
First – this blog is not tax advice. Please consult with a tax lawyer or CPA before doing your taxes, and hey, it goes without saying, but always pay your taxes.
One USD dollar invested in Bitcoin in 2010 is now worth 900,000 dollars. Great news, but how much in taxes do you owe if you sell it?
The news is good if you did not sell and still own it.
Starting in the 2020 tax season, on Schedule 1, every taxpayer has to answer at any time during the year whether you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency as the video above said.
This is an extremely broad question and will require you to check “yes” even if you are just holding crypto in an exchange or wallet. In 2020, the IRS clearly sees noncompliance on virtual currency transactions as a threat to the tax system.
If you mark “yes”, first & foremost, it would signal the IRS to check various forms and schedules of the return for cryptocurrency gains and losses. However, everyone who marks “yes” may not have a reportable taxable event. For example, during 2019, if you just held bitcoin and did not sell, you would not have any taxable amount to report. In these cases, the IRS will use the cryptocurrency question as a way to gather data about US crypto holders and keep an eye on future years for taxable events. HYPERLINK
The IRS sent three different types of notices in the initial phase in 2019: I know because I got one from them via the Bitstamp exchange.
Letter 6174– this wass a soft notice informing the taxpayer that there is a likelihood that they did not report their virtual currency transactions. The notice asked them to re-check their return and, if necessary, file an amended return to correct the misreporting. The taxpayer is not required to respond to the notice and the IRS intends not to follow up on these notices. In short, this is information only to the taxpayer and education on how they comply.
Letter 6174-A– this was a “not so soft notice” from the IRS. As in Letter 6174, this letter tells the taxpayer that there is potential misreporting of virtual currency transactions. However, this notices stated that the IRS may follow-up with future enforcement action. Again, no response was required if the taxpayer believes that they are in compliance. Taxpayers who received this notice should have been aware that they have been put on “notice” that they have been identified as a noncompliant taxpayer for potential future IRS enforcement (audit)
The last notice required a response – Letter 6173. This notice requested a response from the taxpayer about the alleged noncompliance. The letter provided instructions on responding to the IRS. The IRS intends to follow up on these responses to determine if the taxpayer is in compliance.
The IRS started sending a small number of these notices in June, 2019. Mass mailing of these letters will occur during the week of July 22, 2019, and continue through August. Taxpayers receiving this notice will have a special hotline and address at the IRS for any contacts and responses
Bitcoin however, enjoys a favorable tax treatment from the IRS. This is bullish considering its run in 2019. They key is understanding your tax basis and why it should be held for investing purposes but also for its tax treatment.
Capital gains tax in crypto is especially bad because it is extremely expensive to rotate positions in a bull market. Your next investment needs to outperform your current hold by 30-40% to be in the money net of tax. This is why I tell everyone never sell once you buy.
Most talk about why you should never sell BTC, but if you do sell you need to know what your tax basis is. As with all financial advice, check with your tax expert before taking any advice from anyone. So what does the IRS say about BTC/GBTC tax basis?
According to the IRS’ official guidance on crypto taxation, crypto is taxed as “property,” which is just a fancy way to say it’s taxed like a stock.
Thank the Bitcoin God!
Now let’s go back in history to 2010 and see what BTC founder had to say about this aspect of BTC: “Bitcoins have no dividend or potential future dividend, therefore not like a stock. More like a collectible or commodity.”
The US government decided to handle BTC differently. Why?
If you buy bitcoin and hold it for more than a year, you pay long-term capital gains when you sell. For US federal taxes, that means you pay a 15% tax on any gains, unless you make a lot of money (more than $479,000 (for married couples) or $425,800 (for individuals)), in which case you pay 20%. That compares favorably with almost every other alternative investment sold on Wall Street exchanges.
I believe there were two main reasons the government did this. The first one is obvious.
1. Taxing it like a stock makes it very unfavorable to be used as a currency to compete with the US Dollar. They do not want any competition for the dollar because of how they use the dollar to punish countries politically and exert pressure.
2. The second reason was to use IRS tax law to uncover who holds cryptocurrency so they could tracked and surveilled for tax purposes into the future.
The government knows tracking crypto transactions is difficult for the IRS because of manpower. They also know that the cell phone is the ideal way to track people who own crypto. This is one reason why using a VPN on your phone/computer is very wise at the beginning of 2021. The IRS is telegraphing they intend to have the NSA spy on us through our phones. Once they find out who admits they have crypto they’ll know who to surveil via technology. This is why everyone who uses cryptocurrency should consider a VPN for their phone.
Eventually, people will think ‘My phone is spying on me’.” Why are they doing this? Under observation, we act less free, which means we effectively are less free. You have to think critically to know what they government will do when the deck is stacked against them in the crypto-world.
