What is Cryptocurrency?
Cryptocurrency is a type of digital currency that is recorded and verified on a distributed ledger, commonly known as a blockchain or similar technology. The blockchain maintains unalterable records, ensuring the authenticity of transactions and preventing tampering. Cryptocurrencies can be bought, sold, owned, and transferred in various ways, often functioning as an alternative to traditional currency. However, for U.S. tax purposes, cryptocurrency transactions are treated differently from transactions involving real currency.
How Are Cryptocurrency Transactions Taxed?
As early as 2014, the IRS issued guidance regarding the tax treatment of cryptocurrency and other digital assets. Since 2020, a question on Form 1040 has asked taxpayers whether they received or disposed of cryptocurrency during the tax year. Starting in 2023, this question includes all digital assets, not just cryptocurrency.
By the IRS definition, “a digital asset is stored electronically and can be bought, sold, owned, transferred, or traded. Examples include convertible virtual currencies and cryptocurrencies like Bitcoin, stablecoins, and non-fungible tokens (NFTs).
Specifically, the question reads:
“At any time during the tax year, did you:
- “(a) receive (as a reward, award, or payment for property or services), or”
- “(b) sell, exchange, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”
If you answer “Yes” to this question, you will likely need to report your cryptocurrency transactions to the IRS on Form 1040.
Despite the many ways cryptocurrency can be used like traditional currency, the IRS treats cryptocurrency as property, not currency, for federal tax purposes. This distinction means that any transaction involving cryptocurrency—other than buying cryptocurrency with U.S. dollars—may result in a taxable event, such as:
- Receiving cryptocurrency in exchange for services or property (including “airdrops”).
- Selling or exchanging cryptocurrency.
- Purchasing goods or services using cryptocurrency.
These transactions typically generate capital gains or losses. However, cryptocurrency earned in exchange for services or actively traded by individuals may be classified as ordinary income instead.
Similar to the sale of stocks or bonds, gains or losses from cryptocurrency sales are classified as either short-term or long-term. The classification depends on whether the cryptocurrency was held for over one year. Importantly, cryptocurrencies are not considered investment property, so the wash sale rules do not apply. This means you can sell cryptocurrency at a loss and immediately repurchase the same asset without having your loss disallowed.
What Records Should I Keep for Cryptocurrency? How Do I Determine My Basis?
To accurately report cryptocurrency transactions on Form 1040, it’s crucial to maintain detailed records. These should include:
- The amount you paid in U.S. dollars to purchase cryptocurrency.
- The fair market value (FMV) of any goods or services purchased using cryptocurrency.
- The FMV of cryptocurrency received as income, including from airdrops or payments for services.
- The FMV of both cryptocurrencies involved in a hard fork (when one cryptocurrency splits into two).
To calculate your gain or loss on a transaction, you must determine your basis in the cryptocurrency sold or exchanged. Generally, your basis is the amount you paid in U.S. dollars to acquire the cryptocurrency. However, if you acquired cryptocurrency in a manner other than direct purchase, you will need the following information to determine your basis:
- The type of cryptocurrency acquired (e.g., Bitcoin, Ethereum).
- The date and time of acquisition.
- The number of units acquired.
- The FMV of the cryptocurrency when it was acquired (measured in U.S. dollars).
Starting in 2025, the IRS will require brokers, exchanges, and some wallets to issue Form 1099-DA for digital asset transactions. While cryptocurrency held with an entity subject to this reporting requirement will not generate a 1099-DA, all transactions must still be reported on your tax return.
What Valuation Method Can I Use for Cryptocurrency Sales?
Under IRS Code Section 1.1012-1, if you sell or dispose of less than all units of a digital asset and do not specifically identify which units are being sold, the first-in, first-out (FIFO) method will be used to determine your basis and holding period. While other valuation methods may be available starting in 2025, the rules governing these methods are complex.
What Happens if I Make a Charitable Contribution of Cryptocurrency?
If you’re planning to donate cryptocurrency to charity, doing so directly to a qualified charitable organization can result in a greater tax benefit than selling the cryptocurrency first and donating the proceeds. This is because you may be able to take a deduction for the full FMV of the cryptocurrency without recognizing capital gains, provided the following conditions are met:
- The cryptocurrency has been held for more than one year.
- Donations exceeding $5,000 require an appraisal by a qualified appraiser.
- You obtain contemporaneous written acknowledgment from the charity.
Contact us before making a charitable donation to ensure you meet all IRS requirements. Failure to do so may result in the disallowance of the deduction.
What Tools Can Help Me Track My Cryptocurrency?
Tracking cryptocurrency transactions can be challenging due to the complexity of blockchain technology. Since the IRS issued its initial guidance on cryptocurrency taxation, several specialized software tools have emerged to assist taxpayers in tracking their cryptocurrency purchases, sales, and exchanges. These tools can help ensure accurate tax reporting and calculation of gains or losses. Popular options include:
- CoinTracker
- Koinly
- CryptoTrader.Tax
These platforms allow you to import transaction data directly from exchanges and wallets, automatically generating the necessary tax reports.
Conclusion
Tracking and reporting cryptocurrency transactions can be complex, but with careful recordkeeping and the use of specialized tools, you can ensure compliance with IRS requirements. If you’re unsure about how to report your cryptocurrency activities, contact us. As the rules continue to evolve, staying informed and proactive will help you navigate the taxation of digital assets effectively.