The beginning of the 21st century was marked by the digital revolution. The trends of digitalization in the financial sector are becoming increasingly apparent. It is known that at one time, gold and silver coins were gradually replaced by paper money. Today, digital money has turned into a new challenge to the generally accepted traditions of money circulation and is turning into a purely conditional (virtual) reality and a key element of a virtual economy.
The Importance of Cryptocurrency Legalization and Taxation
Cryptocurrencies are a brand-new phenomenon of the 21st century, which has become a subject of research for both economists and political scientists. The history of the world’s first cryptocurrency began about 10 years ago, on October 31, 2008. A user named Satoshi Nakamoto published the white paper called “Bitcoin: A Peer-to-Peer Electronic Cash System,” in which he first described Bitcoin as a decentralized electronic payment system. Later, in January 2009, Nakamoto introduced software that launched the first blockchain network.
Now governments around the world are in a hurry to prepare bills that regulate cryptocurrencies since this is extremely important for the entire civilized world. However, very few scientific papers have been written on the subject of cryptocurrencies, which is rather strange, because nowadays the urgency of this issue is intense. In most cases, cryptocurrencies are examined through various economic paradigms or mathematical models, but there are very few such studies. More often there are works about tax regulation, which in most cases repeat each other. It is even more difficult to find a study that provides a full-fledged comparison of different crypto regulation policies by various governmental agencies. That is why the question of regulation of crypto is still open in most countries around the world.
Cryptocurrencies themselves were created on the beliefs of crypto-anarchism (a philosophical movement whose ideas are based on the principles of using strong cryptography to protect personal privacy and freedom). That is, crypto and blockchain — the heart of any cryptocurrency — were created to exclude all kinds of intermediaries, such as banks, states, as well as interbank payment systems (SWIFT). The code of any cryptocurrency is similar to the constitution, which cannot be violated. It is thanks to this “constitution” of cryptocurrency that we now have the money of a new generation (programmable capital). With the help of digital money, you can avoid problems such as account lock-out, capital theft, double withdrawal of funds from the account, long intercontinental transfers, and falsifications of banknotes. Moreover, cryptocurrencies and blockchain are able to completely eradicate corruption.
The U.S has the biggest crypto community, and the largest trading volumes on cryptocurrency exchanges are located on US trading floors. But in this country, there is literally no single regulatory system, since most states have their own cryptocurrency regulatory policies. Thus, Texas, Kansas, Tennessee, South Carolina, and Montana pursue a soft regulatory policy, trying not to harm the development of cryptocurrency, while New York, New Hampshire, Connecticut, Hawaii, Georgia, North Carolina, Washington, and New Mexico have a tough regulatory strategy. If we talk about the federal regulatory system, the reports of the FBI classify cryptocurrencies as “virtual currencies”, and the US Treasury Department includes cryptocurrencies to “decentralized virtual currencies”.
Regarding taxation, on March 25, 2014, the U.S. Internal Revenue Service published a guide with tax rules for cryptocurrency transactions. So, to pay federal taxes, cryptocurrency is equated to property. This means that when making a profit from a transaction with crypto as an investment tool, it is necessary to pay a tax on capital gains. Moreover, cryptocurrency derivatives (futures) are traded in the U.S. on the Chicago Options Exchange (CBOE) and on the Chicago Mercantile Exchange (CME). These trades received a green light from the Commodity Futures Trading Commission (CFTC). Also, the US Securities and Exchange Commission (SEC) from the end of 2017 launched a large-scale investigation regarding fraudulent ICOs (conducting projects for the initial placement of coins, a kind of crowdfunding). Moreover, this structure tested about 100 hedge funds associated with cryptocurrencies. It is worth noting that the US Treasury Department, led by Steve Mnuchin, as well as many other countries, claims that virtual money is often utilized to evade taxation, finance terrorism, and launder money.
Thus, in the U.S., the policy of regulating cryptocurrencies is carried out at the federal level, but in some states this policy is becoming more stringent, forcing many startups to move to foreign jurisdictions. Therefore, it is impossible to explain in which economic theory the United States generally acts with respect to cryptocurrencies.
Why do You Have to Pay Taxes on Crypto?
In July 2019, the IRS began sending letters to taxpayers related to virtual currency transactions. Those residents who have or plan to open a fintech and crypto business in the United States should be aware that each of them can receive a letter from the tax service reminding or notifying of tax evasion. Depending on the type of violation, the IRS sends out four types of letters in the prescribed form:
- Letter 6173 — A letter stating explicitly about non-payment of taxes on operations with virtual currency, which implies serious punishment and fines;
- Letter 6174 — An information letter that does not require an answer, but reminds the individual that it is possible that he or she has an account with virtual currency; the person may not know about the fulfillment of the requirements for it;
- Letter 6174a — A letter stating that the taxpayer reported foreign exchange transactions, but with a violation of the reporting procedure (for example, an error in the form of income: on capital gains or on entrepreneurial activity).
