Everyone is talking about cryptocurrency these days, and it’s easy to see why. After all, the value of Bitcoin (BTC) temporarily surpassed the $60,000 threshold earlier this year, and Ethereum (ETH) has quadrupled in value since the beginning of 2021. Of course, there are other cryptocurrencies currently making waves and helping at least some people rake in the cash, which continues creating hype among investors and everyone else.
But, there’s one aspect of crypto investing that hardly anyone is talking about — the tax implications. This is partly because taxes are boring in general, but it’s also because a lot of crypto investors have no idea what they’re doing. And — for the record — the same problem is going to come into play this year regarding NFTs, or non-fungible tokens.
How Is Cryptocurrency Taxed Anyway?
Tax partner Jon D. Feldhammer of Baker Botts says that, generally speaking, cryptocurrency is treated as property and taxed accordingly. This means that you’ll face tax implications when you sell your crypto or NFT or you trade either one for another investment or even a purchase.
Let’s say you buy 1 Bitcoin (BTC) for $30,000 on January 1, 2021, and then sell it on May 6, 2021 for $50,000. In that case, Feldhammer says you would have $20,000 of taxable short-term gains.
However, he says things get tricky from here, because it’s common for people to make frequent trades for various purposes. For example, let’s say someone has $50,000 in BTC and they want to buy an NFT. In that case, they might need Ethereum to buy a specific NFT, so they trade BTC for ETH to make the purchase. In this case, Feldhammer says you still face $20,000 of taxable income because you exchanged the property (BTC) for other property (ETH), which is a taxable transaction.
Also consider this scenario: You bought BTC for $5,000 at some point in 2020, and your investment has now grown to over $50,000 in value. Law partner Asher Rubinstein at Gallet Dreyer & Berkey says that, if you decide to use your BTC to pay for a new Tesla TSLA -1.3%, you will have earned $45,000 in taxable income to report on your tax return.
You might like to think of it as a swap, he says, but “it’s like buying $5,000 worth of stock and selling it for $50,000.”
Short-Term Vs. Long-Term Capital Gains
Another factor to be aware of is the fact that, for many crypto and NFT traders, frequent transactions are the norm. For example, there are a slew of investors who constantly “buy the dip” on the favorite cryptocurrency then sell when prices are high only to do it all over again.
Aaron Sherman, who is President of Odyssey Group Wealth Advisors, says many newbie investors may not realize how gains are taxed when you don’t keep crypto for very long. If the asset was held for at least one full year, the gain will be taxed at a long-term capital gain rate, which is lower than ordinary income tax rates, he says. Meanwhile, if the asset was held for less than a year, the gain is taxed as a short-term capital gain, with a rate equal to the investor’s ordinary income tax rate.
“The difference between short-term and long-term tax treatment is meant to encourage investors to hold assets for longer periods,” says Sherman. “Because of this difference, those who are day trading crypto assets could face a large tax bill on any gains they may have.”
In the meantime, Feldhammer points out that NFTs may be considered a “collectible,” in which case they would be subject to a top tax rate of 28%, rather than 20%.
Facing A Crypto Tax Nightmare? Here’s What You Should Do
If you’re someone who believes cryptocurrency is anonymous and thus not subject to taxes, think again. Matthew Unger, CEO and founder of global compliance solution iComply, says that this is not true, and that new regulation called the FATF “travel rule” will effectively capture nearly every wallet owner on a public chain.
“This regulation starts coming into effect in most countries in June 2021…a few weeks away,” he says. “Once travel rule systems are in place, users can expect their local tax authorities to come calling.”
According to tax withholding expert Wendy Walker of global tax compliance firm Sovos, you cannot avoid your tax obligations and expect them to go away.
“Unpaid taxes accrue interest and penalties every single day they go unpaid,” she says, adding that filing an extension “does not get you off the hook because even during the extension period, unpaid taxes will continue to accrue interest.”
Further, the IRS aggressively pursues unpaid tax amounts via liens on personal property, seizures of assets, garnishments of wages, and so forth.
However, Chief Tax Information Officer Mark Steber of Jackson Hewitt says that taxpayers can get on a payment plan with the IRS if they’re unable to pay before the Tax Day deadline. Just keep in mind that telling the IRS you didn’t know your crypto transactions would be taxed isn’t good enough.
“The IRS wants their money and won’t ignore unpaid bills,” he says.
Thomas Shea, Tax Partner at EY, also says that, if you’ve triggered a taxable exchange but don’t have the fiat to cover the tax, you could exchange additional assets for fiat, essentially a “sell to cover.”
If one pursues this route, however, Shea says they should be mindful of the tax consequences of disposing of such additional property (e.g., additional taxable gains on appreciated property, potential offsetting losses of depreciated property).
No matter what, you’re probably better off consulting a tax professional if you’re even a little worried about mucking up your crypto tax bill. Walker says there are a variety of deductions you can take on capital gains liabilities and there are a variety of tax credits and deductions that taxpayers can leverage to minimize the amount of income taxes actually due.
“Navigating the IRS can be daunting if you don’t have experience,” she says. “So rely on someone who does.”
I’m a personal finance expert that focuses on helping millennials get out of student loan debt and start investing for their future. I also help parents make smart choices about college financing options and navigating the complex world of paying for school. I started The College Investor in 2009 as a forum to discuss the myriad of financial issues facing young adults. I majored in Political Science at UC San Diego, and received my MBA from the Rady School of Management at UC San Diego. To learn more about me, go to TheCollegeInvestor.com, or follow me on Twitter @collegeinvestin.