Cryptocurrencies, also known as virtual currencies, have gone mainstream. That’s for sure. For example, you can use bitcoin BTCUSD, -0.13% to buy a Tesla TSLA, +3.93% and to buy or pay for lots of other things. However, using cryptocurrencies has federal income tax implications. Here’s what you need to know at 2021 tax return time if you made crypto transactions last year.
Understand this: the IRS wants to know about your crypto transactions
The 2021 version of IRS Form 1040 asks if at any time during the year you received, sold, exchanged, or otherwise disposed of any financial interest in any virtual currency. If you did, you are supposed to check the “Yes” box. The fact that this question appears on page 1 of Form 1040, right below the lines for supplying basic information like your name and address, indicates that the IRS is serious about enforcing compliance with the applicable tax rules. Fair warning.
When to check the ‘Yes’ box on crypto transactions
The 2021 Form 1040 instructions clarify that virtual currency transactions for which you should check the “Yes” box include but are not limited to: (1) the receipt of virtual currency as payment for goods or services that you provided; (2) the receipt or transfer of virtual currency for free that does not qualify as a bona fide gift under the federal tax rules; (3) the receipt of new virtual currency as a result of mining and staking activities; (4) the receipt of virtual currency as a result of a hard fork; (5) an exchange of virtual currency for property, goods, or services; (6) an exchange/trade of virtual currency for another virtual currency; (7) a sale of virtual currency; and (8) any other disposition of a financial interest in virtual currency.
If in 2021 you disposed of any virtual currency that was held as a capital asset through a sale, exchange, or transfer, check the “Yes” box and use familiar IRS Form 8949 and Schedule D of Form 1040 to figure your capital gain or loss. See Examples 1 and 4 below.
If in 2021 you received any virtual currency as compensation for services, check the “Yes” box and report the income the same way as you would report other income of the same nature. See Example 3 below.
When to check the ‘No’ box on crypto transactions
You cannot leave the virtual currency transaction question unanswered. You must check either the “Yes” box or the “No” box.
A transaction involving virtual currency does not include holding virtual currency in a wallet or account, or the transfer of virtual currency from one wallet or account that you own or control to another that you own or control. If that’s all that happened last year, check the “No” box.
Also check the “No” box if your only virtual currency transactions in 2021 were purchases of virtual currency for real currency, including the use of real currency electronic platforms such as PayPal PYPL, -2.26%.
Key point: For more information on the federal tax treatment of virtual currency transactions, see these FAQs on the IRS website.
How to report crypto gains and losses on your 2021 Form 1040
Now for the meat of this column. Despite what the IRS says, let’s use the term cryptocurrency instead of virtual currency. Onward.
The IRS takes the position that cryptocurrency is “property” for federal income tax purposes. (Source: IRS Notice 2014-21.) That means you’re supposed to recognize and report taxable gain or loss whenever you exchange cryptocurrency for U.S. dollars, Euros, goods or services, real estate, a new Tesla, a different cryptocurrency, or whatever.
If you fail to report cryptocurrency transactions on your Form 1040 and get audited, you could face interest and penalties and even criminal prosecution in extreme cases.
To arrive at the federal income tax results of a cryptocurrency transaction, the first step is to calculate the fair market value (FMV), measured in U.S. dollars, of the cryptocurrency on the date you received it or paid it.
The current values of the most-popular cryptocurrencies are listed on exchanges, and I hope you kept track of what you did last year. For example, Bitcoin and a bevy of other cryptocurrencies are listed on the Coinbase COIN, -1.07% exchange. If you sold one bitcoin on 9/5/21, you should have received about $ 51,750, according to the Coinbase exchange. You might have actually received a little more or a little less. If you bought one bitcoin with U.S. dollars on 9/5/21, you should have paid about $ 51,750. You might have actually paid a little more or a little less. Your basis in the bitcoin for federal income tax purposes would be whatever you paid.
* You’ll have a tax gain if the FMV of what you receive in exchange for a cryptocurrency holding exceeds your tax basis in the cryptocurrency that you exchanged.
* You’ll have a tax loss if the FMV of what you receive is less than your basis.
Key point: Unless you’re in the business of trading cryptocurrencies, it’s hard to imagine that a cryptocurrency holding will be classified for federal income tax purposes as anything other than a capital asset — even if you used it to conduct business or personal transactions as opposed to holding it strictly for investment. Therefore, the taxable gain or loss from exchanging a cryptocurrency will almost always be a short-term capital gain or loss or a long-term gain or loss, depending on whether you held the cryptocurrency for at least a year and a day (long-term) or not (short-term) before using it in a transaction.
Tax treatment of crypto receipts
If you accept cryptocurrency as payment for something, you must determine the FMV of the cryptocurrency on the transaction date and then convert the deal into U.S. dollars. Then calculate your federal income tax results.
Example 1: Last year, you exchanged two bitcoins for a different cryptocurrency. On the date of the exchange, the FMV in U.S. dollars, of the new cryptocurrency that you received was $ 125,000. Your tax basis in the two bitcoins that you gave up was $ 95,000. You acquired the two bitcoins earlier in 2021. Your taxable gain on the exchange was $ 30,000 ($ 125,000 – $ 95,000). Report the $ 30,000 as a short-term capital gain on your 2021 Form 1040, using Form 8949 and Schedule D, because you owned the two bitcoins for less than a year and a day.
