While some people may think otherwise, cryptocurrency is considered an asset. Just like any other asset, it's subjected to taxes. However, since the first crypto hasn't been around for over 20 years, tax administrators have yet to properly disclose information on the rules and regulations when it comes to filing cryptocurrency taxes.
Does it count as capital gains? Should you count it as income? Do you include crypto tokens you received for free? These are some of the questions that remain unanswered.
While the process is still unclear, you can't evade taxes on cryptocurrencies either. For that reason, this guide will go over five common mistakes that you must avoid when filing for crypto taxes.
1. Forgetting About Free Crypto
If you've been dealing with cryptocurrencies like Bitcoin (BTC) for a while now, you're probably aware of the different ways to legally earn free crypto. A few examples include bounties, hard forks, and airdrops. These free cryptos are usually available whenever companies distribute them to the masses to gain traction. Since they’re practically free, most people forget about them when reporting taxes, but that's a mistake.
While there's no clear process on cryptocurrency tax reporting in general, the American Bar Association has made a proposal for tax administrators on how to deal with these types of crypto:
• Free cryptos received due to an action (e.g., registrations, share, referrals) should be considered income when calculating tax rates.
• Free cryptos received purely as gifts should be counted as capital gains.
Take note that ‘free crypto’ isn't limited to bounties and airdrops; there are many other types of cryptos that belong to this category. If you're interested in what types of cryptocurrencies should be included in your tax reports, there are many online sources, like TaxBit, that tackle this subject quite intricately.
2. Not Filing Losses On Crypto Transactions
Everyone knows that profits from transactions involving cryptocurrencies must be taxed, but not many people know that the same applies to losses. Yes, if you suffered a loss due to uninformed crypto investment, you may include this in the tax reports. By doing so, you can claim losses on your current or future taxes.
Currently, the IRS allows investors to deduct up to USD$3,000 on their taxes. If your loss exceeds this amount, you can carry over the remainder for next year or the year after that.
According to https://digitalhoney.money/, taking advantage of losses is one of the many strategies that investors use to minimize losses and build their wealth.
3. Switching Between Different Accounting Methods
If your business dabbles with crypto trading, you must be aware of how capital gains are calculated when buying or selling an asset. You take the difference between the buying and selling prices, and you'll get the gain. While calculating your profit is simple, calculating taxes for cryptocurrencies like Bitcoin or Ethereum would be the opposite.
Currently, the Internal Revenue Service (IRS) allows two ways to calculate crypto taxes:
• First In First Out (FIFO)
• Last In First Out (LIFO)
Many businesses make the mistake of switching from one method to another, depending on which is most profitable. While it may indeed seem practical at first glance, it's not. In fact, it makes the process a lot more complicated, considering how different the two methods are. Hence, it's advisable to choose one accounting method and stick to it until the end.
4. Classifying All Crypto Transactions As Capital Gains
Profits that you earn from investments are typically considered capital gains. While it's certainly understandable why one would assume that all crypto transactions are classified as capital gains, it's only valid in some cases. To be precise, you can only count it as capital gains if the crypto resulted from trading.
If you obtained it in any other way, like crypto mining or as compensation for a job, you should count it as income. Regardless, by making this mistake, you're essentially screwing yourself over.
This is mainly because tax rates on capital gains are much higher than the income tax rate. For your reference, the income tax rate usually goes around 10%, while the capital gains tax rate is 15%.
And if you are mining Bitcoin or other cryptocurrencies, you may want to look into writing off the hardware and electricity costs as miner expenses.
5. Reporting Transactions In Only One Account
One of the many strategies for crypto investors is to use more than one exchange or platform. Doing so allows them to have more options, therefore increasing the chances of finding an ideal trade. If you're using this strategy, then chances are you already have a record of transferring crypto from one exchange wallet to another. The IRS often confuses this ‘transfer’ as a trade or disposal. Hence, they tend to tax these transfers despite not involving a profit nor a loss.
This often happens when the investor reports crypto transactions on only one of their accounts. By doing so, you're not making the IRS aware of your other exchange wallet. So, they don't consider the possibility that a transaction was a transfer instead of a trade or disposal. If you're going to file for your crypto taxes, make sure you fill them in with all the information, such as your other account.
Wrapping Up
People often make the mistake of thinking that cryptocurrency works just like any other asset. Unfortunately, it doesn't, and it most certainly isn't taxed the same way as other assets. Hence, they tend to fall into all these pitfalls that either drives them to suffer a loss or violate the rules and regulations of the IRS.
If your tax season is coming, make sure you know all the mistakes you need to avoid, ensuring smooth cryptocurrency taxation.
