Someone paid you in crypto. Do you have to pay the tax man?

Someone paid you in crypto. Do you have to pay the tax man?

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Taxpayers have always shown remarkable creativity with ways to minimize their tax liabilities. Of late, many have been lured by the promise of generating massive wealth while escaping the clutches of the tax collector through the allure of decentralized currencies and encrypted transactions, also called cryptocurrencies.

Crypto represents an extension of the old practices of bartering and conducting business in cash, allowing people to transact anonymously and operate within a framework of decentralized systems.

What is new is that crypto uses blockchain technology, a digital method of recording transactions that makes it nearly impossible to change, hack, or tamper with the transaction book.

Blockchain is not just for shady deals or underground economies, as the technology is not inherently illegal. A blockchain is like a ledger in a spreadsheet shared among numerous computers where currency sales and purchases are recorded. Anyone can see the data, but they can’t corrupt it.

The decentralized nature of blockchain poses unique challenges for governments and regulatory bodies, allowing people to bypass banks and brokers to hide financial transactions and potentially avoid taxes. The IRS loses approximately $50 billion in tax payments annually from unreported cryptocurrency transactions, according to a May 2022 report from Barclays.

The explosive growth has caught the attention of the IRS. The potential tax money at stake has led to increased regulations for filing and paying taxes. The IRS in March 2021 said it had assembled a team of experts to carry out what has been called “Operation Hidden Treasure” to audit crypto investors, according to a Forbes article.

Here is a summary of how cryptocurrency transactions are taxed.

Cryptocurrencies, like cash, can be bought for goods and services, exchanged for other cryptocurrencies or assets, or sold in exchange for traditional government-faith currencies like the dollar (also called fiat currencies).

In a popular example, Alex and Brady from the Cruisers Academy YouTube channel made a video about how a fan gave them a single bitcoin which they used to buy a 42-foot sailboat.

How are cryptocurrencies different from cash?

Unlike when you pay cash, when you spend cryptocurrency, it is considered a taxable event. I don’t pay tax if I buy something from you for $100 cash. You could, but I don’t. If you were to use crypto instead, that would become a taxable event.

On your taxes, you must report the date you acquired and disposed of the currency, how much you acquired it for, the fair market value of the crypto at the time of disposal, and any resulting capital gains or losses.

The difference between the cost basis (the amount you initially acquired the cryptocurrency for) and the fair market value when you spent, traded, or cashed it out determines whether you have a capital gain or loss.

If you have a capital gain, you may have to report and possibly pay taxes on appreciation in value. You may be subject to short-term or long-term capital gains rates depending on whether you held it for less than one year or more.

For example, when Alex and Brady bought the sailboat, if the bitcoin they used was a gift and it increased in value from when they bought it to when they used it to buy the boat, they would have to report a capital gain.

In addition to reporting crypto gains and losses, the IRS states that you must include income if you were paid for goods or services, including “mining” in cryptocurrency, equal to its fair market value when you received the coin.

Here is another example of how taxes work.

In February 2011, a tax protester offered an unidentified private CPA 1,500 bitcoins trading at $1 per bitcoin (at the time) to prepare his taxes. The CPA refused.

If the CPA had accepted the job, they would have reported $1,500 of self-employment income on their taxes for the bitcoin payment. If the CPA had put a hold on the bitcoin and cashed it out this week, they would have received $38,618,745 in cash. They would then pay long-term capital gains on the difference of $38,617,245. The maximum long-term capital gains rate is 20% plus 13.3% state tax.

What happens if I don’t report?

On Form 1040, the IRS asked: “At any time during 2022, did you receive, sell, send, trade, or acquire any financial interest in any virtual currency?”

Intentionally checking the “no” box instead of the “yes” box to hide taxable events involving crypto could be a criminal offence. A conviction can result in imprisonment for not more than three years and a fine of not more than $100,000. Penalties and interest will also be imposed on unpaid taxes.

If you didn’t know you needed to report your crypto transactions or if you forgot, you can request an extension on prior year’s returns.

What can I do to minimize the tax?

If you have held the cryptocurrency for more than a year, you may qualify for long-term capital gains tax rates, which are lower than short-term rates.

Tax loss collection involves the strategic sale of assets, including cryptocurrencies, that have experienced a decline in value (resulting in a capital loss) to offset capital gains, which could reduce your overall tax liability.

Direct donation of appreciated cryptocurrency may result in a charitable deduction equal to the fair market value of the donated cryptocurrency at the time of the donation. Because you did not sell crypto, there are no capital gains. This strategy allows you to support a cause while potentially reducing your taxable income.

By using a self-directed individual retirement account to invest a small portion of your retirement, if the risk is acceptable, you can defer taxes on capital gains and enjoy tax-free growth.

Given the complexities of cryptocurrency taxation, seeking the guidance of a tax professional who specializes in cryptocurrency can be highly beneficial. Crypto also has its own language. For more information on crypto jargon, go to crypto.com/university. (An example: “cryptosis” refers to someone who won’t stop talking about cryptography.

Michelle C. Herting is a CPA, a Certified Business Appraiser, and a Certified Estate Planner. She specializes in estate planning, business valuations, and trust establishment.

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