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Cryptocurrency Guide

SOLVEDby TurboTax339Updated 2 weeks ago

What is cryptocurrency?

Cryptocurrency is a medium of exchange, which provides:

  • A common unit of value, so things with differing values can be traded without needing to barter
  • A way to put a value on something intangible, like a service, and  
  • A means of storing holding value

National governments typically have backed only their own fiat currency. Increasingly, governments are adopting CBDCs (see the Glossary of cryptocurrency terms section: fiat currency, CBDC).

Note: The IRS treats cryptocurrencies as properties for tax purposes.

All cryptocurrencies reside within a blockchain ecosystem, and can never reside anywhere else, like in a bank account. Contrast this with an online banking system’s money, which can be converted into hard currency and back, via ATM machines or bank tellers. A blockchain recordkeeping system has some potential benefits over a conventional central database regarding security, autonomy (meaning few or no intermediaries), transparency, and community consensus. 

Because cryptocurrency exists only in electronic format, it is a digital currency governed by rules determined entirely by consensus among a virtual (online) community's members. For example, bitcoin resides on the Bitcoin blockchain and ethereum resides on the Ethereum Classic blockchain. In practical terms, virtual currency and digital currency are used interchangeably.

Common cryptocurrency concepts and terms

This diagram may help to clarify some of the terms used with cryptocurrency and digital assets.

