The mainstream adoption of cryptocurrencies has attracted the attention of regulators globally. In recent times, regulators have sought to impose taxes on crypto assets, categorising them as property just like traditional assets (i.e., stocks, bonds and real estate). Although digital currencies are entirely different from stocks and bonds, the same tax regulations apply to them with just a few variations.

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For most investors, paying taxes is not the first thing they consider before venturing into cryptocurrencies. The highly rewarding gains of these digital assets is often the first and major attraction to these investors, despite how volatile they are. However, with crypto taxes becoming a major talking point around the world, including the United States, investors have to consider several questions: what crypto taxes are, how to calculate crypto taxes and what the implications are of defaulting in paying taxes on crypto gains.

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Crypto Taxes Explained

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The US Internal Revenue Service (IRS) defined cryptocurrency taxes in its 2014-21 notice and explained how they apply to blockchain transactions. According to the notice, virtual or digital currency is treated as property or a capital asset for federal tax purposes, such that the general tax principles that apply to assets classified under property apply to transactions involving the use of digital currency. In light of this, crypto assets are not treated as currencies (like fiat dollars or euros).

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The IRS notice dates back to 2014 and has become the basis for the laws of other countries where cryptocurrency taxes are enforced. Thus, for this article, the notice will serve as a guide as crypto taxes and their mode of enforcement in the United States are explained.

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Because cryptocurrencies are considered the same as traditional assets such as stocks, real estate and bonds, investors either incur capital gains or capital losses when they sell, trade or exchange their crypto holdings. For example, if investor A bought bitcoin worth $5,000 last year when the benchmark cryptocurrency was still trading below $24,000 and sold the bitcoin earlier this year for $20,000, he would have incurred a capital gain of $15,000. His personal tax bracket and the duration within which he held the bitcoin determine the percentage he would pay on that capital gain.

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Apart from buying and selling, there are other scenarios where investors could be taxed for earning cryptocurrencies: crypto mining, staking, liquidity farming, airdrops or interest from lending activities in decentralised finance (DeFi). In these instances, investors are liable to pay taxes based on the dollar worth of their crypto holdings.

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When Are Crypto Taxes Owed?

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Crypto taxes are owed when investors incur a taxable event from their crypto investments. The notice imposes a tax-reporting duty on investors whenever they incur a taxable event. A taxable event occurs when investors realise income on their crypto asset. The IRS considers certain activities in the cryptocurrency space taxable events:

●       Exchanging crypto for fiat currencies like USD and EUR

●       Exchanging one cryptocurrency for another i.e., trading Bitcoin in return for Ethereum

●       Buying goods and services with digital currency

●       Earning cryptocurrencies as income from mining or for services rendered

●       Receiving cryptocurrencies as rewards or airdrops

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Is Tax Payable When Crypto is Exchanged for Fiat?

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Each of these activities is a taxable event and attracts taxes from investors. In the first instance, an investor who trades $1500 Bitcoin for fiat after realising a profit of $500 is mandated by law to not only report this activity in the tax form (Form 8949) but also pay the tax resulting from such a transaction. However, if the investor loses on such an investment, this reduces their taxable income because the law recognises losses incurred on crypto investments. The tax payable in this instance is the same as the tax paid on capital assets like real estate and mutual funds.

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Is Tax Payable When a Cryptocurrency is Traded for Others?

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Investors also pay taxes when they trade a cryptocurrency for other cryptocurrencies. Under the notice, this is more or less like trading a crypto asset for fiat. Given this, if an investor purchases 0.5 bitcoin for $30,000 and, after a while, trades the bitcoin for Ether, bringing the worth of the Ether to $32k, the profit of $2k is taxable and is reported in the tax form unless the investor executes the trade at a loss.

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Is Tax Payable When Goods and Services Are Paid for with Cryptocurrency?

