Your Top Crypto Tax Questions Answered

In 2014, the Internal Revenue Service (IRS) issued Notice 2014-21, establishing that virtual currencies are treated as property for federal tax purposes, not currency. This classification means that tax principles applying to property like stocks or real estate also govern cryptocurrency. Any time you dispose of a digital asset, you likely have a taxable event that must be reported. This article will clarify these rules and answer common questions for cryptocurrency holders.

Identifying Taxable Crypto Events

A taxable event occurs when you dispose of a digital asset, which makes a theoretical gain or loss actual for tax purposes. Understanding which activities qualify as a disposition is the first step in maintaining compliance.

Selling Crypto for Fiat Currency

The most common taxable event is selling cryptocurrency for U.S. dollars. This action requires you to calculate and report any capital gain or loss from the sale.

Trading One Crypto for Another

Exchanging one cryptocurrency for another is also a taxable event. For example, trading Bitcoin for Solana is treated as a disposition of your Bitcoin. The proceeds are the fair market value of the Solana received at the time of the trade. These crypto-to-crypto trades are taxable when they occur, not when converted to U.S. dollars.

Using Crypto to Pay for Goods or Services

Using cryptocurrency to purchase goods or services is a taxable transaction. This is treated as a disposition of your crypto, and the gain or loss is calculated based on its U.S. dollar value at the time of purchase compared to your original cost.

Receiving Crypto as Income

Receiving cryptocurrency as payment for services or as wages is taxed as ordinary income. The fair market value of the crypto, in U.S. dollars on the date you receive it, must be included in your gross income. This amount may also be subject to self-employment taxes, and it establishes your cost basis for those specific coins.

Non-Taxable Events

Not every crypto transaction triggers a tax liability. Buying cryptocurrency with U.S. dollars and holding it is not a taxable event. Transferring crypto between wallets you own and control is also not a disposition. Receiving a gift of cryptocurrency is not immediately taxable to the recipient; taxes are deferred until you dispose of the gifted crypto.

Calculating Crypto Gains and Losses

The formula for calculating your gain or loss is: Fair Market Value – Cost Basis = Capital Gain or Loss. The Fair Market Value is the U.S. dollar value of what you received in the transaction. For example, if you sell crypto for $35,000, that is your fair market value.

Cost Basis

Your cost basis is what you paid to acquire your cryptocurrency, including the purchase price plus any other costs like trading fees. If you bought one unit of a cryptocurrency for $1,000 and paid a $15 transaction fee, your cost basis is $1,015.

For crypto received as income, your cost basis is the fair market value on the day you received it. For gifted crypto, the basis calculation depends on whether you sell it for a gain or a loss. To calculate a gain, you use the donor’s original cost basis; for a loss, you use the lesser of the donor’s basis or the crypto’s fair market value at the time of the gift.

Holding Periods

A short-term capital gain or loss results from selling a crypto asset held for one year or less, and these gains are taxed at ordinary income tax rates. A long-term capital gain or loss applies to assets held for more than one year. Long-term gains benefit from preferential tax rates of 0%, 15%, or 20%, depending on your taxable income.

Accounting Methods

When selling a portion of a cryptocurrency acquired at different times and prices, you must identify which units you sold. The IRS permits two accounting methods for this: First-In, First-Out (FIFO) and Specific Identification.

The default method is FIFO, where the first units you purchased are considered the first ones you sell. During a bull market where prices are rising, using FIFO typically results in recognizing a larger capital gain.

Alternatively, the Specific Identification method allows you to choose which units you are selling, provided you have detailed records to support your choice. A popular strategy is Highest-In, First-Out (HIFO), where you sell units with the highest cost basis first to minimize taxable gains. The Last-In, First-Out (LIFO) method is not permitted by the IRS for cryptocurrency.

Tax Treatment for Specific Crypto Activities

Many crypto activities generate income that is taxed differently from capital gains. When you receive a new asset from these activities, it is an income-generating event. The fair market value of the asset at the time of receipt is reported as ordinary income and also establishes the cost basis for that asset’s future disposition.

Mining and Staking

Rewards from crypto mining and staking are considered ordinary income. You must determine the fair market value of the earned coins in U.S. dollars on the day they were credited to your wallet. This amount is reported as income and may be subject to self-employment tax.

Airdrops and Hard Forks

If you receive tokens from an airdrop, you have ordinary income equal to their fair market value at the moment you gain control over them. Similarly, Revenue Ruling 2019-24 clarified that receiving new crypto from a hard fork results in ordinary income equal to the fair market value of the new coins when you receive them. If you do not receive any new crypto from a fork, you do not have a taxable event.

Non-Fungible Tokens (NFTs)

For an NFT creator, income from the initial sale and any subsequent royalties are treated as ordinary income. For a collector or investor, an NFT is a capital asset. Selling an NFT results in a capital gain or loss, calculated by subtracting your cost basis from the sale price. Some NFTs may be classified as “collectibles” by the IRS, which subjects long-term gains to a higher maximum tax rate of 28%.

Decentralized Finance (DeFi)

Activities within the DeFi ecosystem can generate income. If you lend crypto and earn interest, that interest is taxable as ordinary income. Similarly, providing liquidity to a DeFi protocol to earn reward tokens also generates ordinary income. In both cases, the income is valued based on the fair market value of the tokens on the day they became available to you.

Reporting Crypto on Your Tax Return

The Form 1040 Question

On Form 1040, you must answer a question about whether you engaged in any digital asset transactions during the tax year. You must check “Yes” if you sold, traded, spent, or received crypto as a reward or payment. Simply buying and holding crypto, or transferring it between your own wallets, does not require a “Yes” answer.

Completing Form 8949

Form 8949, Sales and Other Dispositions of Capital Assets, is where you detail each transaction. You will use separate forms for short-term (held one year or less) and long-term (held more than one year) transactions. For each sale or trade, you must list:

• The name of the cryptocurrency
• The date you acquired it
• The date you sold it
• The proceeds (fair market value)
• Your cost basis

After listing all transactions, you will total the proceeds and cost basis columns to determine your net gain or loss.

Summarizing on Schedule D

The totals from your Form 8949s are carried over to Schedule D, Capital Gains and Losses. This form consolidates all your capital asset transactions for the year. Your total short-term gains and losses are reported in Part I, and your total long-term gains and losses are reported in Part II.

Final Step

The net gain or loss from Schedule D is transferred to the main Form 1040. A net capital gain is added to your other income, while a net capital loss may be used to offset other income, subject to certain limitations.