The United States Internal Revenue Service (IRS) does not recognize cryptocurrency as currency for federal income tax reporting purposes. However, it does recognize certain types of virtual currencies as property for capital gains and losses. If you are an American citizen living abroad and hold crypto assets, whether those assets are purchased directly or indirectly, you must report them on Form 8949, Sales and other Dispositions of Capital Assets.
In addition, if you trade digital currencies for profit, you must pay taxes on the gain or loss. You must determine what type of cryptocurrency you sold, and use the appropriate form to report the sale. For example, if you bought bitcoin in 2017 and sold it today for $10,000, you must report the transaction on Form 8949, Schedule D, Capital Gains and Losses.
If you traded Bitcoins for profit in 2018, you must report the sale on Form 8814, Sales of Virtual Currency Exchanges. You must provide information about the date and amount of each sale, along with the cost basis of the asset. This includes the total sales price, the number of units sold, and the fair market value of the unit at the time of the sale.
In this article, we will cover everything you need to know about crypto, how it works and most importantly, how it’s taxed.
What is blockchain?
A blockchain is a digital ledger which records transactions between two parties efficiently and securely. Just imagine a gigantic book as it is basically an automated decentralized book of transactions.
It’s usually decentralized, but you can centralize a blockchain, although that would take away most of the benefits of having a blockchain. Nobody wants a blockchain to be centralized.
A lot of people believe that the blockchain is a viable alternative to deeds for real property. Deeds are tracking from owner to owner every transaction involving the ownership of the real property itself.The blockchain is the same thing. With the blockchain, if you want to track something, we can use this digital ledger to track it.
The blockchain is the bedrock of all of these digital assets that we will deal with today. The blockchain is what keeps track of cryptocurrency transactions. Likewise, for non-fungible token transactions, and defi transactions.
When you have cryptocurrency or NFTs or anything else that you own digitally, you keep it in a wallet. The wallet has a public key, a public address, and a private key that is only known by you.
This can theoretically remain anonymous because when the ledger is populated, neither the sender nor the recipient names are not in the blockchain. What’s in the blockchain is wallet addresses public keys.
Nevertheless, someone collecting all the transactions might be able to infer the identity of the various owners. The public keys are visible to everybody. Nobody knows who owns each public key unless somebody reveals it, which they would never want to do.
But nobody except for the owner has the private key. The public key is “Here’s my Bitcoin wallet public key and sends the Bitcoin to this address.” But to access the Bitcoin within that wallet, you need a private key. Only the owner has, and if your private key is compromised, you’re screwed because then a hacker or somebody else can gain access to the wallet itself. And it has happened…
To remedy that, there are two types of storage for those wallets:
Hot storage is when the wallet is connected to the internet, allowing transactions to occur live.
Cold storage is when your wallet is disconnected from the internet and held on a local drive, which could take the form of a USB flash drive. That’s very secure except for the idea that heaven forbid you loose the USB flash drive.
What is a cryptocurrency?
A cryptocurrency is a digital currency that can be used to pay for things online. Many people use them simply as an investment, but they can also be used to purchase items online.
There are many different types of cryptocurrencies, including Bitcoin, Litecoin, Monero, Zcash, Dash, Ripple, Dogecoin, NEM, Stellar Lumens and others. They differ in how they operate, what purpose they serve, and how they are used. Some people use them for transactions, while others use them to store value and earn interest.
Bitcoin is the original cryptocurrency and was introduced in 2008. It is one of the oldest forms of cryptocurrency.
The concept behind Bitcoin is very simple. Instead of having a centralized authority issue money, Bitcoin uses cryptography to control the creation and transfer of currency. Cryptography allows individuals to send and receive Bitcoins anonymously without needing to trust each other. This makes Bitcoin ideal for sending money across borders and eliminating third parties such as banks.
However, there are some drawbacks to Bitcoin. For example, because the number of Bitcoins is limited, the supply is fixed and there is no way to increase the amount of coins being produced. Also, since the total number of Bitcoins is finite, prices fluctuate wildly. As of now, there are about 17 million Bitcoins in circulation.
