Understanding Cryptocurrency Taxation: What is Cryptocurrency Considered by IRS?

Introduction:

Cryptocurrency has gained immense popularity in recent years, but with this rise comes the need for understanding how it is treated by tax authorities. One of the most common questions surrounding cryptocurrency is how it is considered by the Internal Revenue Service (IRS). In this article, we will delve into the classification of cryptocurrency by the IRS, its tax implications, and provide answers to five frequently asked questions.

I. Classification of Cryptocurrency by IRS

1. Cryptocurrency as Property:

The IRS considers cryptocurrency to be property for tax purposes. This means that any gains or losses from the sale or exchange of cryptocurrency must be reported on a tax return. Similar to stocks and other investment properties, the IRS requires individuals to determine the fair market value of their cryptocurrency at the time of sale or exchange.

2. Taxation of Cryptocurrency Transactions:

When it comes to transactions involving cryptocurrency, the IRS classifies them into two main categories: capital gains and ordinary income.

a) Capital Gains: If an individual sells or exchanges cryptocurrency for a profit, it is considered a capital gain. The IRS requires individuals to calculate the capital gain or loss by subtracting the adjusted basis (the original cost plus any improvements) from the selling price. The capital gains tax rate depends on the individual's income and the holding period of the cryptocurrency.

b) Ordinary Income: In some cases, cryptocurrency transactions may be taxed as ordinary income. This includes receiving cryptocurrency as payment for goods or services, receiving cryptocurrency as a gift or inheritance, or disposing of cryptocurrency for a loss. The tax rate for ordinary income depends on the individual's income level.

II. Reporting Cryptocurrency on Tax Returns

1. Form 8949: When reporting cryptocurrency transactions on a tax return, individuals must use Form 8949. This form is used to report capital gains and losses from the sale or exchange of cryptocurrency. It requires individuals to provide details such as the date of acquisition, the date of disposal, the cost basis, and the sales price.

2. Schedule D: After completing Form 8949, individuals must transfer the information to Schedule D, which is used to calculate the capital gains or losses from all property transactions. Schedule D will also be used to determine the tax liability associated with these gains or losses.

III. Common Questions and Answers

1. Q: Do I need to report cryptocurrency transactions that result in a loss?

A: Yes, you must report all cryptocurrency transactions, including those that result in a loss. Reporting a loss can potentially offset capital gains and reduce your tax liability.

2. Q: Can I deduct the cost basis of my cryptocurrency on my tax return?

A: No, the cost basis of cryptocurrency is not deductible. It is used to calculate the capital gains or losses when you dispose of the cryptocurrency.

3. Q: How do I calculate the cost basis of my cryptocurrency?

A: The cost basis of cryptocurrency is generally determined by the fair market value at the time of acquisition. If you acquired the cryptocurrency through a mining operation, you must include the cost of electricity, labor, and other expenses in the cost basis.

4. Q: Are there any special tax rules for cryptocurrency held in a wallet?

A: No, there are no special tax rules for cryptocurrency held in a wallet. However, you must still report the transactions involving the cryptocurrency, regardless of whether it is stored in a wallet or not.

5. Q: Can I transfer cryptocurrency to another individual without reporting it?

A: No, you must report the transfer of cryptocurrency, even if it is done without a cash transaction. The IRS considers the transfer as a sale for tax purposes and requires the reporting of the transaction.

Conclusion:

Understanding how the IRS considers cryptocurrency is crucial for individuals who engage in transactions involving this digital asset. By recognizing cryptocurrency as property, the IRS has implemented tax rules that apply to capital gains and ordinary income. By answering five common questions, this article aims to provide clarity on cryptocurrency taxation and help individuals navigate the complexities associated with reporting their cryptocurrency transactions on their tax returns.