In our last article, “What is Virtual Currency and Should I Invest in it?”, we explained cryptocurrency and the benefits and risks involved in investing in it. This article will explain the tax effects of exchanging cryptocurrency. The year 2020 was the first year the IRS began asking taxpayers to state whether they have purchased virtual currency. The IRS continues to focus on ways to tax transactions where cryptocurrency has been used. In fact, they have requested $13.2 billion for their 2022 budget that would be used on reinforcing the operations that will help prevent the misuse of digital assets. A portion of this funding will be used on software, hardware and to contract cybersecurity experts and others to carry out their tasks.

How the IRS defines Cryptocurrency

Recently, El Salvador has adopted bitcoin as legal tender, meaning individuals can pay their bills, taxes and employers can pay their employees in Bitcoin and more. It is unknown whether more countries, including the US will adopt cryptocurrency as a currency, but as of today, the IRS considers cryptocurrency as property not a form of currency, which affects how it is taxed.

Payments made in Cryptocurrency as an individual or business

Payments received in exchange for goods or services whether you received it as a business or as an individual, is considered income and should be included in your gross income at fair market value measured in US dollars as of the date it is received. In this case, the amount received in cryptocurrency would be taxed at your income tax rate or ordinary rate.

If you receive payments in cryptocurrency for work performed as a self-employed person, you are subject to self- employment tax, as well as federal tax on this income. Payments made to you in cryptocurrency as an employee are still subject to payroll taxes as well.

Taxation of Cryptocurrency as an Investment

Since cryptocurrency is considered property, we must look to how the property is being held or used by the taxpayer to determine how a sell would be characterized. For instance, if the cryptocurrency is being held as a capital assets (i.e. stocks, bonds and other investment property), once it is sold/exchanged, you will have a capital gain or loss that gets reported on your tax return. The amount of the gain or loss is calculated by subtracting your cost basis of the currency from the amount or value received. To avoid tax audit issues that could arise, you should keep good records of your purchases of virtual currency as proof of the price you paid and used in your calculation of your gain or loss.

Your capital gain or loss tax rate will be determined by the amount of other income being reported on your tax return and how long you have owned it. You are taxed at your ordinary income tax rates if you hold your cryptocurrency for less than a year and subject to special capital gain tax rates if you have owned your cryptocurrency for more than one year. If you buy and sell cryptocurrency as a business, you are not afforded special capital gain tax rates. Instead, you are taxed at ordinary income tax rates.

Reporting Payments made in Cryptocurrency

Taxpayers remain responsible for meeting the reporting requirements for payments made in the course of a trade or business, whether paid in cryptocurrency or any other property. Therefore, if you make payments for rent, wages, annuities, etc., related Form 1099 reporting must still be done. Form 1099NECs must be issued to certain contractors, Form 1099MISC for rents paid, etc.

As the IRS increases their enforcement of cryptocurrency transactions, it will become even more critical for individuals to understand their potential tax liability relating to transactions being performed with the use of virtual currency and to keep good records in case of tax audits.