Understanding Cryptocurrency Tax Obligations
The cryptocurrency market has seen some recent pullback. There’s still widespread uncertainty around the concept’s full implications. That’s especially apparent coming out of tax season. Huge sums of money are flowing through crypto markets, but how much of it goes to the government is up for debate. In anticipation of the next crypto uptick, many investors are focusing on understanding cryptocurrency tax obligations for 2019.
Tax Definitions of Cryptocurrency
Currently, most crypto investors rely on a tax advisory service to determine their tax liability. In the United States, the Internal Revenue Service (IRS) has only issued one statement on the tax principles that apply to cryptocurrency. And, it came out in 2014. Yet, a lot has changed since then. Cryptocurrency should be treated as property rather than currency. Therefore, cryptocurrency is subject to capital gains tax. In other words, there is no tax obligation until the owner sells the coins and reaps the reward.
The IRS definition of cryptocurrency is also important. Anything considered “convertible virtual currency” falls under the definition. That means any coin that has an equivalent value in real currency or substitutes for real currency. While a small number of cryptocurrencies do not yet meet this definition, most of the major coins do.
Things are similar in Canada. In 2013, the Canada Revenue Agency (CRA) issued a statement on cryptocurrency taxation. It makes recommendations but does not establish a strict framework. This leaves investors and experts wondering what to report and when. Much like in the United States, the CRA considers cryptocurrencies commodities rather than legal tender. Any gains or losses are taxable. Otherwise, the currency is tax exempt. However, the basic principles of cryptocurrency make this issue murkier for all.
Confusion About Cryptocurrency and Taxes
Common cryptocurrencies like Bitcoin must be mined in order to be earned. Therefore, the act of mining functions as a form of work. The coins that investors gain are an asset and a form of compensation. Just like any other self-employed person, crypto miners must report their earnings. They can deduct related business expenses, such as computers and electric bills. However, they likely still owe taxes on the cryptocurrency they mine.
The tax bill attached to cryptocurrency is confusing for experts and newcomers alike. This is because of a lack of guidance and leadership on the part of regulators. Government agencies are rushing to catch up, and that means an already uncertain tax landscape is constantly transforming. For crypto investors who do not stay in the know, that could mean large and unnecessary tax bills.
Penalties and Liabilities Hidden in Cryptocurrency
In the United States and Canada, capital gains taxes and income taxes can apply to cryptocurrency investments based on how they’re acquired and used. Unfortunately, to calculate the tax obligation accurately, it’s necessary to know the cost basis or the original value of the asset. This isn’t always easy to determine given the fluctuating nature of cryptocurrencies. There’s a very real risk that investors will overlook or underreport significant tax bills.
Failing to report income tax is like any other tax evasion and would be subject to an associated array of penalties, interest, or even jail time depending on the jurisdiction. In the worst cases, offenders in the United States could be sentenced to tax evasion. This carries a potential sentence of five years in prison and a $250,000 fine. No one should underestimate the U.S. and Canadian tax agencies’ investigative capabilities.
Tax Risks with Cryptocurrency
For instance, the IRS can issue a “John Doe” summons with the approval of a district judge. Tax agents can investigate individual or group taxpayers who are otherwise unknown. This type of summons was used to get information about offshore banking. And, it’s increasingly being used to pursue crypto investors.
Coinbase, one of the largest global virtual currency exchanges, experienced this firsthand. It received a John Doe summons demanding all customer identities and account records from 2013, 2014, and 2015. The IRS was suspicious because only 800 to 900 U.S. taxpayers reported cryptocurrency gains/losses in 2015. Yet, Coinbase had 5.9 million users.
The summons was initially ignored after which the IRS narrowed its request to only Coinbase users with transaction volumes greater than $20,000 in any one year. The summons requested the taxpayer identification number, name, date of birth, and address. They also wanted records of account activity and all periodic statements of account or invoices for highly active customers.
Coinbase ultimately complied and handed over records for 13,000 users. This set a new precedent. These records contained detailed financial information. It’s fair to say that it is now relatively easy for the IRS to calculate delinquent tax bills and fine offenders. Of course, those who are targeted by the IRS aren’t necessarily avoiding taxes on purpose. Rather, they’re likely unwitting victims of a regulatory structure that hasn’t kept up with financial innovation.
Meeting Your Tax Obligations
Until the tax laws become concrete and transparent, it’s up to investors to take a proactive approach to cryptocurrency and taxes. Here are a few steps you can take:
1. Track All Your Purchases and Disbursements
Like any other income or assets, you must track purchases and disbursements for each currency so that you can accurately report gains and losses come tax season. Typically, this is easier to do by purchasing stock rather than dealing with multiple transfers in and out of a wallet. Any gains will be taxed. However, any losses will lower your overall tax liability.