- Letter CP2000 — If you received this letter, it means that the IRS thinks you owe them money and suspects you of crypto tax evasion. It gives the recipients 30 days to reply.
It turns out that even with the slightest mistake in your tax return, a letter from the tax service will not take long to appear. And those who have just started their ICO activities may fall under the scrutiny of tax officials due to ignorance of the US legal framework.
The consequences of tax evasion on cryptocurrency transactions may be different. Depending on the amount and the form of a legal violation, the taxpayer may be subject to civil or criminal prosecution.
According to FATCA law, foreign banks are forced to submit reports on accounts of US residents, and the IRS has taken the initiative to track hidden offshore bank and brokerage accounts. The main task of the IRS is to reduce the activity of dysfunctional companies trying to hide income through offshore companies of third countries or use several foreign accounts to evade taxes.
Meanwhile, The GAO urged the IRS to provide more clarity on crypto taxes. Until this happens, other jurisdictions begin to introduce automated control over fintech projects and cryptocurrency exchanges. In September 2019, the Bank for International Settlements (BIS) introduced a project injecting automatic control of fintech and blockchain by reading DLT data. This innovation will affect both financial companies and cryptocurrency firms.
Saving Extra Money on Crypto Taxes
Even though you can’t avoid paying taxes on your crypto gains, you may have a chance to decrease your tax bill. And here are some hacks on how to do this.
Employ the Tax-Loss Harvesting Method
If the value of your assets in cryptocurrency has declined, then harvest losses to offset gains (when you sell your crypto with a lower value in order to realize losses) can be an excellent means to reduce your ultimate tax account. The collection of tax losses is not something dubious or new: it is absolutely legal to compensate for capital gains from capital losses. Therefore, if you are currently holding on to cryptocurrency, and its value has significantly declined, consider selling it to compensate for the profit made earlier in the tax year.
Be a Long-Term Investor
Since cryptocurrencies are usually regarded as property by the IRS, the rate of capital gains will be lower if you hold them for more than a year. Therefore, if you buy crypto and sell it in nine months, your capital gains tax rate will be more costly than if you traded it in thirteen months. Clearly, your profit or loss depends on the volatility of crypto. Sometimes, even after you pay your tax bill on short-term holdings, you are still left with gains. However, it is worth remembering that a reduced capital gains tax in the long run when you decide to buy/sell crypto.
Donating Your Crypto or Giving It as a Gift
Gifts or donations of a certain amount are tax-deductible: you can give away up to $ 15,000 per year. Although this may look like a radical method to reduce your tax bill, if you are willing to divide your capital with relatives and friends, giving gifts in crypto can be an unusual way to do it. Remember that the person you give crypto to will be required to pay taxes if in case of selling it or trading it into another crypto.
Hire a Tax Professional
A qualified CPA will unquestionably find a way to lower your tax bill. Although resorting to a CPA service might turn out to be quite an expensive move, it eventually pays off by saving you money on crypto taxes. Most crypto investors have no expertise in the taxation of digital assets, so it is a wise decision to hire an expert in this area.
Using a Reliable Crypto Tax Software
A professional crypto tax tool, such as ZenLedger, can be utilized to determine your tax liability. Since you need to determine the value in US dollars for each transaction you executed during the year, calculating your profit and loss manually can be a complicated and sometimes even impossible mission. Crypto tax software is designed to optimize and automate the calculation of taxes on transactions with cryptocurrencies. Both CPAs and individual investors can leverage it. Besides, ZenLedger works with all major exchanges.
Turn Crypto Losses into Tax Gains with ZenLedger
The ZenLedger tool can help any investor to harvest losses automatically. Our Tax Loss Harvesting Tool auto-fills IRS forms and was created exactly for the purpose of offsetting losses on crypto taxation. When you import transactions from all your exchanges and wallets, the tool detects all the possibilities for harvesting losses and ensures that your tax report is accurate and you will not have any issues with the IRS.
Use the tool in four simple steps:
- Open the tool — pick the “Tax Loss Harvesting” option and initiate the analysis of transactions;
- Review the results — open the Google Sheet in a new browser tab that contains unrealized losses;
- Realize the losses — sell crypto in a spreadsheet, thus realizing and harvesting losses;
- Redeem assets — redeem crypto via your chosen strategy to maintain asset allocation.
Final Word
Enormous progress in the development of digital technology contributes to the expansion of settlements using electronic money. But their purchase, trade, or usage to pay for goods and services creates taxable events.
Using ZenLedger software, residents of the U.S. and other countries can quickly calculate their income from cryptocurrency transactions. In particular, it is possible to import data from a number of major exchanges (Coinbase, Gemini, Circle, Poloniex, Bitstamp, Kraken, Bitfinex, etc.) and then transfer them to the most popular forms for the tax report. In addition to Bitcoin, ZenLedger also supports most other altcoins, including Ethereum, Bitcoin Cash, Litecoin, Dash, and many more.
Originally published at https://medium.com on June 1, 2020.
