforms have completed the technical due diligence to ensure the safety of the digital wallet reserves of their users. For the government to intervene on such a massive scale, it would be natural that the current tax obligations would either remain the same or increase than before.
There has been a program to appoint a financial regulator to supervise the cryptocurrency market such as SEC or CFTC. The new taxation laws for cryptocurrency would be based on the financial regulators that will control and regulate the crypto sector.
There is also the debate on whether cryptocurrencies should be classified as a security or a commodity. Since cryptocurrencies do not fulfill the requirements of the Howey Test they cannot be classified as securities. On the other hand, whether crypto can be classified as a commodity or not is still undecided and debated.
It is important to stick to the legislative jurisdiction of one country to get the basic idea of crypto regulations and taxation. Therefore, it is best to stick with the IRS operating in the USA. As per the rules of the IRS, cryptocurrencies are legally defined as a store of value, unit of account, or medium of exchange.
The IRS also classifies cryptocurrencies as convertible virtual currencies. It means that investors are obligated to pay taxes on cryptocurrencies whenever they sell their positions to realize profits in the lieu of capital gains.
Furthermore, consumers must also pay taxes if they are intending to use cryptocurrencies for paying taxes. For purchases of other goods or services, the consumers must pay taxes based on the difference between their acquisition price of the cryptocurrency and the value at the time of its spending.
Meanwhile, the businesses that are accepting cryptocurrencies as payments are required to report it as their business income. Lastly, the cryptocurrency miners pay taxes based on the value of the cryptocurrencies when it was mined which is viewed as income for the miners.
Can IRS Track Cryptocurrencies?
The IRS is the federal taxation agency that is overseeing the collection of all taxes and the imposition of taxation laws in the USA. IRS has mandated that its citizens report if they are engaged in cryptocurrency trading or not.
The taxpayers who are filing for tax returns must provide this information on Form 1040. The form will require the filers to submit all the necessary particulars about their crypto trading activities such as purchasing, receiving, selling, sending, exchanging, lending, borrowing, or any other interest related to virtual currencies.
However, there is always a chance that tax filers can lie or manipulate their crypto trading information. It is important to note that all tax report violations are treated to be like perjury (lying under oath).
Furthermore, if a person is found to be lying about their taxation requirements they can receive heavy fines from the government prosecutors.
At the same time, there is some relief for the investors who are allowed to not mark yes on their crypto trading report if they have only purchased cryptocurrencies against USD thus far.
Nevertheless, the investors are under obligation by the law to keep track of every transaction conducted with cryptocurrencies so that they can report it without risking legal violation later.
The investors must note down all types of legal transactions based on their trading strategy, duration, and cost. The IRS can trace down the cryptocurrency transactions of the investors to the extent that they may extract financial data from the exchanges and collect on-chain transaction history from public blockchains.
What are the Issues and Challenges Connected to Cryptocurrency Mining?
There has been a considerable amount of uproar from cryptocurrency miners about the addition of their services to the taxonomy laws. It is important to note that the income generated from mining is very different from the income that is classified as Capital gains.
On the contrary, mining revenues are often defined as business income. However, business income is also not free from the imposition of taxes based on the profit percentage of the commercial entity.
Crypto mining farms can generate income in the form of cryptocurrencies that they have minted or earned as rewards. In this manner, these miners consider the market value of the total minted coins as their profit percentage.
However, the miners are allowed to deduct the costs of their operations from their income and the taxes are imposed on the net profits. The miners can deduct the expense of human labor and purchasing of mining equipment etc.
In some other cases, the miners who have joined a pool to create passive income do not count as a commercial activity. However, it does not mean that the mining pool joiners are completely exempted from taxes.
It also means that the pool joiners are unable to deduct expenses on their “hobby” which could reduce their tax-deductible amount.
How to Report Cryptocurrency Losses
Tax write-offs are tax exemptions granted by the government on account of different reasons. For example, if a person donates a valuable artwork to a museum they can add that amount as a tax write-off in their tax filings.
Thus far, crypto stakeholders are required to pay taxes based on capital gains, personal income, business operations, and hobby, etc. However, there are some areas of dealing with cryptocurrencies that are not taxed.
For example, as long as a person has only purchased cryptocurrencies using fiat currencies they are not required to report to IRS or gain any tax obligations. When consumers are holding cryptocurrencies and the value of their portfolio keeps increasing, they are not required to pay taxes as long as they hold their positions.
The tax obligation will be activated only when a cryptocurrency investor sells their crypto reserves to realize returns. Cryptocurrency investors can also qualify for write-offs for their cryptocurrency returns if they are in losses.
At the point of sale, the investor has to not only record the particular of their realized income but also accurate purchase particulars.
Furthermore, the investors would not have any tax obligations for moving their trade positions from one exchange to another or sending it from one crypto wallet to other. On the other hand, the investors who receive cryptocurrencies as a gift are also exempted from taxes.
However, if the value of gifted currencies is bigger than $15K, it means that the receiver would pay taxes. In case, the gift receiver decided to sell greater than $15K spot price, they would pay the same tax percentages as the person who purchased the cryptocurrency.
Another situation where cryptocurrency taxes are exempted is a donation. The investors who donate their cryptocurrencies must record the transaction particulars to make sure that they are recording the updated spot price of their donated currencies.
How to File Cryptocurrency Taxes?
Every cryptocurrency investor needs to learn about how to pay their taxes. The result of tax violation can lead to legal action or penalties. Here are some simple steps that investors can follow to complete their tax filing process:
Trading Records
For citizens who are present in the USA, they must report all their crypto-related tax obligations to IRS. The first step is to accurately record all the cryptocurrency trades and transactions. The particulars of these transactions should be filled in on the 1099 tax form.
The transaction detail must be inclusive of all trades made on the exchanges, as well as any crypto sales, swaps of tokens, or usage of cryptocurrencies for any purchases.
Gains and Losses
The next step for filing cryptocurrency taxes is to report all the revenue generated using crypto trading. The returns on crypto sales would allow the investors to calculate their capital gains tax obligations.
If the investors have incurred gains they can apply the capital gain tax percentages as per recommendations of the IRS. The investors can subtract the cost basis of their assets from their sales amount or the latest price projections from exchanges at the time of sales.
IRS 8949 Form
Record taxable transactions as per the directions on the IRS Tax form 8949. The summations from the 8949 form will help the tax filer to fill the reporting fields on form 1040 Schedule D.
Crypto Revenues
The investors must ensure to report all their sources of crypto-related income streams while filing for taxes. All of these crypto income streams should be added to the tax return documents. For example, IRS also imposes taxes on crypto-staking positions.
Form 1040 (C)
The tax form 1040 Schedule C is a tax filing document that is mandatory for cryptocurrency miners. The miners must submit all the deductions and report all the mint rewards as per their updated spot prices. Furthermore, if investors are pursuing mining as a hobby they should file their particulars under “other income” on the 1040 Schedule 1 form.
Self-employment Income
The people who are receiving an income from working in cryptocurrency enterprises can register as self-employed. It means that they must submit taxes levied on self-employed income.
Conclusion
The cryptocurrency market is taxed in some countries while it is still tax-free in other jurisdictions. Everyone wishes to save their taxes as much as possible.
Therefore, investors who have acquired enough knowledge about the legal system can take steps to decrease their tax deductions without violating legal obligations.