Cryptocurrency and Taxes: A Comprehensive Guide

Since 2009, cryptocurrency has been shaking up the financial world. Bitcoin, the original cryptocurrency, introduced a system of decentralized financial systems. Crypto transactions are stored on a public ledger known as the blockchain. Since the introduction of Bitcoin, over 23,000 cryptocurrencies have reached the market. 

Of course, any time you change how money is accessed, earned, or stored, there will be tax implications. Anyone who dabbles in cryptocurrency, either occasionally or as a major source of income, must understand how it’s handled by the IRS and what their obligations are. The IRS plans to devote significant resources to tracking down unreported crypto and taking action against incompliant taxpayers. 

If you have unreported crypto gains, questions about the taxation of crypto, or other crypto-related concerns, contact us at the W Tax Group for help. 

Tax Implications of Cryptocurrency

The IRS classifies cryptocurrency as property, not as cash. This means that any transaction involving the trade or sale of cryptocurrency is subject to capital gains tax. When you purchase cryptocurrency, the price at which you purchase it becomes your baseline. If you sell or trade it in the future, the sale price or trade value will be compared to the original price, and you will be taxed on the difference. 

While cryptocurrency that you own is considered property, there are cases in which it is treated as income. When you earn staking rewards or mine cryptocurrency, that money is classified as income and must be reported as such on your taxes. Similarly, if someone pays your business for goods or services with crypto, you also must report that as income.

In addition to paying federal taxes on your cryptocurrency transactions, you will also face state taxes. For example, the Michigan Department of Revenue applies state income tax to all taxable crypto transactions. The rate is the same whether the income is classified as income or capital gains on the federal level.

How to Track Cryptocurrency Transactions

Plan on keeping in-depth records to avoid tax issues if you trade cryptocurrency or accept it as payment in your business. Your documentation should include transaction amounts, purchase and sale dates, and the value of the cryptocurrency at the time of each transaction. Some crypto exchanges make this easy for users, providing detailed ledgers of transactions. However, the responsibility ultimately lies with each taxpayer.

What do you need to document? Although only certain transactions have tax implications, you need to track everything because non-taxable events affect your tax basis. For example, purchasing crypto is not a taxable event, but when you dispose of the crypto, you will need the purchase price to determine your tax basis. 

Taxable Crypto Events

Taxable events include:

• Selling or exchanging cryptocurrency for money such as U.S. dollars.
• Using crypto to purchase goods or services.
• Crypto trades in which you trade one cryptocurrency for another.
• Receiving cryptocurrency as payment for work or services performed.
• Mining and staking activities resulting in income.

Note that in the last two examples, you aren’t calculating capital gains or losses—you are tracking what you’ve earned as taxable income.

Unreported Cryptocurrency Transactions 

Everything seems pretty straightforward so far. Where do people go wrong? When there are tax issues with cryptocurrency, it often comes down to one of a handful of issues, including:

• Failure to report crypto earnings: It’s easy to forget that cryptocurrency is a real asset when you’re exploring it on an exchange, buying and trading small amounts of crypto. However, every single time you sell cryptocurrency or trade it for another form of cryptocurrency, you are creating a taxable event. Failure to track these transactions could mean incurring significant capital gains. That’s why it’s so important to track transactions in detail from the very beginning.
• Failing to report or incorrectly reporting airdrops and hard forks: Per the IRS, new cryptocurrency received via airdrops or hard forks is considered taxable income and must be accounted for on your tax return.
• Incorrectly reporting gains or losses: You have to understand your crypto cost basis to track crypto transactions correctly. Your cost basis is the purchase price of the asset plus any fees involved in the transaction. If you miscalculate the purchase price or sale price of cryptocurrency, you could be miscalculating your capital gains and losses.
• Misunderstanding crypto trades: Exchanges make it very easy to trade cryptocurrency for another type of cryptocurrency. When you’re trying to follow the trends by trading cryptocurrency on a downswing for crypto that seems like it’s on its way up. But when you do that, you are still involved in a taxable event. People tend to forget this since they never actually receive any money for the crypto they’re trading in. When you trade crypto for crypto, you have to track any capital gains or losses from your original price to the cryptocurrency’s price at the time of the trade.
• Not filing taxes at all: The world of cryptocurrency can be unpredictable, and it’s not uncommon for someone to get lucky and secure a massive windfall through good trades. If they haven’t planned ahead for taxes, they could find themselves owing tens of thousands of dollars at the end of the year in capital gains taxes. But if they’ve spent all of their crypto profits and cannot pay what they owe the IRS, they may choose not to file at all. This is a huge mistake that can lead to massive penalties and even criminal charges. 
• Not claiming capital losses: Yes, you have to report capital gains so that you can pay the appropriate amount on them—but don’t forget to track and report your capital losses. While it can be a bit demoralizing to look at trades that went wrong, you are doing yourself a significant financial disservice if you don’t track losses. Your losses can counteract your gains and decrease the taxes you pay. If your losses exceed your capital gains, they can even decrease the amount of taxes you pay on your income.

How Does the IRS Find Out About Unreported Crypto?

The blockchain is not as anonymous as users think it is, and the IRS has invested a significant amount of money into tracking cryptocurrency transactions and identifying taxpayers who are evading their taxes. 

Even if you cannot pay everything you owe upfront, you should still file your taxes. There are payment options for those who cannot pay everything right away, and these options allow you to stay compliant with IRS requirements. If you simply don’t file your taxes, you risk getting caught by the IRS and forced to pay significant penalties.

Potential Solutions and Best Practices

For every tax problem, there is a solution. When it comes to cryptocurrency, planning ahead and preventing problems is far easier than trying to address problems after the fact.

Many cryptocurrency investors find it helpful to utilize tax software that integrates with cryptocurrency exchanges. While you must record transactions, it is often impractical for an investor to manually track every single purchase, sale, or trade they make. This is especially true for major investors who are handling dozens of types of cryptocurrency at any given point. Crypto tax software can bring in transaction data from multiple exchanges and put it together into one document for easier tax returns.

On a similar note, using documentation provided by your crypto exchange can help you avoid some of the problems listed above. Whether you use data from your exchange or tax software, it’s important to remember that you ultimately are responsible for what you put in your tax return. If your tax software or cryptocurrency exchange provides incorrect information, you are expected to catch and correct it.

Working with tax professionals with extensive experience in cryptocurrency is key to avoiding errors and saving yourself both time and money. Ensure that you choose one who’s committed to following and implementing the ever-changing cryptocurrency regulations put out by the IRS. People often think you only need a tax professional at tax time, but if you work with one year-round, you can track transactions as they occur and avoid stress as that April deadline approaches.

Finally, being vigilant with your financial matters allows you to catch errors before they lead to legal issues. Schedule regular audits of your transaction records and documents to look for oversights or mistakes. This is another area where having an experienced tax professional is very helpful.

Get Help With Cryptocurrency and Taxes Now

If you’ve fallen behind on your cryptocurrency reporting, you have options. You may be able to file an amended tax return (or multiple returns if you’ve forgotten to report for multiple years), look into the Voluntary Disclosure Program, or explore other options. 

When you choose W Tax Group, you get access to our team of highly trained and experienced tax attorneys and accountants. Our Michigan team is here to help you unravel your toughest cryptocurrency tax issues and find solutions that suit you. Set up a consultation now by calling us at 877-500-4930 or filling out our online contact form.