Understanding the basis tax implication of cryptocurrency transactions can help individuals avoid issue with the IRS. There are three common transaction cycles with cryptocurrency: a Purchase-Sell Cycle, a Payment-Sell Cycle, and a Purchase/Payment-Exchange Cycle. Each transaction cycle has its own tax implications that can be complicated. Below is a brief description of the tax implications at each step of each cycle.
In this cycle, a taxpayer uses traditional or a fiat currency to purchase cryptocurrency, they hold the cryptocurrency for a period, and then sells it for a traditional or fiat currency. This cycle is virtually identical to a traditional stock purchase, hold, and sell cycle. In this cycle, the purchase of the cryptocurrency is a non-taxable event, however, the cost of the cryptocurrency at the time of purchase becomes the taxpayer’s basis in the cryptocurrency.
The next step in the cycle is the sale of the cryptocurrency. The sales price is lowered by the taxpayer’s basis in the cryptocurrency. That difference is capital gain income. Depending on the length of time the taxpayer held the cryptocurrency, it is either short-term capital gains or loss (less than one year), or long-term capital gain or loss (more than one year).
In this cycle, a taxpayer receives cryptocurrency as payment for goods or services provided. In that step of the cycle, the cryptocurrency is treated by the participants in the transaction as currency, however, for tax purposes it is treated as receiving property. Here, the taxpayer is recognizing ordinary income equal to the value in US dollars of the cryptocurrency at the time it was received.
That value becomes the taxpayer’s basis in the cryptocurrency. Essentially, the US tax system treats this step as a taxpayer receiving US dollars for their goods or services and immediately purchasing the cryptocurrency. Once the taxpayer then decides to sell the cryptocurrency, that transaction is treated the same as the sell step in the Purchase-Sell Cycle.
This cycle has the same beginning as the two cycles described above. After the first step, the taxpayer is holding cryptocurrency with a tax basis. Instead of selling the cryptocurrency, the taxpayer exchanges it for something else (using cryptocurrency to purchase goods or services, including other cryptocurrencies). These exchanges are taxable events based on the current value of the cryptocurrency.
The US tax code treats these exchanges as if the taxpayer sold their cryptocurrency and immediately purchased the other item in the exchange. That means the exchange step of this cycle is treated as a sell of the cryptocurrency, with a capital gain or loss recognized, and a purchase of the other item. If that other item is property, the value of the cryptocurrency at the time of the exchange becomes the basis of that new property.
The descriptions above are the general tax treatment of the common types of cryptocurrency transactions. Other cryptocurrency transactions vary in their complexity and have serious tax implications. If you are unclear on the tax implications of a specific transaction, it is prudent to contact a tax lawyer from Pontius Tax Law to consult on the appropriate treatment.