The IRS Wants to Know about Your CryptoTax Planning
The IRS really wants to know about your bitcoins and other crypto.
It starts at the top of the first page of your Form 1040, where you find the following question right after the spaces for your name and address:
At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?
All taxpayers must answer this question under penalty of perjury, even those who have never heard of Bitcoin and don’t know what cryptocurrency is. You can’t leave the field blank.
Unfortunately, this is something of a trick question. It is so broadly worded, you’d think any transaction involving digital currency requires a “yes” answer. But this is not the case.
This article will clue you in on the following:
- When must you answer “yes” to this question?
- What should you do if you answer the question wrong?
Let’s get started.
What Is Virtual Currency?
Virtual currency is not real currency issued by a government (“fiat money”). Instead, it is issued and usually controlled by its developers, and may be used for payment among members of a particular virtual community.
The IRS is interested only in virtual currency that is convertible into real money or that can act as a substitute for real money.
The best-known form of convertible virtual currency is cryptocurrency. Cryptocurrency uses cryptography to secure transactions, which makes it impossible to counterfeit or double-spend.
Cryptocurrencies don’t have a central issuing or regulating authority—they use a decentralized system to record transactions and issue new units. Bitcoin is the most widely used form of cryptocurrency, but there are dozens of others, including Ethereum, Litecoin, Dogecoin, Tether, and Binance Coin. Cryptocurrencies other than bitcoins are also called “altcoins.”
As we explained in a previous article,2 for tax purposes virtual currency is property, not money. For tax code purposes, you treat it much the same as gold or a share of stock.
When to Answer “Yes”
IRS guidance makes clear that the IRS is interested only in virtual currency transactions that result in taxable income (or loss) that must be reported on a taxpayer’s return. Thus, you must answer “yes” to the virtual currency question only if you engaged in any of the following eight types of transactions.
1. You were paid for goods or services in crypto. You need to answer “yes” because
- you have earned income and
- you were paid in crypto.
The fair market value of the crypto you received for the goods or services is taxable income.
Virtual currency is self-employment income if received for services by independent contractors or for goods sold by sole proprietors. It is taxable wages when paid by employers to employees.
2. You purchased goods or services with crypto. When you buy goods or services with crypto, you need to answer “yes” because you have a taxable gain if the value of the goods or services is less than your basis in the crypto, or deductible loss if your crypto was worth more than what you purchased.
3. You sold crypto for real money. Answer, “yes.” Your taxable income (or loss) is the amount of real money you received minus your basis in the crypto (its fair market value when you received it). The differences are capital gains or losses.
4. You exchanged or traded crypto for other crypto. You must answer “yes.” You have a taxable gain (or loss) depending on the value of the new crypto.
5. You got more crypto through mining activities. Mining involves using high-powered computers to authenticate and process crypto transactions by solving incredibly complex mathematical problems. Miners are rewarded with digital coins for their work and need to answer “yes” to the question. Virtual currency mined by an individual is self-employment income.
6. You got more crypto through staking activities. Staking is depositing crypto with an exchange or other crypto platform for a fixed time period and earning new crypto in return. It’s like earning interest on a bank deposit. Staking results in taxable income, so you must answer “yes.”
7. You got more crypto through a hard fork. A fork is when a cryptocurrency splits into two, which happens when software developers change the rules underlying the blockchain. If your crypto went through a hard fork and you received new crypto, whether through an “airdrop” (new crypto simply shows up in your wallet or account) or some other kind of transfer, you have taxable income and must answer “yes.” If you didn’t receive new crypto, you had no taxable income and can answer “no.” Forks and airdrops are taxed as ordinary income.
8. Any other disposition of crypto. You’re supposed to answer “yes” if you had “any other disposition of a financial interest in virtual currency.” Although the IRS has provided no guidance on the “other disposition,” this would presumably include donating crypto to charity.
Key point. The value of the crypto at the time of the donation is deductible as a charitable contribution if you itemize. And there’s no tax on the gain.
When to Answer “No”
Answer “no” to the virtual currency question if your only transactions involving virtual currency were any of the following three.
1. You purchased virtual currency with real currency. If your only transactions involving virtual currency were purchases of virtual currency with real currency, you are not required to answer “yes” to the Form 1040 question. Thus, for example, you could purchase $1 million worth of crypto and answer “no” to the Form 1040 question if you didn’t sell any of it during the year.
This may seem odd, since a person who purchases virtual currency clearly receives a “financial interest” in it. It shows the IRS cares only about transactions that result in taxable income. If you buy crypto with real money and just hold on to it, you receive no taxable income, the same as if you purchase a share of stock or gold and hold on to it.
2. You received crypto as a gift. If you received virtual currency as a bona fide gift, answer “no.” You will not recognize income until you sell, exchange, or otherwise dispose of that virtual currency. Note that a bona fide gift occurs when someone gives you crypto for nothing of value in return.
3. You transfer crypto from one wallet to another. If you transfer virtual currency from a wallet, address, or account belonging to you to another wallet, address, or account that also belongs to you, then the transfer is a nontaxable event. Don’t check the “yes” box.
What If You Answered Wrong?
It’s highly likely that many taxpayers answered the Form 1040 crypto question wrong. For example, it’s probable that many people who purchased bitcoins and held on to them the whole year answered “yes.” If you answered wrong, do you have to amend your return? It depends.
You answered “yes” when you should have answered “no.” If you answered “yes” to the crypto question when you should have answered “no,” then you don’t have to do anything. There is no need to amend your tax return.
The IRS is only interested in information about taxable crypto transactions.
You answered “no” when you should have answered “yes.” If instead you answered “no” when it should have been “yes,” and you did not report your taxable virtual currency transactions, you need to file an amended return. (If the due date for your return has not passed, you can file a superseding return instead.)
If you fail to do so, you may get a letter from the IRS advising you to file an amended return and pay any taxes due. The IRS began sending out such letters in 2019.
Here are five things to know from this article:
- All taxpayers must answer the question about cryptocurrency on the first page of Form 1040.
- IRS guidance makes clear that the IRS is interested only in virtual currency transactions that result in taxable income (or loss) that must be reported on the taxpayer’s return.
- Answer “yes” if you purchase or sell goods or services with crypto, receive new crypto through mining or staking activities, exchange crypto for real money or other crypto, or get new crypto from a hard fork.
- Answer “no” if you only purchased crypto, received it as a gift, or transferred it from one wallet to another.
- If you answered the virtual currency question wrong on your return, you need to file an amended return only if you had taxable virtual currency transactions you did not report.