Tax season has arrived. Here is what it means for crypto investors who rode the rollercoaster through last year's wild market.
- After a year of wild gains and volatile trading in crypto, it's time to pay the tax man.
- Insider spoke to two experts who broke down what investors can expect ahead of filing.
- Taxes paid on crypto are complicated but not impossibly so.
Tax season has arrived and crypto investors who went along for 2021's wild ride are likely starting to think about what it means for their portfolios.
As with other investments like stocks, if you bought any digital asset and held onto it, you don't have to do anything, said Charles Kolstad, a partner at law firm Withers who focuses on crypto assets and blockchains.
However, once you process a transaction, it immediately becomes a taxable event. This includes selling your crypto, exchanging it with one token to another, mining crypto, and earning interest on your asset, among other things.
And while the Internal Revenue Service has published a thorough list of 46 frequently asked questions on its website, the agency still lacks a detailed list of crypto transactions, said Olya Veramchuk, director of tax solutions at Lukka, a crypto-asset data and software provider.
"The current crypto guidance is so limited, it's always best for taxpayers to understand exactly what type of transactions they've engaged in and then try to analogize them into the existing framework," Veramchuk told Insider.
She explained that different kinds of transactions generate different types of taxes. For instance, selling a crypto asset may trigger capital gains tax, while more advanced activities from staking to yield farming might yield taxes on ordinary income.
Then there are gains from certain transactions that do not neatly fall under any particular category such as wrapping tokens, contributing to and withdrawing from liquidity pools, bridging multichain assets, among others, which she detailed in a blog post. This is why Veramchuk advises taxpayers to consult experts if they are unsure.
The IRS first released its guidance on virtual currencies in 2014, indicating that these must be treated as assets — not currency — for federal income tax purposes. Still, it was only in 2019 when the agency asked about crypto in a Schedule 1 form and only in 2020 when they placed the question prominently in form 1040, the documents US taxpayers use to file their annual income tax return.
Kolstad said he often gets asked whether the IRS is clamping down on these so-called "tax gaps," or the difference between what a taxpayer pays and what they owe. IRS Commissioner Charles Rettig in April 2021 estimated that the yearly tax gap could exceed $1 trillion.
"What I tell them is the IRS may be slow, but they're not stupid," Kolstad told Insider, referring to clients who ask him about the agency's perception of such gaps. "That's why they put it up on the front page so that nobody could say, 'oh, I didn't know.'"
He broke down three general types of income crypto investors need to know:
- Ordinary income - the returns on activities such as staking and mining
- Short term capital gains - assets held less than a year and are taxed at ordinary income rates
- Long term capital gains - assets held for more than a year and are taxed at reduced tax rates
Once you have identified your type of income, Veramchuk explained the different accounting methods you can use to calculate your capital gains or losses.
There is the "highest in, first out" (HIFO) method, which lets the investor sell the asset at the highest cost they bought it to reduce any capital gains. There's also the "first in, first out" (FIFO), which she said the IRS defaults to, as well as the "last in, first out" (LIFO) method, which takes the purchase of the most recently bought assset as the first to be expensed.
Taxpayers can use any method. What's important, she said, is the thoroughness of your record keeping.
"The crypto industry is anxiously awaiting the guidance from the IRS and the Treasury because the crypto ecosystem is growing so rapidly," Veramchuk said. "Many people would love to be as precise as possible in their reporting, but we need a more detailed framework."
In 2021, the total crypto market cap briefly topped a record $3 trillion, with bitcoin peaking near $69,000 to its all-time high in November.
Tax season kicked off on January 24 and closes on April 18 for most taxpayers.