Image describing cryptocurrency digital assets

airdropFree distribution of a nominal number of coins or tokens to multiple users to foster adoption of a new virtual currency
altcoinAny cryptocurrency that is not bitcoin hence an “alternative coin”
API
Application Programming Interface: software enabling computers to work together. A language translator of sorts, for computers
bitcoin (cryptocurrency)The first cryptocurrency, which at time of writing, was still dominant in the broader crypto ecosystem
Bitcoin (network)The first blockchain
blockA data file containing of all transactions made and validated during a specific time frame. Each new validated block is placed first among all blocks on that network, and is linked to its predecessor, forming a blockchain
blockchainSee the preceding definition of block, and see the preceding Section: Cryptocurrency and digital assets
CBDCCentral bank digital currency is: regulated solely by a country’s central bank/treasury (not decentralized). It’s intended as a digital replica of the country’s traditional fiat currency, and isn't restricted in supply like most cryptocurrencies
cold walletAn offline cryptocurrency wallet or storage device for private keys. More secure but less convenient than an online hot wallet
consensus mechanismA progam used in blockchain systems to ensure data safety and integrity, and keep those with nefarious intentions locked out of distributed ledgers
cost basisA tax term for the dollar value of a property at time of possession. Transaction costs of obtaining e the property are included
cryptocurrencySee the preceding Section: Cryptocurrency and digital assets
cryptocurrency exchangeA platform where digital properties are bought, sold, and traded for fiat currency or other digital properties, somewhat like a conventional Dow Jones. Currently, Binance is the largest cryptocurrency exchange
decentralizedA decision-making and control model where a blockchain community's decisions are made by majority consensus among the blockchain's users. Unlike centralization, where a single entity has decision-making power and control
DAODecentralized Autonomous Organization: a “trustless” blockchain business model, governed by smart contracts, to avoid conventional “top down” organization structure and control
DeFiDecentralized Finance: uses smart contracts on peer-to-peer blockchain networks to enable a variety of tokenized lending, trading or borrowing services without a central financier (bank)
delegationUsers in the community who can’t meet minimum proof of stake mining requirements can stake a lesser amount of cryptocurrency, to earn some staking rewards (similar to earning interest) while the community delegates the validation work to a proof of stake miner
depositCryptocurrency sent to an account from an exchange, wallet, or custodian, often with a transaction (gas) fee charged by the blockchain network
digital assetsSee the preceding Section: Cryptocurrency and digital assets
digital currencySee the preceding Section: Cryptocurrency and digital assets
distributed ledgersShared databases that record information that is networked for many users in different locations to access
etherEther (ETH) is the native cryptocurrency of the Ethereum blockchain, currently ranked second after bitcoin in price and market value
fiat currencyA medium of exchange, store of value, and unit of account issued and backed by a national government’s finances, rather than by a physical commodity (such as gold)
forkAfter an update to a blockchain’s protocol, if some users don't agree to adopt the update, the blockchain is divided in two. See also hard fork and soft fork.
fungibleAll units are identical, as with a commodity or a currency.  A cryptocurrency (such as bitcoin) is fungible
gas feeStrictly speaking, a fee for transactional use of the Ethereum blockchain network. Other blockchains may use terms such as transaction or miner fees. In practice, the term gas fees sometimes gets used to generically refer to any such fees
hard forkA fork in which the old and new protocols are incompatible and users not adopting the update can’t interact with adopters. For example, bitcoin cash emerged from a Bitcoin hard fork
hot walletAn online wallet 
keyA long string of alphanumeric characters used for security in the blockchain ecosystem. See also public key and private key
miningA process for validating and securing pending cryptocurrency transactions (by paid third party virtual community users- miners) before being recorded on the blockchain. See also proof of stake and proof of work
mintingNon-fungible tokens are minted onto the blockchain by a creator who'll connect to an NFT marketplace, upload the token to their blockchain of choice using a creation widget, specify any royalties via smart contract, pay applicable fees, then hold the NFT, or list it for sale
mobile walletA wallet app installed on a smartphone. Mobile wallets are typically hot wallets
nodeA computer connected to a distributed blockchain network to serve various purposes such as validation of transactions, or observing activity on the blockchain
non-fungible token (NFT)A unique (thus non-fungible) token, for proving ownership of a digital asset like an artwork, recording, virtual real estate or pet image. The use of NFTs is broadening to include real world assets like event tickets and limited-edition wines. Buy and sell transactions occur on NFT marketplaces such as OpenSea
peer to peer (P2P)A decentralized network structure intended to work in the best interest of all parties involved, with no intermediary (bank or other institution) involvement
private keyEnables secure account access, and digital user ID for anonymous sign-in before performing any transaction, including “unlocking” of any cryptocurrency received
public addressShortened version of a user’s public key that can receive transactions, similar in purpose to a bank account number
public keyA key enabling sending of cryptocurrency to a recipient user when paired to the recipient’s private key
proof of stake miningA selected user will stake (ante up) a (usually) large amount of cryptocurrency for the right to validate and record a new block, and then receive a cryptocurrency staking reward, plus the return of their stake
proof of work miningMiners use massive computing and electricity resources, competing to be the first to solve an epically detailed arithmetic puzzle. The winner then validates and records the pending block, and is paid in cryptocurrency
smart contractAn agreement that is coded, stored, secured and executed on the blockchain, visibly and irreversibly. It basically replaces conventional paper-based documents and legal intermediaries (lawyers, courts)
soft forkA backwardly compatible blockchain software update. The new protocol can still “talk to” the  old one. So, upgraded network nodes can still communicate with non-upgraded nodes
software walletHolds a user's keys (public or private) and secures their cryptocurrency.  Typically an app on the user's desktop or mobile device, connected online
stablecoinA type of fungible token, combining the benefits of cryptocurrency with the stability of cash, efficiently and economically. Often pegged to a stable fiat currency, or, may be stabilized by other DeFi means. Tether is currently the dominant stablecoin
staking- delegationSee delegation
staking- validationSee proof of stake mining
store of valueAn asset that will likely keep its value over time, and can be reliably retrieved and exchanged in future, such as fiat currency, real estate, and rare metals such as gold and silver
tokenA digital asset governed by a smart contract, enabling the transfer and storing of value on a blockchain network. Can be either fungible or non-fungible
validationVerification and approval of a pending transaction by a user selected by the community, under the blockchain’s verification protocol
walletA device or service providing: storage for a user’s public and private keys, and an interface for crypto asset access

How is cryptocurrency taxed?

Note: In this section, for simplicity, the term “cryptocurrency” is used as a catch-all for cryptocurrency, digital currency, virtual currency, tokens, NFT’s, digital assets. For more info on these and other terms, see the section covering Digital Assets. For information on “digital assets” for IRS federal tax purposes, see Digital Assets.

Depending on the situation, cryptocurrency is taxed as:

  • Ordinary income, if for example, it earns a return for the holder from an income stream (similar to interest) or
  • A capital gain or loss from a sale of property after its value has increased or decreased
  • If merely bought and held, it’s not taxed until something is done with it, such as disposal

See the sections that follow for answers to common questions around cryptocurrency and how it is taxed.

Most any property with a lasting use or value, like a home, car, stocks and bonds or cryptocurrency, is a capital property. When an investment property (such as a cryptocurrency) is sold, a capital gain results if the sale proceeds are more than the cost of the property when acquired, plus any transaction costs. If the proceeds are less, it’s a capital loss. 

