A cryptocurrency is a decentralized, digital store of value and medium of exchange. The word crypto in cryptocurrencies refers to the cryptography process that is required for the creation of digital currencies and their transactions. It is virtual money that takes the form of coins or tokens. The key difference between cryptocurrency and fiat currencies is that they are decentralized and not controlled and regulated by any central authority, unlike fiat currencies.
The most popular among cryptocurrencies is Bitcoin which was created by Satoshi Nakamoto; it was invented in 2008 and released as open-source software in 2009. The first transaction took place between Nakamoto and an adaptor of Bitcoin in 2009. Many currencies have arrived after Bitcoin and Bitcoin has become the standard for other currencies. The currencies modeled after Bitcoin are collectively called altcoins. The other important cryptocurrencies are:
· Bitcoin Cash.
· Binance Coin.
The cryptocurrency relies on encrypted, distributed ledgers called blockchain technology to record and verify all the transactions.
Photo courtesy Coindesk.
There has been an almost tenfold rise in the price of bitcoin since the last year. People have made money in bitcoin like no other asset class. The US Internal Revenue Service(IRS) feels left out of the action and wants to collect revenues as it was missing an important source of revenue. It has initiated operation hidden treasure to bring out unreported hidden income and is stepping up its enforcement capabilities with a new program dedicated to cryptocurrency tax compliance.
According to the Director of the Office of Fraud Enforcement, Damon Rowe, with the “Operation Hidden Treasure,” the IRS will search for unreported crypto-related income. It is a joint operation between the IRS civil office of fraud enforcement and its criminal investigating unit that will train agents to look at blockchains to root out tax evasion among cryptocurrency users. IRS employees are also training alongside European Union Agency for Law Enforcement Cooperation(Europol) as part of the initiative.
Carolyn Schenck the national fraud counsel in the IRS Office of Chief Counsel has remarked that the agency is working with private contractors and vendors, mostly blockchain analytics firms to develop signatures or the telltale signs of fraudulent activity.
The indicators include looking for those transactions just below reporting requirements, like sending a series of $10,000 transactions and using shell corporations to hide funds. Cashing out of crypto or making every-day purchases is seen as a taxable event and Operation Hidden Treasure is designed to track and attribute such transactions to taxpayers.
Criminal Tax Evasion
Criminal tax evasion is defined by I.R.C. section 7201 as-Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law.
People have to be aware that there is a consequence for being willfully non-compliant with tax obligations and the consequence is going to jail. If the government can prove that you were aware of what you did, the case is criminal. If you made a mistake it is civil. Even if the IRS decides not to pursue criminal charges the civil consequences include a penalty of 75% of the understatement of tax.
A news host believes that these regulations would impact retail and small-time traders and not billionaires and Big Tech companies such as Tesla or MicroStrategy.
The taxation of Cryptocurrency
Cryptocurrency is taxed based on the IRS ruling of 2014 which states that cryptocurrency should be treated as a capital asset like stocks and not like a currency(like dollars). They are taxed whenever they are sold at a profit.
When you purchase goods or services with cryptocurrency which has gained in value over the price you initially paid, you incur capital gains tax. Suppose you bought $200 worth of Bitcoin and held it till it appreciated in value to $600. Now if you use bitcoin to purchase $600 worth of goods you will have capital gains tax on the $400 profit you had realized.
You have to pay taxes only if you spend and realize a profit. If you sell and incur a loss you don’t have any to pay taxes on the transaction. Let’s say you bought bitcoin for $1000 and sold it for $600, you don’t owe any taxes and you could use $400 of the bitcoin loss to offset other investment gains.
How much Crypto taxes you owe?
It depends on your annual income and the length of period you have held the cryptocurrency. If you have held the cryptocurrency for less than a year before selling it and if a profit is generated then short-term capital gains will have to be paid, taxed at your normal income tax rate. If you have held it for a longer period, more than a year, the profit would be taxed as long-term capital gains, taxed at a lower rate, determined by your annual income.
The tax that you owe depends on how you got the cryptocurrency and how you use it.
· When you mine cryptocurrency i.e. when you use computers to solve all the complicated equations and in return, you are paid crypto tokens, you have to pay taxes on the entire value of the cryptocurrency you have obtained by mining.
· When you receive cryptocurrency as a reward or through marketing promotion, it is a taxable income.
· When you receive cryptocurrency as a payment for goods or services rendered, the entire payment is a taxable income.
· If you sold cryptocurrency to realize an investment gain, and when it is more than the amount that you paid for, you owe tax the same way as in stocks.
· When you convert one cryptocurrency to another you owe taxes to the amount of gain you get in the transaction. Suppose you purchased $1000 worth of Bitcoin and used it to buy $2000 worth of Lite coin, you owe $1000 in realized profits.
For filing the tax returns you have to keep a record of all the crypto transactions like how you paid for crypto, how long you held, how much you sold it for, and the receipts of each transaction. If your investing platform doesn’t keep track of the cryptocurrency transactions there are software companies that detect the transfers between wallets and give you reports of all the transactions. If you find filing the cryptocurrency taxes too complicated you can hire a professional accountant who specializes in this type of filing tax returns.
There are a few ways by which you can minimize the crypto taxes:
Holding for the Long Term
When you hold the cryptocurrency for the long term i.e. more than a year the gains would qualify as long-term capital gains tax.
Offset gains with the losses
You can take advantage of the cryptocurrency gains by adjusting with losses for the year you realize a profit. Like you make a gain of $20,000 by selling Bitcoin, but you lost $20,000 by selling Litecoin, you don’t owe any taxes as you broke even. You can also carry forward the unused losses to offset your future investment gains.
Claim expenses for mining
Mining crypto comes with many expenses which include computers, servers, electricity, and the internet. You can deduct all these costs against the mining income. The amount you would be able to deduct would depend on whether you categorize your operation as a business or a hobby.
Invest through a retirement plan
When you invest in a cryptocurrency using a retirement plan like a traditional IRA or Roth IRA you can defer or avoid investment gains entirely, but it is not easy doing this through a normal brokerage account.
Despite the uncertainty and lack of guidance in some areas of cryptocurrency taxation, the IRS is taking an aggressive stance on taxpayers who have not complied with the reporting requirements issued in 2014. The IRS has displayed concern over the massive underreporting of income generated by cryptocurrencies. So the need of the hour is not to take shortcuts and file the returns as per the requirements.