Tracking gains and losses requires specific information about each transaction. This includes when you bought the coin, how much you paid for it when you sold it, and what you received in return. This information identifies the cost basis of the coin or the original value of the asset. Typically, the basis is the purchase price, but this fluctuates due to splits and dividends. It’s impossible to compare it to the current market price and assess how much you’ve gained or lost on the investment until knowing the true cost basis.
You won’t overlook important transactions when using a systematic approach and focusing on first-in and first-out (FIFO). Canada uses the “adjusted cost base” (ACB) for taxing cryptocurrency. This is calculated as an average. Regardless of whether you’re tracking the value of your coin with FIFO or ACB, record dollar amounts when trading one cryptocurrency for another. Therefore, gains/losses can be calculated and reported based on the native currency. Recording the date of the transaction is just as important for accurate pricing data.
2. Determine the Source of Your Crypto Income
Crypto income can be earned either by buying and selling coins or by mining them. This dictates what tax liability is levied — capital gains tax or income. All crypto income falls into one category or the other, and it’s possible to occupy both.
Any cryptocurrency gained through mining is subject to normal rates of income tax minus any relevant business expenses. If the currency sits static afterward, there’s no further tax liability. If the currency is sold, traded, or bartered for a product, then there are capital gains taxes.
The math is fairly simple. If you purchased $5,000 in Bitcoin and sold it for $15,000, then you owe capital gains taxes on $10,000. The situation is identical when trading one cryptocurrency for another. Report gains/losses on the transaction and include applicable cryptocurrency transfer fees.
In some cases, losses can offset the tax liability from gains. In Canada, there are no offset or time deference limits. Learn what tax laws apply to which crypto income. Then, leverage those laws to your advantage.
3. Rely on a Tracking Resource
The reporting requirements of cryptocurrency are immense. It doesn’t make sense for active investors to try to track transactions individually. The better strategy is to rely on a third-party tracking resource.
Tracking each asset’s cost basis in real time means properly identifies them as short-term capital gains. Otherwise, investors are day traders. Then, they must pay business income taxes instead of capital gains.
Taxes aren’t the only justification for using a tracking resource. Crypto markets move incredibly quickly and can fluctuate on a whim. The number of tradable currencies is also exploding. This means extra complexity with each new coin that arrives. Add to this the 24/7 nature of the trading cycle, and it’s obvious why manual tracking is unsustainable.
A number of tracking resources are available. Some are designed for the serious investor and others for the crypto novice. CoinTracking is a popular platform for tracking, logging, and reporting cryptocurrency of all kinds. Then, bitcoin.tax is a helpful tool for those who trade and invest in Bitcoin. Google Sheets has an add-on called CRYPTOFINANCE that automatically connects to cryptocurrency exchanges to supply real-time data. Canadian taxpayers can benefit from the calculator tool on AdjustedCostBase.ca or SimpleTax’s spreadsheet. The right resource is largely up to you. In all cases, the goal is to eliminate complexity. At the very least, the resource should track gains/losses and translate those into the tax liability in that jurisdiction.
4. Learn the Legislation in Your Jurisdiction
Few rules apply specifically to cryptocurrency in either the United States or Canada, but a number of other broader tax laws could impact liability. Furthermore, the rules regarding cryptocurrency are evolving all the time, as are the crypto markets themselves. It’s up to every investor to learn the legislation that applies to his or her jurisdiction, typically with the help of a tax advisor.
It’s easy to overlook important rules without expert guidance. U.S. citizens pay worldwide income tax. Therefore, global cryptocurrency gains are potentially taxable. Similarly, purchasing a property using cryptocurrency that has gained value will subject the purchaser to capital gains taxes. Just because something happens outside U.S. borders does not mean it’s exempt from U.S. tax laws.
Cryptocurrency and Taxes Evolve
The wide reach of these laws is not always negative. For example, the IRS does not charge tax on cryptocurrency donations to tax-exempt organizations. The IRS makes this exemption for other types of charitable giving and recognizes that giving cryptocurrency is not meaningfully different. With the help of a tax expert, it may be possible to find other beneficial tax laws in your jurisdiction.
Cryptocurrency was born on the fringe. Yet, it’s becoming more mainstream all the time. That may contradict its rebellious character. However, it also means more investment, better security, stronger markets, and more attention from tax collectors. Rising tax bills are a sign of cryptocurrency’s success. If this success is going to continue, investors must see themselves as taxpayers, too.