The Internal Revenue Service may run on ancient technology, but that isn’t stopping it from taking its cut from your newfangled cryptocurrency winnings.
In case you didn’t notice last year — or pretended not to — the I.R.S. moved the question about whether you sold, exchanged or “otherwise” disposed of any financial interest in virtual currency. It’s now high up on the 1040 form — above even where you list your wages.
How serious is the government getting about crypto? This month, President Biden signed an executive order that raised the possibility of a central bank digital currency. And the next day — perhaps driving home the point about the tax implications of all this — the I.R.S. announced that two owners of a cryptocurrency company were going to prison for a combined eight years for tax evasion.
“Crypto actors,” a Texas federal prosecutor said, “are required to pay their fair share of taxes, just like everyone else.”
That can be complicated if you jumped in with both feet. Are you befuddled by the ramifications of your first gain or loss? Or maybe confused about how exchanging one crypto asset for another creates a taxable event?
Fortunately, service providers are starting to show up to help crypto enthusiasts with the software equivalent of picks and shovels.
CoinLedger is one of them. It offers a specialized tool that can help track what you paid for digital assets and figure out any tax liability. We asked its chief executive, David Kemmerer, about the tax illusions (and delusions) that crypto investors have as they navigate this process.
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This interview was condensed and edited for clarity.
In what circumstances would you have to pay taxes on your cryptocurrency?
Cryptocurrency is treated very similarly to stocks or equities from a tax perspective, in that capital gains apply when you dispose of cryptocurrency. If I bought that Bitcoin for 100 bucks and then sold it later for 1,000, that $900 capital gain is income that needs to be reported on my taxes.
If you’re earning cryptocurrency from a job — and people actually get paid in crypto nowadays — that is taxable income, at the fair market value at the time you received it. Let’s say I did a job for someone and they paid me one Bitcoin right on Feb. 23. Well, on Feb. 23, I’m incurring $40,000 of income. Or whatever the fair market value of Bitcoin was at the time that I received it for my services.
Why did your software need to exist?
The problem that’s unique to cryptocurrencies that does not exist for equities is this data is fragmented across multiple different platforms. Let’s say I’m using E-Trade to buy and sell Tesla stock. Everything happens on E-Trade. It’s not normal for any trading person to send their Tesla stock somewhere else.
That’s just not the case for crypto. All of a user’s transactions can take place across multiple different wallets and across multiple different third parties.
The software exists to kind of be the TurboTax for cryptocurrency investors. We integrate with all of the various platforms of the crypto economy. All that data gets fully normalized, and then it gets routed through our tax engines. Then we can generate with the click of a button necessary capital gains, capital losses and income reports.
What do you tell cryptonewbies when they ask you about the I.R.S.’s view of cryptocurrency?
They’re paying very close attention to the digital asset space. It’s not accurate to think that “I’m using crypto, it’s pseudo-anonymous, they’re never going to know what type of income I’m making.” The I.R.S. has the ability to see a lot of what’s happening in this space, and they’re very quickly increasing their investment into being able to do that.
It’s been a big year for nonfungible tokens. What happens with those?
If you bought an NFT and then you later sold it or somehow disposed of it, traded it away for something, you realized capital gains on the fluctuation of that asset.
Expand Your Cryptocurrency Vocabulary
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A glossary. Cryptocurrencies have gone from a curiosity to a viable investment, making them almost impossible to ignore. If you are struggling with the terminology, let us help:
Bitcoin. A Bitcoin is a digital token that can be sent electronically from one user to another, anywhere in the world. Bitcoin is also the name of the payment network on which this form of digital currency is stored and moved.
Blockchain. A blockchain is a database maintained communally and that reliably stores digital information. The original blockchain was the database on which all Bitcoin transactions were stored, but non-currency-based companies and governments are also trying to use blockchain technology to store their data.
Cryptocurrencies. Since Bitcoin was first conceived in 2008, thousands of other virtual currencies, known as cryptocurrencies, have been developed. Among them are Ether, Dogecoin and Tether.
Coinbase. The first major cryptocurrency company to list its shares on a U.S. stock exchange, Coinbase is a platform that allows people and companies to buy and sell various digital currencies, including Bitcoin, for a transaction fee.
DeFi. The development of cryptocurrencies spawned a parallel universe of alternative financial services, known as Decentralized Finance, or DeFi, allowing crypto businesses to move into traditional banking territory, including lending and borrowing.
NFTs. A “nonfungible token,” or NFT, is an asset verified using blockchain technology, in which a network of computers records transactions and gives buyers proof of authenticity and ownership. NFTs make digital artworks unique, and therefore sellable.
Web3. The name “web3” is what some technologists call the idea of a new kind of internet service that is built using blockchain-based tokens, replacing centralized, corporate platforms with open protocols and decentralized, community-run networks.
DAOs. A decentralized autonomous organization, or DAO, is an organizational structure built with blockchain technology that is often described as a crypto co-op. DAOs form for a common purpose, like investing in start-ups, managing a stablecoin or buying NFTs.
What sorts of crypto transactions make up the largest volume of entries into your software?
The most common is spot market trades — buys, sells — right on centralized cryptocurrency platforms like Coinbase.
What about the fees that crypto traders sometimes incur when they buy or sell digital assets on exchanges or other platforms? Can that reduce your taxable gains?
So let’s say I’m buying Bitcoin on Coinbase. Coinbase charges me, let’s say, a 3 percent fee. That fee can be added to my basis of the asset that I purchased. If I purchased $100 worth of Bitcoin but I also pay this $3 fee, now my basis in that Bitcoin is actually $103. When I turn around and sell it, that is advantageous for me: I’m not incurring as much gain, because my basis is higher.
What are the questions that you hear about most?
A lot of people ask, “Hey, this is only taxable once I cash out to fiat, right?” And the reality is, “No.”
When you’re disposing of assets, whether or not you actually come back to U.S. dollars, you can still incur a tax bill.
So even if I use my Bitcoin to buy another cryptocurrency like Ether, I can still be taxed on any gains I’ve seen from my initial investment?
Let’s say you buy Ethereum on Coinbase for $1,000, and you hold that for a few months and it rips — it’s at $2,000 now. You sell it to buy stable coins, or Bitcoin. If it was at $1,000 at the time you bought it, you’ve realized $1,000 in capital gains
What about evading taxes? Are there already tax lawyers specializing in cryptoshelters — or whatever it would be in the blockchain world?
There are a lot of tax lawyers who have carved a niche out into the digital asset world. And a lot of those folks can definitely help from a tax planning and tax avoidance perspective. No one we work with is helping with tax evasion — that’s illegal. But there’s a lot of smart people who can help you reduce your taxes through proper planning.
Do you have any sense of the overall tax compliance rate?
In our survey, we found that over 50 percent of crypto investors were reporting their digital asset activity on their taxes. And we’ll see the number continue to drastically go up in the years to come.