Litecoin was founded in 2011 and is based on open source software developed by Charlie Lee. Like Bitcoin, it eliminates banks as intermediaries and aims to provide fast, cheap global financial transactions.
Ethereum was launched in 2013. Its main goal is to become a decentralized computing platform that runs smart contracts. Smart contracts allow developers to write programs that automatically execute once certain conditions are met.
What are Smart Contracts?
Smart contracts are the foundation to decentralized finance. They should really be called human-less contracts. Smart contracts are automated mechanism by which computers execute transactions with certain conditions have been fulfilled.
If I list my NFT on a market place such as OpenSea, and someone purchases it with Eutherium for the price I listed it, the smart contract will be executed. A bot will instantly send my NFT out of my wallet and I will receive the amount of Ethereum requested. These are contracts executed by computers.
When you have a smart contract, it really allows you to understand that a human being can’t toy around with whether that contract is going to be fulfilled.
In a smart contract, you have if then conditions that are executed by Bots.
You can have complete confidence that if you meet the if then condition, then the result is going to follow through because a computer is doing it. A computer can’t actually change its mind. So that’s why they call it smart contract.
It’s like a system where you don’t need to have the trust in the counterparty. It’s all done by Bots. In decentralized finances, a lot of transactions are done by a smart contract.
The problem with smart contracts is that if you have a hacker that could put a really sophisticated smart contract together and then fool you into accepting it then they can still steal from you.
Smart contracts are automatically executable by the computer. The bot literally self-executes.
A vending machine is a type of smart contract – you put in a dollar, press the button to get the thing out of the vending machine that you want to drink; you put the dollar in, press the button, and you get it.
This is all done by a computer program in the vending machine. It’s very simple, but that’s the way it works. Smart contracts are the same way. You put you okay, you put 50 ether into this Public public key wallet, and then you’re gonna get an NFT back.
These are supposed not to require any trust in human beings because the computers are doing everything right? Of course, there’s a command being given by a human being to set the whole chain in motion, but the computers are taking care of all of it.
What are Tokens?
Tokens are transacted through smart contracts. Cryptocurrency could be the mean of exchange and the blockchain underpins all of it.
There are two type of tokens; fungible tokens and not funglible tokens.
Fungible tokens are all equal in value. If you have two Bitcoins, they both are the same in value. They are easily interchangeable.
Non-fungible tokens however are all unique. Each NFT you own is unique. There’s no other little jpeg like it in the world. There are differences between one NFT and another.
Both fungible and non-fungible tokens are exchanged either through smart contracts or through individual transactions between human beings.
The jpeg itself is not really the NFT. The NFT is really the token of ownership. It’s a certificate of authenticity saying yes, I own this ape. A non-fungible token is you presenting it to somebody similarly to showing a certificate of ownership.
How does the IRS treat Cryptocurrencies?
In 2014, the Internal Revenue Service (IRS) classified cryptocurrencies as property rather than currency. Taxpayers must report their income, gain, or loss from all taxable transactions involving virtual currency on their Federal tax return. All crypto transactions have to be reported regardless of the amount or whether information return wa issued.
Since 2020, you must answer on the first page of Form 1040 whether they receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency during the tax year.
The IRC require taxpayers to maintain records that are sufficient to establish the positions taken on tax returns. You should keep all your records documenting purchases, sales, and other dispositions of virtual currency and the fair market value of the virtual currency at the time of transaction.
Buying Cryptocurrency or an NFT is not a taxable event. It’s a purchase of an asset. You don’t need to answer “yes” on Form 1040 if your only transactions involved purchasing virtual currency using real currency.
Calculating the cost basis
Your cost basis is the amount you paid for the virtual currency, including any fees, commissions and other purchase costs. Your adjusted basis is the basis you will use for figuring out whether you owe taxes on any gain from selling an asset. It’s the basis you increase by expenses you paid during the year, decrease by deductions or credits you received during the year.
Transfering the Currency
Transfering the currency between wallets is not a taxable event even though the price might have changed significantly since you aquired the digital asset.
