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8 Cryptocurrency Tax Nightmares and How To Avoid Them

Joel Anderson
·9 min read
eclipse_images / Getty Images
eclipse_images / Getty Images

You will owe taxes on any profits you might have made from cryptocurrency this year. You might be thinking to yourself at this point “No, that can’t be true. My friend Phil told me this was a sure-fire, no-risk way to double my money without owing any taxes.” Guess what? Phil is unreliable and no part of that is true.

See: Tesla Stock Drops as CEO Elon Musk’s Bitcoin Tweet Bites Back

But if you are murky on precisely what the tax implications of your side hustle trading cryptocurrency are, you’re not alone. And because plenty of people might not understand how taxes on their bitcoin or ethereum work, plenty of those same people are in the process of backing themselves into a cryptocurrency tax nightmare — the sort of bad dream where you’re giving a speech to a room full of bitcoin only to realize that your 1040 has been showing the whole time.

So, here’s a look at some of the potential cryptocurrency tax nightmares you can easily wander into and, more importantly, how you can be sure you avoid them.

Last updated: Feb. 25, 2021

An editorial stock photo of a studio shot of a Bitcoin with some IRS 1040 tax forms.
An editorial stock photo of a studio shot of a Bitcoin with some IRS 1040 tax forms.

How the IRS Treats Cryptocurrency

The most important thing to understand about the tax implications of cryptocurrency is that the IRS has designated all “virtual currency” as a form of property. So, for tax purposes, your bitcoin is more like a stock. If and when you sell your cryptocurrency, you will owe capital gains taxes on any profit. That means that you need to be able to state the “cost basis” for the cryptocurrency — i.e. what you paid for it — so you can determine how much value it gained while you owned it.

Read: Bitcoin’s Value Skyrockets to $1 Trillion as Price Hits $54,000

man upset with stock chart on computer screen
man upset with stock chart on computer screen

Nightmare No. 1: 'My God, How Do I Owe So Much Money?!'

You’ve been actively trading cryptocurrencies all year and you’ve done a pretty fine job for yourself. However, when you finish painstakingly entering your record of every transaction into your tax software, your bill is way higher than you were expecting. A big chunk of your profits just gotten eaten up by taxes — profits that you may or may not have already spent on a jet ski. Now you’re scrambling to cover a tax bill you just weren’t expecting.

Check Out: Bitcoin Is Pricey and Headed For a Crash – Consider These Smart Crypto Alternatives

person buying bitcoin transaction
person buying bitcoin transaction

How To Steer Clear

This is a similar problem faced by day traders who are moving in and out of stocks constantly. Capital gains — i.e., the money made from the investment — is only taxed at the lower, long-term capital gains rate if you’ve held the property for at least a year. If you’re moving in and out of different cryptocurrency positions without holding them for more than a week, it’s taxed as short-term capital gains and gets the same rate as any other income.

Economy Explained: How Does Cryptocurrency Work — and Is It Safe?

frustrated man with trading charts in background
frustrated man with trading charts in background

Nightmare No. 2: 'Should I Have Been Writing All This Down?'

You’re ready to report your taxes after a year when you unwound some major investments in cryptocurrency to help fund a down payment on your first house. However, when you get ready to report the income for your cryptocurrency, you realize that you’re not exactly sure how much money you made. You’ve been active in mining and trading cryptocurrency for years, so how do you know how much you “made” on the transaction?

Binance exchange app on smartphone for cryprocurrency trading
Binance exchange app on smartphone for cryprocurrency trading

How To Steer Clear

You need to keep careful track of each and every transaction you make involving cryptocurrency, noting the date, time and recording the fair market value (FMV) at that point. That’s because you need to know your “basis” — what you paid for it — to be able to determine what sort of profit — if any — you made while you held it. So, save yourself the hassle of having to try to scour the blockchain and crypto exchange records looking for the details on prices years ago by keeping meticulous records on any transaction, no matter how small.

The new US Federal Income Tax Forms for the tax year of 2018 to be filed in 2019.
The new US Federal Income Tax Forms for the tax year of 2018 to be filed in 2019.

Nightmare No. 3: 'Which Box on My 1040 Indicates I've Been Getting Paid in Bitcoin?'

Your boss insisted that paying her employees in cryptocurrency would be a huge PR coup for your hip startup firm, so your paychecks all came in the form of cryptocurrency transferred to your wallet. You thought it was a minor inconvenience at first, but now you’re on TurboTax and beginning to realize that it might be time for a new job. And that you’re really unclear on how to even figure out your taxable income for the year.

Other Issues: Tax Mistakes Everyone Makes — and How To Avoid Them

Financial Planning Accounting Report Spreadsheet Concept.
Financial Planning Accounting Report Spreadsheet Concept.

How To Steer Clear

Your boss’ decision to compensate you with cryptocurrency is legal, but it creates some complications for you. Namely, you need to be sure you have a clear record of the FMV of the cryptocurrency in question on the day your paycheck was processed for each and every pay cycle. That FMV is what you’ll report as your income.

That’s not all, though. Since the price of those bitcoins might change before you get a chance to cash them, be sure you’re also recording their value at that point as you’ll owe money on those capital gains, as well.

Young businessman on the phone.
Young businessman on the phone.

Nightmare No. 4: 'But I’ve Been Trading Cryptocurrency FOR Cryptocurrency. That Still Counts?!'