In the United States a capital gain or loss from a property held for:

  • One year or less is a short-term capital gain or loss
  • More than one year is a long-term capital gain or loss

Net long-term capital gain is: the long-term capital gains for the year less long-term capital losses including any unused long-term capital loss carried over from previous years.

Net capital gain is: the net long-term capital gain for the year less your net short-term capital loss for the year.

The tax rate applied to capital gains depends on one’s holding period (short or long term), taxable income, and filing status. Net short-term capital gains are taxed at the rate for ordinary income, and net long-term capital gains are taxed at specified rates. For 2023 tax rates, and also more info on capital gains, see A Guide to the Capital Gains Tax Rate: Short-term vs. Long-term Capital Gains Taxes.

The tax term for the cost of an investment property is cost basis. Like any investment property, the cost basis of cryptocurrency is the amount paid for it, including transaction fees, upon acquisition. Cryptocurrency can be received (and its cost basis established) in many ways. Some examples are when virtual currency is received: 

  • As payment for having provided goods or services to someone
  • As wages from employment services
  • For no consideration (free)
  • From NFT royalties
  • From an airdrop
  • From mining or staking
  • From swapping for a previously held cryptocurrency 
  • By purchasing it with fiat currency

A capital gain or loss will result from the disposal of cryptocurrency:

  • As payment for goods or services received
  • In exchange for cash
  • In exchange for a different cryptocurrency

Capital losses are first used to offset capital gains of the same type. Short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other kind of gain.

For example,

  • If one has $2,000 of short-term loss and only $1,000 of short-term gain, the net $1,000 short-term loss can be deducted against net long-term gain (assuming you have one)
  • If one has an overall net capital loss for the year, they can deduct up to $3,000 of that loss against other kinds of income, including salary and interest income
  • Any excess net capital loss can be carried over to future years, to be deducted against capital gains and against up to $3,000 of other kinds of income
  • If using married filing separate filing status, the annual net capital loss deduction limit is only $1,500

So, tracking and reporting these unused losses year to year for possible future use is important.

Having the correct cost basis is needed to determine the correct capital gain or loss amount, to report and pay the correct tax. So keeping records of all cryptocurrency deposits is really important.

Pitfall to avoid: a cryptocurrency can be moved from one virtual location (such as an exchange or wallet), to another location. The cost basis upon the initial acquisition is required for determining the correct capital gain or loss, if one needs to be reported at tax time. A subsequent wallet or exchange account (post-transfer) will likely not have a record of the initial cost upon the initial acquisition. 

Example:

  • Jean bought one ExampleCoin on the Binance exchange in year 1, for $100 cash
  • In year 2, Jean transferred the ExampleCoin to a Coinbase exchange, when the value of one ExampleCoin was $200. Transfer between accounts isn’t a taxable event
  • In year 3, Jean sells the ExampleCoin for $300
  • The year-end report that Jean receives from Coinbase lists a cost basis of $200 for the one unit of ExampleCoin that was sold (the value of the ExampleCoin when it arrived at Coinbase)
  • Jean uses only a report from Coinbase and calculates an INCORRECT capital gain of:
    • $300 proceeds less $200 cost basis = capital gain of $100
  • In fact, the CORRECT capital gain is:
    • $300 proceeds less $100 cost basis (original cost) = capital gain of $200

Jean may eventually receive an enquiry from the IRS, asking if the capital gain has been under-reported by $100. 

If one holds two tokens of a cryptocurrency that were acquired at different points in time, they will likely not have the same cost basis. If a token is sold, what cost basis amount is used to calculate the capital gain or loss? Is it the first token (known as first in, first out, FIFO), the last one (last in first out LIFO), an average of the two cost bases (average cost basis ACB), the highest cost token (highest in first out HIFO), or by picking one (specific identification)? 

The IRS allows specific identification. If specific identification isn't used, the IRS considers one to have used FIFO. Use of the same cost basis calculation method year-over-year is recommended so as to avoid double counting or missing any transactions.

As one's volume of disposal transactions increases, the required information gathering and calculations can become more daunting, exhausting and risky.

Using an automated cryptocurrency tax calculator is an option worth considering. One such option is described in the next section, What's Intelligent Tax Optimization?  

Review the following sections for more information about how each type of cryptocurrency is taxed.

Is cryptocurrency mining taxed?

Cryptocurrency compensation received from proof of work mining or proof of stake mining:

  • From a business-like activity, is taxable as Business Income
  • From nonbusiness activity, is taxable as Other Income

How's the reward from staking delegation taxed?

