There are loads of different ways you can invest in future generations. But one of the fastest rising asset classes you may want to consider investing in is cryptocurrencies.
Cryptocurrencies (or “cryptos”) are digital currencies that are independent of central bankers and lawmakers. Over the course of the last decade, cryptos have exploded in value — making them an attractive way to invest financially.
They can also be a great way to invest in a child’s financial future, helping them build a nest egg.
But because regulators don’t treat crypto like cash, it’s also taxed differently. Before you enter into a crypto transaction, it’s important that you understand its tax implications.
This guide explains what types of crypto are taxable, how much crypto is taxed, and how to legally avoid paying taxes on crypto.
Do You Pay Taxes on Crypto?
When it comes to how cryptocurrencies are taxed, crypto investors run into a lot of conflicting advice. But the short answer is: yes, you do need to pay taxes on crypto.
Although the Internal Revenue Service (IRS) doesn’t recognize cryptos like Bitcoin (BTC) or Ethereum (ETH) as legal tender, they are considered a capital asset class. As a result, cryptos are taxed in the same way that loads of other asset classes and “property” types (excluding real estate) are.
Translation: in the eyes of the government, trading crypto is a lot like selling vintage cars or collectible coins that appreciate in value.
Whenever you make a gain on a cryptocurrency position, lose money on crypto, or earn crypto as payment for something, you need to report those changes to the IRS.
It’s important to note that the IRS is going to expect you to report all taxable income from crypto and virtual currency transactions whether you get a tax form from a cryptocurrency exchange or not.
Why do taxpayers need to know all of this?
Simply put, you need to know all of this because the IRS isn’t messing around when it comes to cryptocurrency taxes.
If you misunderstand your tax obligations and fail to report income when you sell crypto or get paid by somebody in crypto, the IRS could end up handing you some heavy penalties.
What Types of Crypto Transactions Are Taxable?
Taxes on crypto can be levied by the IRS in a couple of different ways. Generally speaking, the way you pay taxes on crypto depends on the type of transaction that’s taken place.
To help give you an idea of when and how you’ll be expected to report crypto transactions to the IRS, let’s quickly break down the most common crypto transactions and how they’re taxable.
Selling crypto for cash
The first type of crypto transaction that you’ll be expected to pay tax on is when you sell crypto for cash.
For tax purposes, the IRS considers cryptocurrency to be your property rather than a hard currency that you actually own.
As a result, anytime that you sell crypto back onto the market for traditional cash like US dollars (USD), this qualifies in the eyes of the IRS as you having realized your gain on that property. That means you have to pay tax on your crypto sale — just like any other capital gain.
That being said, it’s also important for you to know that the IRS will then tax those capital crypto gains you’re reported on in a different way based on how long it’s taken you to realize those crypto gains.
When selling cryptocurrency for cash, you have two capital gains taxes to consider: the short-term capital gains tax and the long-term capital gains tax.
A short-term capital gains tax applies if you’ve held on to one or more crypto coins for a period of 365 days or less. The IRS taxes short-term capital gains just like ordinary income — so the amount of tax you’ll pay on a short-term crypto sale will depend on your existing tax bracket status.
But let’s say you’ve had a crypto coin in a digital holding account for 366 days or longer. If you turn around and decide to sell that coin after the 12-month mark, your capital gain on that sale will count as a long-term capital gain.
These capital gains tax rates are a bit different from income tax rates — but we’ll break down exactly what those rates are and when they apply in just a minute.
It’s also worth noting that if your crypto sale generated a capital loss rather than a capital gain, that should help to reduce your crypto tax liability a little bit. For example, let’s say you bought six Bitcoins for $55,000 each. But when it comes time to sell those Bitcoins, the price has dropped to just $50,000.
You’ll then be able to report a loss of $15,000 on your tax return, which should ultimately help to lower your overall amount of tax due to the IRS.
All of this information needs to be reported on your individual income tax return (IRS Form 1040).
To make things simpler and ensure nothing is missed, the IRS recently added a section to Form 1040 to ask whether you’ve taken part in any crypto transactions during the most recent tax year for which you’re filing.
Paying for goods or services
Selling crypto for cash isn’t the only reason you’ll have to pay taxes on a crypto transaction. If you use crypto like normal cash, that transaction is going to be taxable, too.
For example, let’s say you bought a single Bitcoin for $100 a few years back. You’re pretty lucky because that Bitcoin could now be worth over $50,000. But you also want to treat yourself, so you decide to use that Bitcoin to purchase a new sports car.
In the eyes of the IRS, this transaction is going to qualify as a taxable event. This is because you have to dispose of your digital asset — which, in this case, is your Bitcoin.
That Bitcoin was originally worth $100, and your new asset (that fancy car) is worth $50,000. To the IRS, this transaction counts as a capital gain of $49,900.
This is a pretty big gain, and you need to report it on your taxes in the same way you’d report a crypto-for-cash sale: IRS Form 1040.
In most cases, this capital gain is probably going to generate some type of tax expense you’ll need to pay to the IRS.
