Regardless of your feelings towards them, taxes remain an integral aspect of daily life for the majority of people in today’s world. In particular, crypto tax policies have become an increasingly important issue as we witness the wider acceptance of crypto assets globally. The development of these policies has been a challenging process as governments and tax authorities have continuously amended and updated the regulations that were initially established.

In 2011, the Internal Revenue Service (IRS) released some basic guidelines on the taxation of virtual currencies, but these did not specifically address all cryptocurrencies. It wasn’t until 2014 when the IRS would later state that digital currencies should be treated as property for tax purposes; meaning that gains and losses from cryptocurrency transactions must be reported on tax returns and are subject to capital gains tax.

Since then, tax authorities around the world have followed suit, with many countries, such as Canada, Australia, and the United Kingdom, adopting similar tax policies to the United States. Other countries, such as Germany and Switzerland, have installed their own policies in place; for example, they classify cryptocurrency as a currency, and it’s therefore subject to value-added tax (VAT).

As we’ve witnessed the crypto landscape evolve and become more complex over the years, so have tax policies. NFTs and DeFi have presented new challenges for tax authorities, as these new types of digital assets do not fit neatly into existing tax categories. These types of crypto transactions are often difficult to track and regulate, creating complex tax implications.

Over recent years, tax authorities have also been investigating the use of mass audit tools to track and monitor cryptocurrency transactions. These tools can scan the blockchain to link transactions across groups of wallets back to a KYC’d exchange, allowing tax authorities to identify and investigate potential tax evasion or money laundering on mass.

This has instigated many crypto investors to undergo the proper due diligence required to file their tax returns so that they don’t get caught out in the future. The fact that public, decentralized blockchains like Bitcoin and Ethereum keep an immutable transaction record of all past transactions makes it incredibly easy for tax authorities to audit past transactions en masse. If the technology is not there today, but gets developed in the future, mass audits of previous years will still occur and could catch those who did the wrong thing thinking they wouldn’t get caught.

It’s important to note that crypto tax policies and regulations can differ significantly between countries, so it’s crucial to consult your local tax authority or use online resources like CryptoTaxCalculator’s country guides for more detailed information.

Photo by Rodion Kutsaiev on Unsplash

In many tax jurisdictions, including the U.S, there are two main types of tax that you will come across when trading and investing in digital assets. These are Capital Gains Tax and Income Tax. Depending on your circumstances, you may have to pay Capital Gains Tax AND Income Tax for cryptocurrency transactions.

Capital Gains Tax Basics

Understanding capital gains tax is essential knowledge for managing your crypto portfolio and making sure you don’t overpay on tax, or end up in a sticky situation down the track.

If you’re thinking about selling your crypto and making some money, it’s good to know how much of your profit will go toward paying taxes. Understanding this can help you decide if or when you should sell certain cryptocurrencies in your portfolio to optimize for tax. Let’s take a look at the basics of capital gains tax on different crypto transactions.

In many tax jurisdictions, including the U.S.,nytime that you dispose of a cryptocurrency, either at a profit or loss, a capital gains tax event could be triggered. Let’s run through some scenarios.

1.Selling Crypto

To calculate your capital gains when you sell your cryptocurrency, you can simply subtract the cost basis from your capital proceeds. Consider the below example:

• You purchase 2 BTC for $40,000 (at a price of $20,000 for each BTC)
• 3 months later you sell your 2 BTC for $60,000 (at a price of $30,000 for each BTC).
• The capital gains from this transaction can be determined by first ascertaining your cost base and capital proceeds:
  • Cost base : $40,000
  • Capital proceeds: $60,000
  • Capital Gains = Capital proceeds - Cost basis = $60,000 - $40,000
• Therefore your capital gains equates to $20,000.

NOTE: if your cost basis exceeds your capital proceeds, then this will result in a capital loss.

2.Crypto to crypto trades:

This is similar to selling cryptocurrency, the only difference is that instead of receiving fiat currency (e.g. USD) in exchange for crypto, you receive another cryptocurrency. Consider the below example:

• You purchase 1 BTC for $15,000 and one month later you exchange this for 10 ETH valued at $25,000 (at the time of exchange).
  • Cost basis: $15,000
  • Capital proceeds: $25,000
  • Capital gain = Capital proceeds - Cost basis = $25,000 - $15,000
• Therefore your capital gains equates to $10,000

3.Purchasing items with crypto:

This is the exact equivalent to selling crypto. Consider the below example:

• You purchase 0.001 BTC for $10 and 3 months later, you use this 0.001 BTC to purchase a McDonald’s meal worth $15.
  • Cost basis: $10
  • Capital proceeds: $15
  • Capital gain = Capital proceeds - Cost basis = $15 - $10
• Therefore your capital gains equates to $5

4.Profits made from trading NFTs:

The tax treatment of NFTs follows the same principles as cryptocurrency. This means that NFTs are treated as Capital Gains Tax (CGT) assets, and therefore the following activities will trigger a taxable event:

• Selling NFTs in exchange for cryptocurrency
• Exchanging an NFT for another NFT

We will dive into further detail with NFT transactions in the next lesson.