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The IRS notice rules that taxes are payable when investors purchase goods and services with digital currencies such as Bitcoin, Ether and Bitcoin Cash. For example, a crypto investor owns 10 bitcoins, which he bought for $100 each before 2014. Following a spike in the price of Bitcoin, say to $17,000, he buys a new Tesla which costs $51,000 with three bitcoins. A taxable event has occurred because the investor realised a capital gain of $50,700 on the three bitcoins by purchasing the electric car.

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Is Tax Payable When Cryptocurrency is Earned as Income?

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Earning cryptocurrencies as income, either through services rendered or mining, is a taxable event. If a Bitcoin miner running a node on the network mines one bitcoin every day, they would have to recognise the dollar value of the one bitcoin they mine each day. As such, if one bitcoin is trading in the market at $10,000 at the time of mining, that would represent the dollar value. The miner is obliged to report the income earned through mining in the relevant form.

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Is Tax Payable on Airdrops or Crypto Received as Rewards?

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The IRS notice provides that any cryptocurrency received as a reward through a marketing campaign or an airdrop counts as taxable income. Therefore, taxes are payable on airdrops and crypto rewards.

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When is Crypto Tax Not Owed?

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Certain situations are not taxable events. Therefore, they do not attract taxes from investors or warrant investors to report transactions in the tax form. These situations include the following:

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Buying and Holding Cryptocurrency

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Investors who buy digital currencies and simply hold them in wallets without selling or trading them do not have any obligation to report them. This is because they are yet to realise any capital gain or loss on their investments. The obligation is only imposed when selling or trading the crypto assets in their custody triggers a taxable event. This is also when either a capital gain or loss is realised.

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Transferring Cryptocurrency from One Wallet to Another

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Sending cryptocurrency from one wallet to another does not incur taxes. In this situation, a taxable event is not triggered because no capital gain or loss has been realised on the digital currency.

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Donating Cryptocurrency

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Donated crypto is tax-free and deductible as long as an investor donates to a registered charity. Donations above $500 require reporting in Form 8283.

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Crypto Gifts

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Gifting cryptocurrencies to friends or family members is tax-free, unless such a gift is above $15,000 in Bitcoin or altcoins.

Calculating Crypto Taxes

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Investors might find it difficult to calculate their capital gains and losses on several crypto transactions, so the IRS notice has provided a helpful formula:

Fair Market Value - Cost Basis = Capital Gain/Loss

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The fair market value represents the price that a cryptocurrency would sell for in the market. The price is usually estimated in terms of USD.

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Cost basis refers to the amount of money an investor spent in buying a particular crypto asset. This includes associated costs such as fees.

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However, where an investor has executed several transactions, it may be difficult to determine the cost basis, much less the investor’s capital gains and losses. For example, an investor purchases one bitcoin in three separate transactions and at different prices, and on the fourth transaction, trades 0.5 bitcoin for eight Ether. To calculate the gain/loss, he needs to subtract his cost basis from the fair market value at the time of the sell-off. Because there are three separate transactions involving the purchase of one bitcoin each, determining the cost basis may seem difficult because he has to identify which bitcoin was traded for the eight Ether.

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For situations like this, accountants have developed specific costing methods: First-In-First-Out (FIFO), Last-In-First-Out (LIFO) and Highest-In-First-Out (HIFO). Using the FIFO method, the first Bitcoin purchase is used to determine the cost basis and the capital gain or loss. With the LIFO method, the cost basis is calculated from the last Bitcoin purchase, whereas with the HIFO method, the capital gain or loss is determined using the highest cost basis. Although each of these costing methods may have its advantages and disadvantages, investors mostly use the FIFO method because it is considered the most conservative.

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Reporting Crypto Capital Gains and Losses

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Capital gains and losses incurred from capital assets like stocks and bonds, including cryptocurrencies, are reported in tax forms. The tax form used to report sales of capital assets is Form 8949. This form only applies to cryptocurrencies that were bought and traded off, not those earned as rewards from airdrops or mining. Investors fill out this form by listing their crypto trades, their sell-offs along with the dates they acquired and sold or traded each crypto asset, their proceeds (fair market value), their cost basis and their gains or losses on each trade.

