El Salvador's adoption of bitcoin as legal tender may have been a watershed moment for cryptocurrencies. But in the United States, even though you can use crypto to buy and sell products or services, don't think for a minute that makes it just like cash — at least not if you want to avoid trouble with the IRS.
Virtual currencies are taxed as property, or as an investment, when you sell them. To make matters more confusing, using them to buy something technically counts as selling.
If you're paid in bitcoin or other crypto, on the other hand, that will be treated as taxable income to you.
Indeed, almost every transaction may be taxable and should be reported.
While bitcoin and other cryptocurrencies may be virtual, they have very real-world tax consequences. If you fail to pay the tax you owe, you will be subject to interest and penalties and, in some circumstances, even criminal prosecution.
So if you couldn't resist getting in on, say, bitcoin's wild ride — it rose 437% in just the past year, at one point trading north of $60,000 in April and dropping below $43,000 this week - keep good records, because you are responsible for preserving documentation for every one of your transactions.
Do crypto transactions get reported to the IRS?
There is no legally required third-party reporting of crypto trades or many types of crypto payments. But that may soon change if the Infrastructure Investment and Jobs Act is enacted. If it is enacted, then exchanges like Coinbase would have to report your trades. The bill has passed the Senate and awaits a vote in the House this month.
In the meantime — and especially if the bill doesn't get enacted — there are a variety of ways the IRS will assess whether you have engaged in taxable crypto transactions.
For instance, any business paying more than $600 to a non-employee or paying wages to an employee must report that income to the IRS, said Mark Luscombe, principal federal tax analyst for Wolters Kluwer Tax & Accounting.
Plus, every federal tax filer at the top of their 1040 form must truthfully answer a question about whether they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency during the tax year.
That doesn't mean the IRS will simply rely on an honor system. "They have the perception that there are many more people engaged in virtual currency transactions than is being reported on returns," Luscombe said.
So, together with the U.S. Department of Justice, the tax agency is actively seeking compliance in a few ways.
It has started a "virtual currency compliance campaign" that will include public outreach but also "examinations." That can mean audits.
In addition, the IRS sent letters in the summer of 2019 to 10,000 people alerting them to their tax obligations regarding virtual currencies and urging them to review and amend past returns if they owe back taxes, interest and penalties.
How did it get the names of those 10,000 people? "[T]hrough various ongoing IRS compliance efforts," the agency noted.
One such effort: The IRS is seeking customer lists from cryptocurrency companies through legal summonses.
"The Department of Justice will continue to work with the IRS to ensure that cryptocurrency owners are paying their fair share of taxes," the DOJ said in a statement in April.
The IRS also has a Criminal Investigation Cyber Crimes Unit, charged with snuffing out illegal activity in virtual currency transactions.
What tax do I owe on cryptocurrency if I sell it?
You must report any capital gain or capital loss from the sale of your cryptocurrencies. That will be determined by the difference — in U.S. dollars — between how much you paid when buying them and how much you received when you sold them.
If you held the investment for a year or less and it had appreciated in value by the time you sold it, your gain will be taxed as ordinary income. If you held it longer than a year, then it would be subject to capital gains tax rates.
If you lost money on the sale, you may use your capital loss to offset any capital gains you incurred in other investments, Luscombe said.
How about if I got paid in a virtual currency for a good or service?
That's reportable as ordinary income to you. And the amount of income reported should be the value in U.S. dollars of the virtual currency the day you received it.
What if I paid someone else in virtual currency?
That's like a sale of bitcoin on which you will realize a gain or loss. The IRS notes that the gain or loss is determined by "the difference between the fair market value of the services you received and your adjusted basis in the virtual currency exchanged."
What should I report if all I did was buy virtual currency?
You don't have to report it on your tax return, according to the IRS, just as you wouldn't report an investment you purchased and are holding in a brokerage account, unless it threw off taxable income, such as dividends or interest.
Will my state tax my crypto transactions?
Probably, but you should see what your state revenue department has said on the issue.
"Most states have not specifically addressed virtual currency, which means that the majority of states that have an income tax would follow the federal lead," Luscombe said.
Any money you earn from your crypto investments or income payments will be factored into your federal adjusted gross income. And most states use your federal AGI as a starting point.
Two states — Nevada and Wyoming, neither of which have an income tax — did specify they would not subject virtual currency transactions to the state property tax, Luscombe said.
(For more information on these and other questions, the IRS has created this FAQ. And if your situation is particularly complex, see a tax professional with experience in this arena.)
A beginner's guide to crypto lingo
Bitcoin is a cryptocurrency created in 2009 by an unknown person (or people) using the alias Satoshi Nakamoto. Unlike traditional currencies such as the US dollar, bitcoin isn't controlled by a bank or government. Bitcoin is by far the most valuable and popular cryptocurrency in use today.
A blockchain is a digital ledger and the key technology underpinning most cryptocurrencies, non-fungible tokens (more on those later) and other unique digital items.
Blockchain can be used to store all kinds of information, but so far its most common use is in recording cryptocurrency transactions. Once a transaction is made, it's entered on this public ledger, which is managed by a global peer-to-peer network — millions of computers, in bitcoin's case.
Blockchain is fundamental to bitcoin's appeal: As a decentralized database, it can't be controlled by any one person or group — unlike a fiat currency such as the US dollar, which is managed by a central bank.
Buy the f****ing dip (BTFD)
A rally cry for crypto bulls that urges investors to buy coins when prices drop.
The leading cryptocurrency exchange platform. The company went public in April, an event that many viewed as a turning point in the story of cryptocurrencies' journey into the mainstream marketplace.
An all-digital money system made up of "coins" or "tokens" that are controlled by a decentralized ledger.
The oddball of the crypto family began as a joke based on the "doge" meme in 2013. But as cryptos have broadly gained mainstream interest, dogecoin has emerged as an unexpected heavy hitter. It now has a market cap of more than $30 billion and it has surged more than 5,000% so far this year. And unlike its more popular brethren, a single dogecoin is still cheap — it hit an all-time high of about 45 cents in April. Whether or not its a smart investment remains an active question.
Tesla CEO whose tweets have been known to spark rallies in cryptocurrencies such as bitcoin and dogecoin.
An open-source blockchain-based software that controls the cryptocurrency Ether. It is the second-largest digital currency by market cap at nearly $300 billion.
FUD ("fear, uncertainty, doubt")
In crypto parlance, FUD refers to negative information that weighs on an asset's value.
The complicated process by which new bitcoins are entered into circulation. Mining is not for amateur enthusiasts: It requires high-powered computers that solve complex mathematical puzzles to create a new "block" on the blockchain.
The mining process eats up a lot of computing power and electricity, which has led to concerns about bitcoin's environmental impact.
Non-fungible tokens, or NFTs, are pieces of digital content linked to the Ethereum blockchain. "Non-fungible" essentially means one-of-a-kind, something that can't be replaced, unlike, for example, a dollar bill that you can replace with any other dollar bill. In the simplest terms, NFTs transform digital works of art and other collectibles into one-of-a-kind, verifiable assets.
The pseudonym that refers to the person (or people) who invented bitcoin. Their real identity remains unknown.
Satoshis, aka "Sats"
The smallest unit of bitcoin ever recorded on the blockchain, equal to one one-millionth of a bitcoin.
Like the physical thing you carry your cash and cards in, a wallet in the crypto world is a place to store digital currency. The main thing you need to know about wallets is that you must never, ever lose or forget your password.
Editor's note: This story is an update of the original version, which ran in April 2021.