Income Tax events

In certain scenarios, profits earned from cryptocurrency transactions may be subject to income tax as opposed to capital gains. In each of the transaction types below, any profits earned are generally taxed according to your income bracket’s tax rate.

1.Mining crypto:

The tax treatment of cryptocurrency mining can sometimes depend on whether you are mining crypto at an individual level (as a hobby - e.g., solo mining & mining pools) or if you are mining crypto as a business activity (e.g., self-employed or with a company).

• If you are mining as an individual hobbyist, then any rewards or crypto earned from mining will most likely be taxed at a personal income tax level.
• If you are mining as a business, your mined tokens will generally be taxed as business income and need to be reported on various business forms depending on your business structure.

Businesses should keep records of expenses such as electricity and equipment costs, as these could potentially be deducted from the taxable income.

2. Staking rewards and yield farming:

Both staking crypto and yield farming are quite similar in the sense that they generally involve depositing crypto into a protocol or smart contract and being rewarded in return. The rewards earned from staking or yield farming are akin to earning interest from a bank deposit and are therefore viewed as an income tax event. For example:

• Say you hold 10 ETH in an Ethereum staking pool.
• Your pool reaches a consensus and as a reward you receive 1 ETH valued at $2000.
• This $2000 worth of ETH is considered income and will be taxed accordingly as per your income tax bracket.
• If you decide to exchange your ETH in the future, you will pay Capital Gains Tax (in addition to the income tax you’ve already incurred) with the cost base being $2000, since that was the price of the ETH when your staking rewards were received.
  • For example, say you held onto that 1 ETH and it raised to a value of $3000, at which you decide to sell.
    • Cost basis: $2,000
    • Capital proceeds: $3,000
    • Capital gain = Capital proceeds - Cost basis = $3,000 - $2,000
  • Therefore your capital gains equates to $1,000

3. Airdrops:

An airdrop occurs when cryptocurrencies, blockchains or projects distribute a coin or token, often employed as a marketing mechanism to gain momentum in the early stages. Airdrops get treated as ordinary income at the fair market value of the tokens when you receive them.

Similar to staking rewards, if you decide to dispose of the tokens you received by airdrop at a later day, it is likely you may also have to pay capital gains tax on these tokens, with the cost basis being the value of the token when you received it.

Some tax jurisdictions see airdrops as capital acquisitions, with a cost basis of $0, which means that the airdropped tokens will not be subject to income tax but when sold, the entire proceeds will be classed as a capital gain.

4. Hard forks:

A hard fork occurs when there is a major update to a blockchain protocol that results in the creation of a new and separate blockchain; and therefore a new token.

For example, in 2017, Bitcoin was hard forked and Bitcoin Cash was born. Bitcoin Cash was designed to reach better scalability and higher transaction amounts per block compared to Bitcoin, by increasing the block size from 1MB to up to 32MB. However, since this required a significant change in the blockchain’s protocol, a new cryptocurrency ‘BCH’ was created.

Hard forks are subject to income tax at the fair market value when the tokens are received. For example:

• Say you hold 2 units of Bitcoin.
• A hard fork occurs, and as a result you now own 2 BTC (Bitcoin) and 2 BCH (Bitcoin Cash).
• At the time you received the 2 BCH, it had a market value of $10,000 total.
• The $10,000 will be subject to income taxes.
• If you decide to sell these 2 BCH tokens a few months later when they have accrued to a value of $50,000 combined you will incur Capital Gains Tax with a capital gain of $40,000 since your cost base for the 2 BCH sold was $10,000.

5. Salary paid in crypto:

Some businesses nowadays may compensate employees in the form of cryptocurrency. As expected, earnings paid in crypto are subject to income tax at the value of the crypto at the time it was received. If you then decide to sell your crypto at a later date, it may be subject to capital gains tax with the cost basis being the value of the tokens when you received it.

Non-Taxable Events:

There are certain cryptocurrency transactions which are typically viewed as non-taxable. These include:

• Buying crypto with fiat money (e.g., purchasing BTC with USD)
• Transferring crypto between different personally owned wallets/exchanges/accounts
• Donating crypto to an approved charity
• Rebrands of tokens (e.g., LEND —> AAVE)
• Staking deposits and withdrawals
• Taking out a crypto loan
• Putting crypto up as collateral

Be sure to check which transactions are treated as non-taxable with your local tax authority.