Example: You transfer 5 Ethereum from your Metamask Wallet to your Coinbase Wallet.
Swapping tokens for different currencies
Suppose you wanted to swap your Bitcoin for USDC (stable coin) and buy Bitcoin later when the value drops again. You can do that using a liquidity pools such a UniSwap. When you perform a token swap, the previous tokens are discarded and replaced by new ones. This makes a taxable event and the 26 U.S. Code § 1001 applies.
All cryptocurrency is all property. So when you swap property for property: that is a taxable event under section § 1001. Coin swaps are different from crypto-to-crypto currency exchanges because the coins being swapped are not actually exchanged for another cryptocurrency; instead, they’re simply discarded in favor of a new one.
Example: Mark purchases $100 of DogeCoin. Elon twits about the coin and DogeCoin appreciates to a wooping $250. Mark swaps DogeCoin for Ethereum. As a result, he incurs $150 capital gain.
The IRS hasn’t provided any guidelines on wrapping tokens and whether it should be treated the same as a crypto-to-crypto swap.
Cottage Savings Ass’n v Commissionner:
An exchange of property constitutes a “disposition of property” under §1001(a) only if the property exchanged is materially different.
Properties are materially different if their respective owners have different legal rights or the nature of the properties is different. Even though the assets are economically substantially identical (1 ETH = 1 WETH), they may still be materially different for IRS purposes because they’re not interchangeable in their use.
This means wrapping ETH may be a taxable event.
Now, if instead of wrapping, you bought a non-fungible asset, an NFT. Is it a taxable event? Yes. Likewise, it would be a section §1001 exchange.
Example: Mark buys $250 of Ethereum. The value of Ethereum increases to $400. Mark decided to buy an NFT with his Ethereum. Mark incurs $150 capital gain.
Selling NFT for fiat currency or crypto currency is also a taxable event. Let’s go back to Mark’s example.
Example: Mark doesn’t like his NFT and after a week he sells it for $300 of Ethereum. Mark incurs $100 capital loss.
In 2021, LooksRare airdropped Looks tokens to all wallets that listed their NTFs on their platform. The amount airdropped was based on wallet’s OpenSsea activity.
Under Rev. Rul. 2019-24, the IRS clarified that they regard any airdrop and forks as income under the catch-all section 61 of the IRC.
“A taxpayer has gross income, ordinary in character, under § 61 as a result of an airdrop of a new cryptocurrency following a hard fork”
New tokens received in an airdrop are taxed as ordinary income. Recipients recognize ordinary income based on the FMV of their tokens at the time of the airdrop. Therefore, you owe income taxes on the new coins you have in your wallet as a result of an airdrop (whether or not you want to own those coins).
Liquidity pools happen when several investors get together to invest in cryptocurrency, and the issue here is that it can easily be regarded as a partnership, with the related reporting requirements.
When you put a token into a liquidity pool, you take a different type of token out of it. That seems like a seller exchange whether it’s a partnership or not doesn’t change the outcome. It’s either a section § 707 sale or it’s a section § 1001 exchange.
Under code section § 761 “the term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate. Under regulations the Secretary may, at the election of all the members of an unincorporated organization, exclude such organization from the application of all or part of this subchapter, if it is availed of—
(1) for investment purposes only and not for the active conduct of a business,
(2)for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted, or
(3)by dealers in securities for a short period for the purpose of underwriting, selling, or distributing a particular issue of securities,
if the income of the members of the organization may be adequately determined without the computation of partnership taxable income.”
As we can see, IRC section § 961 would define liquidity pools as partnerships, but it also gives the opportunity to opt out of such classification, provided that all partners take part in the election to opt out of partnserhsip status and that “the income of the members of the organization may be adequately determined without the computation of partnership taxable income”.
Wash Sale Rule and Crypto
Under the wash sale rule, if an investor has sold and then bought back shares of a stock within three days, they cannot report the loss as a tax deduction. This is designed to stop investors from artificially inflating their tax deductions by claiming too much capital loss.
Cryptocurrencies are not considered securities under U.S. law, so the wash sale rules may not apply to them. This might change in the future.