You’re more than ready to pay the taxes you owe on your cryptocurrency trading over the course of the year, but you assumed that exchanging one cryptocurrency for another one wouldn’t result in any taxes. Now, you’re visiting your accountant and she’s insisting that you do owe taxes on each and every transaction despite the fact that the money you “made” is already in another cryptocurrency

bitcoin and ethereum cryptocurrency coins
bitcoin and ethereum cryptocurrency coins

How To Steer Clear

It’s important to remember that, for tax purposes, exchanging one currency into another is technically you selling the old currency and then buying the new one. So, if you’re swapping $10,000 of ethereum for $10,000 in bitcoin — and the ethereum was originally purchased for $5,000 — you’ve realized the $5,000 capital gain on your ethereum investment and that’s taxable. You also need to note that $10,000 price for the bitcoin as it’s the basis for that investment if and when you sell it.

So, even though you never received any cash from the sale, you will owe taxes as if you did. So, avoid any rude surprises at tax time by tracking any swaps between coins carefully, noting your tax burden and setting aside any money you’ll need to pay it in a high-yield savings account.

pizza delivery guy
pizza delivery guy

Nightmare No. 5: 'I Spent All My Bitcoin on Pizza.'

You’ve been spending your currency wherever possible, taking full advantage of any and all local vendors who accept bitcoin — including your favorite local pizzeria. Since you didn’t want to deal with any additional cryptocurrency come tax time, you kept spending those virtual coins as fast as they were coming in. Now, you’re discovering you owe more in taxes than you realized and you’re stuck without any records.

Mark Cuban: Bitcoin Is Exactly Like the Dot Com Bubble

man eating pizza with headphones on computer
man eating pizza with headphones on computer

How To Steer Clear

Once again, because cryptocurrency isn’t really a currency in the eyes of the law, “spending” it is technically a property exchange in which you’re exchanging your cryptocurrency for goods and services. As such, the difference in the FMV between when you acquired it and when you “spent” it represents a realized capital gain (or loss). That involves you needing to have an FMV for when you “spent” the cryptocurrency and the FMV when you acquired it so that you can accurately record any gains created by your craving for the meat lovers combo meal.

So, even if you’re using your cryptocurrency in an actual transaction, you’ll want to record that FMV and keep it in your records.

A young mixed race Indian and Caucasian man, in his 20s, with long black hair, beard and mustache.
A young mixed race Indian and Caucasian man, in his 20s, with long black hair, beard and mustache.

Nightmare No. 6: 'I Only Need to Track the Transactions Where I Made Money, Right? RIGHT?!'

You kept careful track of each and every cryptocurrency transaction where you turned a profit, not wanting to avoid any taxes you might owe. But, come tax time, you’ve gotten back a massive tax bill for your cryptocurrency trading despite the fact that you actually took a sizable loss on the practice this year.

guy inputing financial record data into computer from tablet
guy inputing financial record data into computer from tablet

How To Steer Clear

Losing money on a sale of cryptocurrency might not mean you owe taxes on that specific deal, but you should be sure it makes its way into your records just the same. That’s because any realized capital losses can offset your capital gains elsewhere. If you sold any cryptocurrency at a loss, you’ll want to deduct it from your gains lest you appear to be much more successful in your trading to the IRS than you actually were.

girl looking in mail box for mail
girl looking in mail box for mail

Nightmare No. 7: 'It’s Almost March and I Still Haven’t Received My 1099s!'

After years of watching your bitcoin continuing to increase in value, you’ve finally made the determination that it’s time to sell. Or, rather, it was time to sell awhile ago, but you’re ready to admit you missed that window and still want to get what you can.

The only issue is that it’s nearly March and you still haven’t received your 1099 forms from the exchange you used to execute the sale. How are you supposed to file without them?

person recording financial transactions on tablet
person recording financial transactions on tablet

How To Steer Clear

Bad news, friend: there are no 1099s forthcoming. When it comes to virtual currency, you have to self-report any income. You might be lucky enough to have an exchange where they do opt to send you one as a service, but that’s unlikely. Coinbase, for instance, only provides a 1099 form to customers with at least $20,000 in profits and 200 transactions that year.

So don’t wait around for paperwork that you would expect from a stockbroker as the cryptocurrency world doesn’t operate that way. Keep careful records and self-report any and all income.

Programmer preparing mining rig with GPU.
Programmer preparing mining rig with GPU.

Nightmare No. 8: 'I’ve Been Mining Cryptocurrency for Years, How Do I Know What My Basis Is?'

You were out ahead of the crowd when it comes to cryptocurrency, turning your computer into a mining rig early and racking up tons of bitcoin before anyone had any idea what they were. Unfortunately, now that you’re trying to sell them for cash and collect your massive windfall, you’ve started getting some very concerning letters from the IRS about underreporting your income.

One man, sitting in his office next to the mining rig, using computer for mining bitcoin.
One man, sitting in his office next to the mining rig, using computer for mining bitcoin.

How To Steer Clear

Mining is somewhat unique to cryptocurrency, but the IRS has stated that any cryptocurrency you get from mining is includible income in the year that you receive it. As such, you need to keep track of the FMV of any cryptocurrency on the day that you mine it. You then need to include that in your taxable income for that year. That information will also be essential if and when you sell the cryptocurrency as it’s also the basis for your capital gains.

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This article originally appeared on GOBankingRates.com: 8 Cryptocurrency Tax Nightmares and How To Avoid Them