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Reporting Crypto Ordinary Income

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Cryptocurrencies earned from jobs or rendering services; mining; airdrops; hard forks; staking rewards and crypto lending interests on DeFi protocols like Uniswap, Maker and Compound are all considered as ordinary income and are reported in separate sections.

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Investors who earn digital currency as a business entity, such as by receiving payments for a job or mining, have to report their income in Schedule C.

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Cryptocurrencies earned as staking and interest rewards from lending assets on DeFi protocols are reported as income in Schedule B.

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Digital currencies earned from airdrops and hard forks (Bitcoin Cash is a hard fork of Bitcoin) are reported in Schedule 1 as other income.

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How Tax Authorities Detect Unreported Taxes

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Tax authorities adopt several means to discover unreported taxes. The most common one is the 1099 reporting system, which the IRS has also adopted. Using this reporting system, the IRS mandates crypto exchanges in the United States, such as Coinbase, Gemini and Kraken, to report certain customer activity through Form 1099-K and other related forms. These forms, including the 1099-K, all help investors report non-employment-related income to the IRS.

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At the end of the year, both investors and the IRS are sent a copy of these forms. If the IRS realises that an investor has failed to report their taxes or has done so inaccurately, their account on the exchange will be flagged and a notice entitled CP2000 will be sent informing them of the discrepancy.

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Failure to report taxes is termed as tax fraud and attracts several penalties from the IRS and tax authorities in other countries. Penalties include criminal prosecution, up to five years imprisonment and a $250,000 fine. These penalties vary in other countries.

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Taxes on Algorand Wallet and Protocols

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Algorand is a carbon-negative and green blockchain that allows developers to build decentralised applications with support for activities like staking, lending and yield farming. Because these activities are taxable events, investors have to fill tax forms for every taxable activity they carry out on Algorand-based DeFi protocols and with the blockchain’s native token ALGO. To facilitate tax reporting for investors in light of their activities on Algorand wallets and protocols, Algorand partnered with ZenLedger earlier this year.

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The partnership will allow Algorand users to connect their transactions to the ZenLedger platform to easily manage their crypto portfolio and generate their required tax forms. It will also provide users with tax support on tracking transfers, trades, rewards, Algorand Standard Assets token imports, fees and more, helping them stay tax-compliant. Algorand wallet also supports the integration of other crypto activity tracking sites like CoinTracker and Koinly for tax reporting purposes.

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Algorand is a public blockchain running on a pure proof-of-stake (PPOS) consensus mechanism. As such, third parties, including tax authorities, can observe on-chain activity. Rewards users earn for preserving the carbon and negative blockchain through staking can also be monitored.

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Why Crypto Taxes Are Important

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Although it may be difficult for tax regulators to track crypto activities because of the decentralised nature of cryptocurrencies, the benefits of crypto taxes are significant.

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One, they are a great stream of revenue for countries. The transactions executed daily in the crypto space run into the millions, and the taxes resulting from these transactions could finance a large chunk of a country’s yearly budget.

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Crypto taxes help regulators keep track of illegal activities bankrolled with cryptocurrencies. Apart from KYC and AML[P30]  regulations, which digital currency exchanges are required to comply with, reporting the crypto transactions of users through Form 1099 is a great way to monitor activities relating to money laundering and terrorism financing.

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Crypto taxes foster more mainstream adoption. When mainstream investors realise that tax authorities have a bit of control over activities in the space, they are encouraged to invest in products like Bitcoin exchange-traded funds.

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Conclusion

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The cryptocurrency ecosystem is evolving and is yet to have a full-fledged regulatory sandbox. Even in the tax aspect, there have been controversies concerning the tax principles that govern staking pools with the auto-compounding feature. The controversy borders on the number of times an investor incurs a taxable event if their crypto asset is automatically harvested and restaked by the pool intermittently. Tax regulators in the United States and other countries are yet to announce their position on this. In the coming months, further tax regulations will be unveiled.