Bitcoin was created as a means to replace the current monetary system by simply quitting the old one. A new system that makes the old one obsolete. Permissionless, censorship-resistant, unconfiscatable – it provides true ownership to its holder.
While this new asset class was young and under the radar, financial authorities didn’t know about it or haven’t been incentivized to deal with it. Why would they start drafting policies around something that hasn’t yet been considered equal to money? While the market grew and this new asset class rose in popularity, so did the interest from regulators, especially because of the vast profit-making opportunity that caught their attention.
Be it as it may, while making a transition into this new monetary paradigm, exchanging fiat currencies for crypto and further crypto to crypto has started to be considered a taxable event. This could be seen as a sign of triumph in a sense that cryptocurrency has been recognized not only as a form of money but a totally diverse financial instrument.
This is why the rules and regulations behind cryptocurrency taxation are still changing and can vary significantly from state to state, with some still failing to recognize crypto as a revenue source for their government budget.
U.S. Leading The Way
China was one of the biggest cryptocurrency markets prior to 2017 with 80% of Bitcoin being traded in yuan. This was due to the popularity of Bitcoin mining in the Chinese provinces especially in the industrial areas where electricity was cheap. But since 2013, the government has made a continuous effort to restrict its citizens from being involved with the virtual currencies. They issued warnings, restricted trading activities, prohibited banks from offering services, and banned initial coin offerings. These measures have been effective. The People’s Bank of China reported that in 2017 it reduced yuan-based trading volume in Bitcoin to only 1%.
Even though the country has failed to recognize cryptocurrency as a legal tender and prohibited its banking system from accepting cryptocurrencies, its tax code recognizes income derived from trading cryptocurrencies.
This has been addressed in the official reply made by the (Chinese) State Administration of Taxation titled “Issues regarding Levy of Individual Income Tax on Individual Income Derived by Individuals from Virtual Currency Trading over the Internet”. It states that all profits made by the difference in purchasing and selling price would be a taxable income from the individual income tax, and would be paid under the category of “property transfer income”.
This deliberate clampdown from the Chinese government on one hand, and the culturally-driven capitalist interest on the other hand, has led to a rise in U.S. dominance over the cryptocurrency market. This is why the U.S. regulators have been more active and engaged in making policies that go into more detail and make distinctions both between digital asset types and level of participation in this digital economy, i.e. are you investing, trading, simply transferring, etc.
The U.S. has thus led the way in cryptocurrency regulation and policymaking, especially for tax purposes. The I.R.S notes that “the sale or other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences that could result in tax liability.”
For specific information, it is best advised to check the tax code of your local jurisdiction, but in general cryptocurrency, taxation works similarly to property taxation Capital gains tax is applicable so if the asset appreciates in value from the purchasing price, you are susceptible to taxation while if it depreciates in value from your purchasing price you might be eligible for a deduction.
There are several categories distinguished besides plain profit-making by buying and selling. Also, there is a specific way to calculate the actual price for which the asset was purchased or in other words – cost basis.
Calculating the cost basis can be done in two ways according to the IRS FAQ on Virtual Currency Transactions. The first one being first-in first-out (FIFO) means that the first coin that was purchased is the first coin counted for a sale. The second being the specific identification method (specific ID). This method implies that you are to identify which particular coin was used at the time of taxable transaction and disregards chronological order of entry.
Mining proceeds are distinguished between hobbyists and enthusiasts and professional mining companies and farms. There are certain criteria by which this distinction is made such as expertise, the manner in which the activities are carried, time and effort expended, and so on. In the first case, the income goes in line 21 of your Form 1040 Schedule 1, while in the second case income and expenses are declared in a Schedule C.
Forks and Airdrops are also considered a taxable event even though you potentially didn’t want to do anything with it, or didn’t know about it but still received a newly (hard) forked coin. The IRS specifies along the lines that “found” money is a taxable event, and the income realized is equal to the fair market value of the new cryptocurrency when it is received.
Gifts and donations alike are not taxed as such but are fairly more complicated to prove as by principle they should be tax-free. However, in reality, it is hard to say when a transaction is a gift unless it’s sent to a registered charity organization.
Payments are the most obvious form of taxable events and are straight forward to calculate. When using cryptocurrency to purchase goods and services, the gain and loss are equivalent to the difference between cost basis and fair market value at the date of disposition. This is still filled as capital gains tax but in the near future, it is expected to transition to VAT.
Transactions between exchanges for wallets you own aren’t taxable. This applies to all personal wallets and exchanges between custodians.
There are numerous problems in attempting to apply an old law principle to a new monetary model. For example, what distinguishes a transfer between personal wallets from a payment? Or why are you responsible to pay tax on a coin that one day all of sudden appeared in your wallet?
How to stay compliant
Even though the IRS is making attempts to collect data from major exchanges of its users to link user IDs to their respective wallets through KYC information, this is only one gateway and a domestic one at that. The crypto market is a global phenomenon and its reach doesn’t follow jurisdiction. This is why last year the IRS issued over 10,000 letters of tax notice for US citizens to declare their digital assets and made proceeds.
In order to stay compliant, the financial authorities such as the Internal Revenue Serves or other tax collection equivalent governmental bodies still rely on the honesty and self-interest of the taxpayer to report its cryptocurrency profits.
If you are an individual investor you might not be incentivized enough to stay compliant or include cryptocurrency in your tax return. But if you are a legal entity that exists to serve clients in the cryptocurrency market and operates for profit, you probably want to play by the book.
You might want to consult with your lawyer on the tax code of your jurisdictions and your accountant on the specifics of filing tax returns. For the tax reports to be submitted correctly, it is vital to keep track of all the transactions you’ve made. These can include investment, an internal transfer, a client deposit, a DeFi yield or a short-term trade.
Crypkit offers a solution to feed all of your various holdings into one user-friendly platform which helps you to stay on top of your financial investments.
With the rules and regulations still changing to accommodate the tax requirements of a specific country, one thing remains unchanged. Profit will always be taxable and the first ones that would have to comply are registered companies. This is why real-time tracking of your transactions will have you prepared and ready for every requirement.
The Crypkit platform offers advanced features for various asset and activity tracking. On top of tracking your crypto holding across exchanges and wallets, it also provides support for data generated by staking, lending, providing liquidity, and DeFi technology. It is suitable for fund managers, crypto-related start-ups, and businesses dealing with a large scale of transaction and/or investment operations.
The platform also allows you to bring your accountant, co-workers, or auditors on board to help facilitate record-keeping and staying compliant. This complies with not only the requirement of financial authorities but also with the standards of the asset management industry. In this way we are also staying compliant with the new trustless economy whose mantra can be summed up in – don’t trust, verify.
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Disclaimer: this article does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.