How is Crypto Taxed?
Cryptocurrency is treated as an investment asset in the U.S., not as a currency. For tax purposes, digital assets such as cryptocurrencies are considered property or traditional investments such like stocks and bonds. Some of crypto transactions are reported and taxed as capital gains or losses, others are taxed as ordinary income.
If your profits come from an increase in the value of your assets, they’re considered capital gains and are subject to capital gains tax. If you sell virtual currency for cash or another form of money, you must report it as a capital gain. Taxable capital gains are taxed based on the tax bracket your fall under and whether the gain was short-term or long-term.
If you’re a high frequency trader and treat your trading as a business and generate substantial income from it, you can elect a trader status. Your earnings become ordinary income and you avoid the applicability of the $3,000 capital loss deduction limit.
Ordinary income also comes from airdrops and interest.
Crypto tax rates
Your crypto ordinary income tax rate is determined by your overall income and might range between 10% and 37%.
The income bracket you fall into also affects your capital gains rate. And so does the amount of time you held the traded asset. If you hold an asset for one year or less, your profits from its sale are treated as short-term gains and taxed at the same rates as your ordinary income.
If you hold an asset for longer than one year, you’ll get better tax benefits. Depending on your overall income, you’ll be taxed at 0%, 10%, or even 20%.
How Crypto Tax Rules affect American Expats?
US Expats face an exceptionally difficult situation while reporting their crypto transactions on their expat tax returns. They are taxed on their worldwide income regardless of where they reside, and they are taxed in their country of residence. They might not always owe any tax, but they have an obligation to file the return. Moreover, foreign countries have started to tax cryptocurrencies to various degrees, which sometimes is inconsistent with the IRS framework.
If you have ordinary income, you can use the Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion allows taxpayers to exclude up to $112,000 of foreign earned income in 2022. This exclusion applies to both resident and nonresident aliens. In addition, it does not matter how much money is actually earned; just the amount of currency in which it is earned counts toward the limit.
Traders with self-employement income must make an election to be treated as an active trader and they will receive a preferencial tax treatment. Their income will be classified as ordinary income. Thus, will be elibibe to be excluded using FEIE (assuming the either the Physical Test or Bone Fide Residence Test was met).
If you have capital gain income, you can claim the Foreign Tax Credit
If you paid tax on your capital gains in your current country of residence, you can claim dollar-to-dollar amount of your foreign tax paid to offset your U.S. tax liability. You can claim foreign tax credit on form 1116.
Tip: You can claim capital losses on your cryptocurrency investments and offset up to $3,000 againt your ordinary income.
Gifting cryptocurrency and its tax implications
Cryptocurrency transactions are taxable events for US taxpayers. If you receive cryptocurrency as a gift, you must report it on Form 709. You do not need to file Form 8949, Gift Tax Return, unless you want to claim a tax deduction for the value of the gift.
If you transfer cryptocurrency as part of a trade or barter transaction, the rules are different. See Publication 17, How To Report Gains And Losses From Virtual Currencies For information about reporting gains or losses.
What if I don’t file?
There is a misconception regarding cryptocurrency that since it’s anonymous, evading taxes is fairly easy. This couldn’t be furhter from the truth.
Every transction is recorded on the blockchain and most crypto exchances like Coinbase send 1099-MISC to the IRS togehter with their customer information and records of crypto income. If your return does not match the 1099 the IRS received, the return will be flagged an automated CP2000 notice with be sent.
While the IRS has a voluntary disclosure program and form 14457 as it relates to cryptocurrency and digital assets, if you live outside the US, I would still prefer and recommend the Streamlined Foreign Offshore procedure to get into compliance.
Finding the right tax accountant
If you’re facing a special situation such as crypto transactions, expat taxes, or filing back taxes, we recommend connecting with a tax accountant.
Crypto tax laws are becoming increasingly common for accountants to discuss, but finding an accountant who has experience dealing with both cryptocurrencies and expat taxes may be difficult. That’s one reason why 1040Abroad provides its clients with access to expat-savvier accountants.