Cryptocurrency taxation is complicated. Have you been reporting income and gains properly? You may be receiving a 1099-B for cryptocurrency transactions in 2023 and being familiar with the concepts below may help you understand the numbers reported this IRS form.
Cryptocurrency is treated as property for federal income tax purposes, and general tax principles related to property transactions apply to transactions using cryptocurrency. Thus, the sale or other exchange of cryptocurrencies, or the use of cryptocurrencies to pay for goods or services, or holding cryptocurrencies as an investment generally has tax consequences that could result in a tax liability. Also, you may receive taxable income when you receive additional cryptocurrency with respect to cryptocurrency you already own. In addition, the receipt of cryptocurrency in payment for services is subject to federal income tax. It is important to keep records of your cryptocurrency transactions.
The IRS defines virtual currency as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. However, it does not have legal tender status in the United States. Cryptocurrency is defined as a type of virtual currency that utilizes cryptography to validate and secure transactions digitally recorded on a distributed ledger, such as a blockchain.
In general, the IRS treats all cryptocurrencies as property for tax purposes, without regard to the terminology used and without making distinctions between different types. The IRS has not addressed whether cryptocurrency should be treated as either a security or a commodity for tax purposes.
Transfers Between Different Accounts
The cryptocurrency you own is generally held in a wallet, address, or account. If you transfer cryptocurrency from a wallet, address, or account that belongs to you to another wallet, address, or account that also belongs to you, the transfer is a nontaxable event.
Sales and Exchanges of Cryptocurrency
Capital gain or loss is recognized when cryptocurrency held as a capital asset is sold or exchanged. The gain or loss is equal to the difference between your adjusted basis in the cryptocurrency and the amount received in exchange. If the cryptocurrency is held for more than one year before it is sold or exchanged, the capital gain or loss is long term and generally eligible for special capital gain tax rates. Short-term capital gain or loss on an asset held for one year or less is taxable at ordinary income tax rates.
In general, your basis is initially the amount you spent to acquire the cryptocurrency, including fees, commissions, and other acquisition costs. Your adjusted basis is your basis increased by certain expenditures and decreased by certain deductions or credits. If you receive cryptocurrency as a gift, your basis in the cryptocurrency is generally carried over from the donor. If cryptocurrency is included in your gross estate for federal estate tax purposes, the person who inherits the cryptocurrency generally receives a basis stepped up (or down) to its fair market value on the date of your death.
Receipt of Cryptocurrency with Respect to Cryptocurrency You Own
When you receive additional cryptocurrency with respect to cryptocurrency you already own, you may have taxable income.
A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger. This may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. An airdrop occurs through a distribution of cryptocurrency to multiple taxpayers' distributed ledger addresses. If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency (whether through an airdrop or some other kind of transfer), you don't have taxable income.
If the hard fork is followed by an airdrop and you receive new cryptocurrency, you have taxable ordinary income equal to the fair market value of the new cryptocurrency when it is received. You have received the cryptocurrency when you can transfer, sell, exchange, or otherwise dispose of it, which is generally when the airdrop is recorded on the distributed ledger. Your basis in the new cryptocurrency is equal to the amount included in income for federal income tax purposes.
A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger, and new cryptocurrency is not created. A soft fork does not result in any taxable income to you.
Staking occurs when you pledge your cryptocurrency to help validate transactions on the blockchain (including participation through a cryptocurrency exchange). If a cash-method taxpayer stakes cryptocurrency and receives additional units of cryptocurrency as rewards as a result of the validation, the fair market value of the validation rewards must be included in the taxpayer's gross income for the taxable year in which the taxpayer gains dominion and control over the validation rewards.
Cryptocurrency in Payment for Services
If you receive cryptocurrency in exchange for performing services, you recognize ordinary income. The fair market value of the cryptocurrency paid as wages to you as an employee is subject to federal income tax withholding and Social Security and Medicare tax, and is reported on a Form W-2, Wage and Tax Statement. The fair market value of cryptocurrency received for services performed as an independent contractor is subject to income tax and self-employment tax. Your basis for cryptocurrency received in exchange for performing services would then generally equal the amount included in income as wages.
Mining is a process by which someone uses computer resources to validate transactions on a blockchain in return for a cryptocurrency reward. This would be treated as receiving cryptocurrency in payment for services and recognized as ordinary income.
If you pay for a service using cryptocurrency, you will generally recognize a capital gain or loss. Your gain or loss is the difference between the fair market value of the services you receive and your adjusted basis in the cryptocurrency.
Identifying Specific Units of Cryptocurrency
If you own multiple units of one kind of cryptocurrency, some acquired at different times and with different tax basis amounts, you can choose which units of cryptocurrency are deemed to be sold, exchanged, or otherwise disposed of if you can specifically identify which units of cryptocurrency are involved in the transaction and substantiate your basis in those units. You can identify a specific unit of cryptocurrency either by documenting the specific unit's unique digital identifier, such as a private key, public key, and address, or by records showing the transaction information for all units of a specific cryptocurrency held in a single account, wallet, or address.
If you do not identify specific units of cryptocurrency, the units are treated as sold, exchanged, or otherwise disposed of on a first-in, first-out (FIFO) basis.
Tax Records for Cryptocurrency
You must maintain records that are sufficient to establish the positions you take on tax returns. For example, you should maintain records documenting receipts, sales, exchanges, or other dispositions of cryptocurrency; your basis; and the fair market value of cryptocurrency.
Starting with the 2023 tax year, certain digital asset transaction details must be reported to you and the IRS on IRS Form 1099-B. Digital assets are defined as any digital representation of value that is recorded on a cryptographically secured distributed ledger or any similar technology. Transaction details include the sale proceeds, the adjusted tax basis, and whether any gain or loss is long term or short term. The Form 1099-B will be provided by your broker or any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.
Cryptocurrencies are not a traditional investment, are highly speculative instruments, carry a significant amount of risk, and are not suitable for all investors. Cryptocurrencies are not typically subject to the same reporting and data integrity requirements that apply to more traditional investment products. Cryptocurrencies lack many of the regulations and consumer protections that legal-tender currencies and regulated securities have.