Example 2: Last year, you sold a vintage auto that you had restored to perfection for two bitcoins. On the date of sale, bitcoins were valued at $ 55,000 each, according to the Coinbase exchange. Your tax basis in the auto was $ 65,000. To report this transaction on your 2021 Form 1040, convert the two bitcoins that you received into U.S. dollars ($ 55,000 x 2) = $ 110,000. Your taxable gain on the sale is $ 45,000 ($ 110,000 – $ 65,000). Report the $ 45,000 as income or gain on your Form 1040. Assuming you’re not in the business of restoring vintage autos, you have a short-term or long-term capital gain, depending on how long you owned the auto. Report the gain on Form 8949 and Schedule D.
Tax treatment of crypto used in business transactions
If you receive cryptocurrency as payment in your business, the first step is to convert the payment into U.S dollars. Then follow the normal rules to determine the federal income tax results.
Example 3: You’re a self-employed professional. You operate your business as a single-member LLC that’s treated as a sole proprietorship for tax purposes. Last year, you accepted one bitcoin as payment from a major client. On the date of receipt, bitcoins were valued at $ 55,000 each, according to the Coinbase exchange. On your 2021 Schedule C, you should recognize $ 55,000 of taxable income for services rendered. Because you’re self-employed, the $ 55,000 is also subject to the dreaded self-employment tax.
If you use cryptocurrency to pay for a business expenditure, the first step is to convert the expenditure into U.S dollars. Then follow the normal rules to determine the federal income tax results.
Example 4: Last year, you used 1 bitcoin to buy tax-deductible supplies for your booming sole proprietorship business. On the date of the purchase, bitcoins were valued at $ 55,000 each. So, you have a 2021 business deduction of $ 55,000. Include the $ 55,000 as an expense on your 2021 Schedule C.
But there’s another piece to this transaction: the tax gain or loss from holding the bitcoin and then spending it. Say you bought the bitcoin in January of 2021 for only $ 31,000. So, you had a $ 24,000 taxable gain from appreciation in the value of the Bitcoin ($ 55,000 – $ 31,000). That $ 24,000 gain is a short-term capital gain —because you did not hold the bitcoin for more than one year. Report the gain on Form 8949 and Schedule D.
If you use cryptocurrency to pay employee wages, the FMV of the currency counts as wages subject to federal income tax withholding, FICA tax and FUTA tax. Like any other wages paid to employees, you must report the wages to the employee and to the IRS on Form W-2.
If you use cryptocurrency to pay an independent contractor for performing services for your business, the FMV of the currency is subject to self-employment tax for the contractor. You’re required to report the payment on Form 1099-NEC if payments to that contractor during the year amount to $ 600 or more.
As illustrated in Example 4, you may also have a tax gain or loss due to appreciation or decline in the value of the cryptocurrency during the time you held it before paying it out as to cover employee wages or services from an independent contractor. Because you’re not in the business of buying and selling cryptocurrencies, the gain and loss will be a short-term or long-term capital gain or capital loss, depending on how long you held the cryptocurrency. Report the gain or loss on Form 8949 and Schedule D.
Will your 2021 crypto transactions be reported on 1099s?
Maybe.
How is crypto reported on Form 1099-MISC?
Some cryptocurrency exchanges report gross income from crypto rewards or staking as “other income” on Form 1099-MISC. The 1099-MISC won’t report individual transactions from staking or rewards, just your total income from them. You should to report each transaction, as well as any other crypto transactions, on your Form 1040.
Key point: The IRS gets a copy of any 1099-MISC sent to you. So don’t assume you can just fly under the radar without detection.
How is crypto reported on Form 1099-K?
Form 1099-K reports the total value of cryptocurrencies that you bought, sold, or traded on the platform that handled the transactions. Form 1099-K is also known as a Payment Card or Third Party Network Transactions form. It’s commonly used by credit card companies and payment processors like PayPal to report payment transactions that were processed for third parties.
Form 1099-K is also used by some crypto exchanges to report receipts from crypto transactions — as in Examples 1, 2, and 3 above. However, Form 1099-K is typically sent only to U.S. taxpayers who made 200 or more transactions with a total volume of $ 20,000 or more. The amount reported on Form 1099-K does not equate to your tax gain or loss from crypto trading conducted on the reporting exchange. If you traded often, you could have a large trading volume reported on Form 1099-K, but only a relatively small net tax gain or loss.
Key point: The IRS gets a copy of any 1099-K sent to you, and the agency will therefore expect to see some crypto action on your Form 1040.
How is crypto reported on Form 1099-B?
Form 1099-B is mainly used by brokerage firms and barter exchanges to report capital gains and losses. Unlike Form 1099-MISC and Form 1099-K, Form 1099-B reports gains and losses from individual transactions. While each gain or loss is calculated separately, the brokerage firm will typically report consolidated numbers — for example your net short-term gain or loss amount. A few crypto exchanges issue Form 1099-B.
Key point: The IRS gets a copy of any 1099-B sent to you.
When you won’t get a 1099
If you simply made a payment last year using a cryptocurrency, as in Example 4 above, you won’t receive a Form 1099 for 2021. Form 1099, in any of its various flavors, is only issued if you receive a payment.
The bottom line
You may be unaware of the federal income tax implications of cryptocurrency transactions. But the IRS doesn’t usually accept ignorance as an excuse for failure to comply with tax rules.
Detailed records are essential for compliance. Your records should include: (1) when the cryptocurrency was received, (2) the currency’s FMV on the date you received it, (3) the currency’s FMV on the date you exchanged it (for U.S. dollars, a different cryptocurrency, or whatever), (4) the cryptocurrency trading exchange that you used to determine FMV, (5) and your purpose for holding the currency (business, investment or personal use).
With this information, you and/or your tax pro can determine the federal income tax consequences of your 2021 crypto transactions. Depending on where you live, there may be state income tax consequences too. Good luck with all this.
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