No, You Can’t Pay Cryptocurrency-related Taxes with Cryptocurrency

Nowhere in the world of investing and trading is there a wilder roller coaster ride than cryptocurrency. The cryptocurrency market is extremely volatile, and only traders who understand what drives the crypto market – and who have nerves of steel – thrive in it.

When they do thrive, Uncle Sam is there waiting for the government’s cut, because like all profitable enterprises cryptocurrency trading yields income that is subject to tax.

Like other trading platforms such as the stock market, the cryptocurrency market is characterized by two major activities – buying and selling. Every time a trader makes a trade, it triggers a taxable event. The active knowledgeable traders know that, but there are beginners and “side hustlers” in the crypto marketplace who are not aware of the tax implications.

Property, Not Currency

The IRS has not helped deliver the message. The agency was slow to provide guidance to tax professionals when Bitcoin – the oldest and most well-known cryptocurrency – started trading in 2009. When it did finally weigh in, the IRS defined cryptocurrency as property rather than currency, meaning all the tax principles that apply to property transactions apply with crypto.

That’s where the complexity comes in. While the crypto market is still largely unregulated and extremely volatile – attracting traders who act quickly and don’t look back – the fair market value (FMV) of the cryptocurrencies they are trading must be tracked carefully in order to satisfy the IRS.

The crypto market has grown and diversified over the past decade to the point that most activity today involves trading one type of crypto for another, rather than simply buying and selling Bitcoin. At the same time, the taxation of property exchanges requires the knowledge of fair market value of the property on each side of the trade.

So, if you make a trade of Bitcoin for Etherium, another well-known type of cryptocurrency, you must know three FMVs – the basis of the Bitcoin, the value of the Bitcoin at disposal and the basis of the newly acquired Etherium. For traders who make hundreds of trades a year, that’s a lot of valuation activity.

Frequently Taxable Events

Besides trading, other activities in the cryptocurrency market that trigger tax liability include:

Mining – It is impossible to understand cryptocurrency without understanding blockchain, the platform upon which cryptocurrencies exist and are traded. Simply put, blockchain is an encrypted, decentralized distributed platform on which thousands of different types of transactions are recorded and verified. Verification is achieved when the encrypted transactions are added to a “block” to be verified and recorded by powerful hardware that is owned by individuals who mine blockchain. The block then gets added to a “chain” at which point the blockchain is publicly available. The process of solving the encryption, or verifying, the blocks and adding them to the public blockchain is called mining.

Miners often are rewarded for their efforts with payment in the cryptocurrency of the block they worked in, with payment based on each miner’s contribution to the verification. Again, FMV must be determined on the payment and its value determines the tax.

Airdrop – Traders sometimes are given free crypto as a marketing strategy by companies that want to boost their cryptocurrency in the marketplace. This is called an airdrop, and it is considered a gift and therefore not taxable to the recipient. However, if its value is over $15,000, the giver is subject to the gift tax. This kind of value in an airdrop is extremely rare but is possible given the volatility of the cryptocurrency market. When you dispose of crypto received through an airdrop, the trade will trigger a taxable event, so you must know the basis FMV even if you received it for free.

Hard fork – Similar to a stock split, a hard fork occurs when the company behind a cryptocurrency makes a significant change in the technology – such as a verification encryption – that changes the code. The change in code splits the cryptocurrency into a new kind of cryptocurrency that runs alongside the original and is verified in a different way. Now you own both, and this can result in a significant gain in the value of your holdings. The increase in FMV is factored into your tax liability when you trade.

Other Tax Issues

Your trading activity may be impacted by other tax-related issues, as well, including the question of whether it constitutes a business or a hobby. As with model trains or carpentry, the IRS will look at such factors as revenue, profit and loss patterns and the consistency of your trading activity to make the business-or-hobby distinction. The benefit to being deemed a business is that your trading-related expenses are deductible, as are a host of other miscellaneous costs that hobbyists can no longer deduct. Many cryptocurrency traders start out as hobbyists and even after growing it into a business still have “day” jobs, so good recordkeeping is essential if you want to prove to the IRS that your crypto speculation is a business.

Believe it or not, there are also inventory issues. If you sell part of your holdings in one type of crypto, you must track the holdings based on an inventory valuation process utilizing a first-in-first-out (FIFO) or last-in-first-out (LIFO) method. There has been demand for more guidance on this issue, but the IRS has not been forthcoming.

What Happens if There are Losses?

As with other types of property that go down in value, income losses stemming from a drop in FMV on cryptocurrency is considered a capital loss. Keep that in mind, because the world of cryptocurrency is one of extreme price volatility and little regulation. Capital losses are a real possibility.

Despite its volatility and the Wild West nature of the cryptocurrency world, there is little doubt that it is here to stay because it is an outgrowth of blockchain and because there are certain things that it does very well. The combination of blockchain and cryptocurrency makes transferring money very easy – that is one market where it has made a significant impact. Recently, people have been creating lending operations, making loans of cryptocurrency and receiving interest income from the loans. So, blockchain and cryptocurrency are showing the potential to compete with or even replace traditional banking services for some sectors of the marketplace.

The cryptocurrency market is still in its infancy, but signs of it emerging into the mass marketplace are happening. Even Intuit has programmed QuickBooks to recognize cryptocurrency as payment. But we are a long way from seeing small businesses routinely accept cryptocurrency as payment from customers due to the volatile nature of the market. And despite the inevitable wishes of some traders, the IRS does not accept cryptocurrency as payment of trade-related taxes.

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