For instance: GOLD IS NOT AS BITCOIN FRIENDLY AS BTC when it comes to taxes.
Gold is taxed as a collectible. That means, no matter how long you hold it, the lowest tax you can pay when you sell is 28%. And yes, this is true even if you hold a gold exchange-traded fund like the SPDR Gold Shares (GLD); there’s nothing magical about wrapping physical gold in an ETF that changes its tax treatment.
Currency is taxed at regular income rates. No matter how long you hold a currency investment like the Invesco CurrencyShares Japanese Yen Trust (FXY), you never qualify for long-term capital gains. Instead, you pay your marginal income tax rate on any gains, up to 37% on federal taxes. This one hurts the pocketbook.
Commodity futures–and ETFs that hold commodity futures like the US Oil Fund (USO)–are what’s called Section 1256 contracts for tax purposes. That means two things, neither of which are good for long-term investors:
- First, any investment in a Section 1256 contract is “marked to market” at year-end, which means you owe taxes on paper profits at the end of the year even if you don’t sell.
- Second, regardless of your holding period, 60% of any gains are considered long-term capital gains, and 40% are considered short-term capital gains. That means the blended tax rate for someone in the highest federal income tax bracket is 26.8%.
The relatively high tax rate is unfortunate, but it’s the mark-to-market feature that kills long-term investors. People really don’t like paying taxes on paper profits, and the inability to defer taxation can have a meaningful impact on long-term returns.
Bitcoin futures, for what it’s worth, are considered Section 1256 contracts, so they fall under this tax classification; direct holding of “physical” bitcoin (or investing in a fund that holds bitcoin) does not.
WHAT ABOUT THE TAX BASIS OF AIRDROPS AND HARD FORKS FOR BTC?
An airdrop, in the cryptocurrency business, is a marketing stunt that involves sending coins or tokens to wallet addresses in order to promote awareness of a new virtual currency. A hard fork is a radical change to the protocol of a blockchain network that makes previously invalid blocks/transactions valid (or vice-versa).
A “hard fork” of a cryptocurrency owned by a taxpayer does not result in gross income for a taxpayer if the taxpayer receives no units of the new cryptocurrency, but taxpayers receiving an “airdrop” of units of a new cryptocurrency after a hard fork have ordinary gross income from the airdrop, the IRS ruled in Rev. Rul. 2019-24, issued in October in 2019. The IRS also updated its Virtual Currency Transactions frequently asked questions on its website to reflect the ruling.
The last thought: the US tax system relies on a voluntary compliance system. This means that the the IRS expects you to report all taxable transactions (whether the IRS knows about those transactions or not)
The IRS is now asking you to self report what crypto transactions on your 1040 return you have made in 2020 because without this information they are flying blind to a degree. They do get some help however. If you receive a Form 1099-K or Form 1099-B from a crypto exchange, without any doubt, the IRS knows that you have reportable crypto currency transactions. … If you receive a Form 1099-B and do not report it, the same principles apply. Likewise, Coinbase, Kraken and other US exchanges do report to the IRS.
This is thanks to the “matching” mechanism embedded in the IRS Information Reporting Program (IRP). During any tax year, if you have more than $20,000 proceeds and 200 transactions in a crypto exchange, you will get a Form 1099-K indicating proceeds for each month. The exchanges are required to create these forms for the users who meet the criteria. A copy of this form is provided to the account holder, and another copy goes to the IRS. If you file a tax return and do not include these amounts, the IRS computer system (Automated Underreporter (AUR)) automatically flags those tax returns for under reporting. This is how you get tax notices like CP2000. If you receive a Form 1099-B and do not report it, the same principles apply.
Over the past few years, the IRS has issued subpoenas to several crypto exchanges ordering them to disclose some user accounts. Many crypto investors got caught in that web after the 2017 drop because many people sold BTC and did not hold it. This created huge IRS interest. Word is this is another reason why IRS decided to treat BTC as a stock to get more tax monies. Anyone who sold it at a loss would want to offset the loss with a gain so the IRS could find out how many Americans were really holding cryptocurrency.
For example, in 2018, Coinbase had to disclose approximately 13,000 user accounts including taxpayer identification number, name, birth date, address, records of account activity, transaction logs and all periodic statements of account or invoices (or the equivalent) pursuant to John Doe summons. On another occasion, the IRS subpoenaed Bitstamp to release more information about a taxpayer who filed an amended return and requested a $15,475 refund. Let’s just say I know that taxpayer and how the IRS tracked the person of interest.