When a reward is received from staking delegation, the tax treatment depends on the type of reward. If the reward is for:

  • Additional tokens, it's taxed as ordinary income
  • An increase in the value of tokens already held, it's taxed as a capital gain

How's a hard fork taxed?

A hard fork, on its own, isn't a taxable event. If the hard fork is followed by receipt of new tokens, the tokens are taxable as ordinary income based on the fair market value at the time of receipt.

How's an airdrop taxed?

Tokens received from an airdrop are taxable as ordinary income based on the fair market value at the time of receipt.

How are decentralized finance (DeFi) arrangements taxed?

DeFi tries to mirror financial services like lending, borrowing, and earning interest, on a blockchain with no intermediary such as a bank. Existing ordinary income and capital gains rules can be applied to basic DeFi transactions. Tax treatment of more specialized DeFi arrangements can be reviewed at Decentralized Finance (DeFi) is red hot, but what are the tax issues?

How are decentralized autonomous organizations (DAO) transactions taxed?

A DAO may initially raise capital by receiving fiat currency (money) in exchange for its native token. It may invest in assets if there is consensus of approval.

When cryptocurrency is received from a DAO in exchange for goods or services, or via promotion upon a DAO launch, the cryptocurrency received will generally be taxed as income, similar to the general case when there's no DAO involved, say, as payment received for goods and services provided, or from air drops.

How are stablecoin and NFTs taxed?

In 2022, the IRS clarified its position: cryptocurrency, stablecoin, and NFTs, are all digital assets, subject to the same tax treatment. See Digital Assets for more information.

Yes, the following aren't taxable:

  • Cash purchase of cryptocurrency
  • Holding of cryptocurrency
  • Transfer of cryptocurrency between wallets
  • Receipt of cryptocurrency as a bonafide gift
  • Gifting of cryptocurrency within these limits:
    • Any gift amount under the $17,000 (2023) annual gift tax exclusion limit 
    • Any gift amount over $17,000 but under the $12.92 million (2023) cumulative lifetime exclusion limit
    • For more information see Instructions for Form 709
  • Donating cryptocurrency to a charitable organization
  • Cryptocurrency transactions within a tax-deferred or tax-free account

1099 forms in general are intended for disclosing non-employment income. Currently with cryptocurrency there can be inconsistency in how and when the forms are used, and the completeness and accuracy of the information they contain. Note: Regardless of whether one receives a 1099 form, one is required to accurately report all cryptocurrency income to the IRS. 

Form 1099-B is issued by traditional investment brokers and exchanges to report a client’s individual securities disposals and gains or losses. Beginning in tax year 2023, US-based crypto exchanges must collect tax reporting information from their customers so that they can send them (and the IRS) 1099 forms. 

Form 1099-B contains potentially useful information for reporting cryptocurrency disposals, including the cost basis. One must use caution; see the prior section Why's cost basis so important, and what pitfalls must be avoided?

Form 1099-K shows the gross total of all transactions, both taxable, and nontaxable, on a given platform. For income tax purposes, each transaction needs to be reported. 

Form 1099-K tracks income you receive, usually through credit cards or processors like PayPal, Venmo, Square, Etsy, Uber, or Ebay, for selling goods or providing services.

You should receive a 1099-K if you made over $20,000 from more than 200 transactions.

Form 1099-K tells the IRS and the cryptocurrency investor that there's been potentially taxable cryptocurrency activity during the year. Taxable cryptocurrency transactions must be reported on the investor’s tax return regardless of whether a 1099-K has been issued.

Form 1099-MISC is issued to indicate total miscellaneous income. It's used by some cryptocurrency platforms to indicate other income of more than $600, from cryptocurrency staking, rewards and other sources of income. It doesn't disclose individual income transactions and it has no information about gains or losses. The individual income transactions must be imported or uploaded into the tax return software to be reported as either: other income if not self-employed, or as self-employment income if self-employed.

There's no available tax deduction for losses from lost or stolen cryptocurrency.

How do I enter cryptocurrency in TurboTax?

Intelligent Tax Optimization (ITO) is a crypto aggregator within the TurboTax application. It helps make cryptocurrency tax filing easier.

ITO is able to:

  • Connect to exchanges and wallets, and import transactions and tax forms
  • Identify taxable transactions
  • Calculate the cost basis values for transactions
  • Make remediation (filling any information gaps) easier

Here are some articles that will help you enter your crypto transactions in TurboTax:

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