Using crypto to buy more crypto
You also need to pay taxes on crypto transactions in which you use crypto to buy more crypto.
When you use one crypto to buy another, this is called “converting crypto.” For example, let’s say you use Ethereum to purchase a Bitcoin. Because you’ve gotten rid of one capital asset and acquired another one, the IRS counts this as a “disposition” of your crypto.
Again, that’s a taxable event.
Just like when you pay for goods or services using crypto, any transaction associated with converting crypto will be based on your capital gain. That could be a short-term gain taxed as normal income or a capital gain based on your particular gain and tax filing status.
Getting paid in crypto
If you get paid crypto by an employer, this acquisition is classed by the IRS as compensation. That means the amount you were paid for work will be taxed according to your normal income tax bracket.
Just like converting crypto or using crypto to pay for products, you need to report crypto compensation using your normal IRS tax return.
How Much is Crypto Taxed?
As we’ve already touched on, how much the IRS taxes crypto depends on the transaction type and how long you hold onto that crypto.
First, let’s cover short-term capital gains. If you held on to a crypto coin for 12 months or less, the capital gain (or loss) you realized over that period would be taxed as ordinary income. That means your income tax rate will decide how much tax you pay on the transaction.
If you submit your annual tax return as a single filer in 2022, that means you can expect to pay:
- 10% for any gains of up to $10,275
- 12% for any gains of $10,276 to $41,775
- 22% for any gains of $41,776 to $89,075
- 24% for any gains of $89,076 to $170,050
- 32% for any gains of $170,050 to $215,950
- 35%, for any gains of $215,951 to $539,900
- 37% for any gains of $539,901 or greater
If you and your spouse jointly file your taxes as a married couple, the caps work a bit differently. For the 2022 tax year, joint income tax return rates are:
- 10% for any gains of up to $20,550
- 12% for any gains of $20,551 to $83,550
- 22% for any gains of $83,551 to $178,150
- 24% for any gains of $178,151 to $340,100
- 32% for any gains of $340,101 to $431,900
- 35%, for any gains of $431,901 to $647,850
- 37% for any gains of $647,850 or greater
But that’s short-term gains we’re talking about here. You also need to consider long-term capital gains tax, which applies to all crypto assets you hold onto for more than a year.
Long-term capital gains tax rates are a lot simpler than normal income tax — and they’re normally a lot lower, too. You’ll either be taxed on your long-term capital gains at a rate of 0%, 15%, or 20%. The rate at which you’ll be taxed depends on how big your gain was.
For a single filer in 2021, you should expect to pay a tax rate of:
- 0% tax rate on any gains of up to $40,400
- 15% tax rate on any gains of $40,401 to $445,850
- 20% tax rate on any gains of over $445,850
The same rate applies to married couples filing separately. But if you joint file with your spouse, the capital gains thresholds are doubled.
At the end of the day, it’s critical you know this stuff. After all, before investing, you need to understand how much you’re going to be taxed on a transaction. You’ll then be able to enter into a transaction confident of both the long-term and short-term ramifications.
How Can You Avoid Paying Taxes on Crypto?
We’ve already mentioned that the IRS taxes most types of crypto transactions. But it’s also worth noting that there are a couple of scenarios in which you can legally avoid paying taxes on crypto transactions.
The first way you can avoid paying taxes on crypto is by gifting your assets to somebody else. But in this instance, you’ve got a couple of tax implications to consider.
If you’re the person lucky enough to be getting crypto as a gift, you won’t have to pay taxes on the crypto you receive — at least, not immediately. In being gifted an asset, you don’t have to pay taxes on that asset until you sell it.
But if you ultimately decide to exchange a crypto coin you’ve been gifted for real cash, you’ll need to pay tax on your capital gain. The cost basis of that gain will be decided upon by the worth of the coin when it was gifted to you.
The person who gives crypto to someone as a gift may need to pay a tax after transferring the crypto. As of 2022, The IRS allows you to gift crypto up to a value of $16,000 per person per year without having to pay taxes.
This is thanks to the IRS gift tax limit. But if your crypto gift exceeds $16,000 per recipient, you’re going to have to file a gift tax return (IRS Form 709).
You can also avoid paying taxes on crypto transactions if the transaction is part of a charitable donation.
You can give crypto directly to a 501(3) charitable organization and then claim charitable tax deductions on your tax return that are equal to the fair market value of your donated crypto assets.
Finally, you won’t get taxed for transferring crypto between different digital wallets that you own.
As long as your cryptocurrency transactions aren’t recorded by your crypto exchange or brokerage service as a disposition, the IRS should just view this as you moving your assets around instead of realizing gains.
To learn more about how crypto taxes apply to your specific situation, we recommend speaking to a tax professional.
At the end of the day, you need to report any gains or losses you make when you earn, sell, or use cryptocurrencies (even if your gain or loss isn’t material).
That means you need to do your homework and understand the short-term and long-term federal tax reporting responsibilities before you enter into a transaction. Fortunately, there are a few ways you can legally avoid paying taxes on crypto — such as thanks to the gift tax limit.
Are you ready to start investing in crypto for a loved one? Download EarlyBird today.