A 2020 point: If you took a crypto loan from an exchange remember the interest is tax deductible but the loan amount can be calculated from the interest paid. This tells the IRS that a balance had to be present on the exchange at some point to make the collateral based loan.
IS DeFi HANDLED DIFFERENTLY?
That was all Bitcoin, what about Defi crypto transactions on Etherium?
There are three big topics in DeFi to cover for taxes – liquidity pools, staking and yield farming, and NFTs.
Very simply, a liquidity pool, or a DEX, is a smart contract where you can exchange one token for another. I have written about them already in the BTC series. Have a look at them.
Trading on a DEX is exactly the same treatment as trading anywhere else. There is one level of complexity which is that Dex’s are 100% token to token trades, as opposed to exchanges where one side of the pair is often a fiat currency.
Liquidity Providing
But, let’s talk about the DeFi part – providing liquidity to a pool. I pick a pair (let’s say the SushiSwap WBTC / WETH) and I deposit 50% value of each asset. For instance, in March that would be around 1 WBTC and 25 WETH. As part of that deposit, I get a token back indicating my ownership percent of the pool. People then trade against that pool, and over time my holding will shift in line with the relative movement of WBTC and WETH. Perhaps in a week my holdings will be with 1.1 WBTC and 24 WETH.
There are a few ways people are treating this for tax purposes. On the one hand, some people treat the initial deposit and token issuance as a trade. That is to say, you’re 100% disposing of the WBTC and WETH, and acquiring a new token with the cost basis of the tokens you disposed of.
For a lot of people, this is a perfectly reasonable treatment, especially if you only recently got into crypto. That’s because you pick up a gain or loss based on that disposition – if you’ve been hodling a month that might be a minor loss. If you’ve been hodling 5 years, you may be creating an enormous tax bill for yourself which would require you to liquidate assets.
To deal with that problem, some tax professionals are recommending you treat this as a containerization – the best analogy is to think of a blind trust. Back in the day, politicians would put their assets into a blind trust when they took office, which is to say they didn’t sell all their stock, but they put it under the care of a professional who would not consult with them on trades. Theoretically, this decreased the chances of the politician making self-enriching policy.
In that case, the transfer to the blind trust was not a taxable event, but every trade that the blind trust executed would be even if you weren’t directing it.
That’s essentially what a liquidity pool is – you deposit some funds, then other people are actually doing the trading on top. So, in a perfect world, you’re not recognizing the transfer into the pool as a taxable event, you’re monitoring the trades and recognizing those on a block by block, day by day, or month by month basis. We build software to automate that, but you can do it yourself by just picking a time once a day to check your underlying asset balance in the liquidity pool, recording that in a spreadsheet, then having a column that tracks the relative deltas of the assets. Turning that into a trade can be simple for a 2 asset pool, perhaps more complex for a pool like Balancer, and you have to follow some rules around multi-asset trades.
In this way, you are essentially only recognizing the change to your holdings, not a full sale of all your deposited crypto. In fact, a similar discussion arises around WBTC and WETH – is the movement from ETH to WETH a sales and acquisition, or a containerization? Some tax professionals are ok with the containerized approach, some aren’t – so, talk to your tax person before you jump into this world!
FOR DeFi TRADING CONSIDER A CORPORATE CRYPTO ACCOUNT
Interestingly, in the eyes of the law, Corporations are afforded similar rights to natural living humans. Corporations have the right to transact, own assets, buy and sell property, and conduct business – as the business deems fit, as a legal person.
Corporations function under what is known as a corporate veil. This is an important distinction that separates the actions of the corporation from the actions of the business owners (shareholders) and it also affords protection to the shareholders from being liable for the corporation’s actions.
A Corporation has many of the same rights as a natural person and more rights than a natural person — under the age of majority (minors are not permitted to enter into legally binding contracts).
Suffice it to say, the legal status given to a corporate entity makes it a very powerful vehicle to conduct business and offers significant tax advantages and asset protection when compared to transacting as a natural person. Your tax professional can help you figure out how to maximized this option for your needs.
Yield Farming & ETH 2.0
What about staking and yield farming for tax purposes?
There are a lot of great articles about how to do taxes on mining revenue, and for the most part you can follow that guidance for staking and yield farming as well. Let’s take the above example – I want to deposit my SLP token and earn some SUSHI yield on that. Because you retain full control over those staked assets, and can remove them any time, you can really think of this as a bank account that’s earning interest. There is then the same debate about the staking rewards as there already exists about mining – namely, do you treat it as income immediately when it hits your wallet, or do you treat it as a zero-cost basis item, and only pay tax when you sell it. The more conservative treatment is to treat it as income as it hits your wallet (either looking at the balance in the staking contract or when you claim it) – your tax authority wants their money, and they want it now – deferring is usually a more aggressive stance. But, as always, talk to your tax professional. Your mileage might vary.
This applies to various forms of deposit contracts – Yearn / Harvest vaults, Compound / AAVE deposits, and other instruments that look and smell like interest-bearing accounts.
But, what about something tricky that I know everyone is thinking about – ETH 2.0 staking? Well, that is a lot more complicated. Because you can only deposit into the ETH 2.0 contract right now, and because there’s no concrete plan to enable withdrawals, and it’s up to a bunch of random people with GitHub screen names – this really feels like a non-callable loan. Like a loan to your sister-in-law, you can hope it gets repaid, but you shouldn’t be counting on it. Talk to your tax professional about how to treat it, but many tax professionals in the crypto space are saying not to recognize any of the ETH 2.0 staking rewards until you can actually claim them.
NFTs: THE SLIPPERY SLOPE OF THE DeFi SPACE
We’ve tackled liquidity pools, we’ve tackled staking and yield farming – how about NFTs? Well – this one is tricky. At a high level, they are an asset like anything else on the blockchain – you want to treat the acquisition of an NFT like other assets (see how we treat multi-asset transactions, for instance, if buying the NFT took some tokens, some WETH, and cost some fees).
But here’s where things get complicated – in the United States (and several other tax jurisdictions), collectibles are taxed differently than stocks and bonds. That is to say, they generally don’t have long term capital gains treatments. What does that mean for you?
Well, and I’m sounding like a broken record, but talk to your tax professional.
The treatment comes down to intent and use – did you buy a Steph Curry TopShot because he’s your favorite player and you loved the 3-pointer he was draining? That feels a lot like collecting. Were you putting money into a crypto bond to earn a yield? Not so much collecting (though, some crypto bonds have really pretty digital designs, which definitely starts to muddy the waters). It gets even more tricky if you’re a business that’s actively trading NFTs, that feels more like normal business operations rather than collecting, but boy does it get gray. Tax professionals are your friends in this chaos!
Finally, if you’re creating NFTs to sell, and selling them for a profit, that’s just like any other artist and you probably need to pay income taxes on them. My third cite below is a link to DeFi crypto experts to help you along your path.
There are some things I haven’t covered (like lending pools, how to record losses from hacks, and what to do about token vesting periods), but this should get you started down the path of paying your taxes. And please remember – pay your taxes and be honest with the IRS.
Usually, tax resistance is futile. If you decided to buck the system people receive letters from the IRS stating they owe funds. Also common: having 15% of their social security check or employment check garnished every month to pay the tax debt. More recently, with crypto IRS debt, if someone has a significant tax debt (over $50,000) they may not be allowed to renew their passport. The IRS knows crypto investors can move their fortunes easy without being detected.
Which brings us to the last taxing question: Do you know about tax havens?
There are roughly 195 countries in the world and almost 25% (45) of them are considered tax-havens. The more popular tax-havens most people are familiar with are the ones located on small tropical islands, such as the Cayman Islands, Bahamas, St. Martin, St. Lucia, Seychelles, Turks and Caicos, and Bermuda.
There are the lesser-known tax-havens located in key business hubs such as Hong Kong, Panama, and Singapore.
There are also tax havens in well-established and developed countries like Ireland, the United Kingdom, and the Netherlands.
Two jurisdictions worth mentioning for cryptocurrency enthusiasts are The Republic of Malta and Panama. They offer some interesting options for people. Research them.
You can now set up an offshore haven easily with the help of a new company, Korporatio. Blockchain is a perfect ‘use case’ for recording and storing incorporation filings and one such company that has taken this to task is Korporatio, which offers blockchain incorporation for various off-shore jurisdictions starting at just $1,000. Research them to learn about how to use the rules to favor yourself.
Again, here is the hyperlink for my crypto tax software.
The take home from the IRS: Don’t sell your crypto if you don’t have to because no taxes become due.
I buy my crypto by depositing USD in the Gemini/BlockFi exchange because they have the low transaction charges. Then I send the crypto assets to my wallet.
If you have smaller balances and want to Dollar cost average look to Swan Bitcoin: https://www.swanbitcoin.com/DrJackKruse
If you want the most yield for USD or BTC look here: https://platform.ledn.io/join/a02c7816be789573a80c8b513395b9fd
Want to earn a safe and easy passive income with your crypto purchases? Then try out Blockfi here: https://blockfi.com/?ref=34f06254
You can earn: % on your Bitcoin balance
8.6% dollars $USDT
CITES:
https://www.irs.gov/pub/irs-drop/n-14-21.pdf
https://gordonlawltd.com/1040-crypto-question/
The podcast, The DeFi Daily.