Who is paying attention in the middle of all this fun?
As we continue to hum along on our respective crypto journeys, the inevitable question of calculating and paying taxes is starting to pop up, like a sunflower during a cold winter... for some. But for the most of us quite expectedly.
There are many ways that the sphere participants might generate income. Every time we should be concerned with whether or not any tax is currently due. Below is my initial list and possible tax outcomes, if you think that something is not covered, do leave a comment, and I will surely address it in the future posts.
I’ve read and heard some doubts and uncertainty as to how it is all taxed, and wanted to put together this post as a guide and alert for those who would like to listen. Below are the current tax rules before we hear something new from the tax authorities or law makers. Disclaimer - this presentation is a quick, approximate, and to the point outline of a very complex body of law which US taxation has become. Please, be sure to consult your tax adviser for a proper interpretation of your individual circumstances and for a timely personalized advice as to what to do next.
The frame of reference
There are following relevant possibilities for the Federal taxation of various income (I am ignoring the states; the taxability should be the same for the most part but the rate may vary between zero and 13.3%):
“Ordinary income,” (OI) including interest income, is taxed at the rates between zero and 39.6%.
“Business income” (BI) is taxed at the same rates plus the self employment tax, an extra 13% on the first $125K (annually adjusted upward by about $7K or so) and 2.5% thereafter.
“Short term capital gains” (Shote) are taxed the same as OI.
“Long term capital gains” (Lote) are taxed between zero and 20%.
Additionally, some income above is subject to the “Obama Care” tax of 0.9% for BI and 3.8% for investment income (Shote, Lote, some of OI).
To put things in perspective, Lote is cheaper than Shote, on average by about 14%.
A couple of important concepts to lay out before proceeding.
One is the constructive receipt (CORE) doctrine. What it says is that as soon as you have access to the additional assets, - cryptocoins or dollar denominated credits that somehow accrued on your trading accounts, - as soon as they are available for withdrawal, it becomes your income. I’ve heard commentaries before that if one does not touch the assets or the money, there is no income to be recognized but this is not true.
A sporadic pursuit versus business motivated by profit making. If a person conducts an activity as a hobby, for personal enjoyment or interest, without a strong incentive or intention of making profit, then income from such activity is OI. If it is a trade or business, then it’s taxed as BI. Such a distinction can be quite difficult to make, and courts must often opine on the border line situations. Note, that if it is a hobby, then related expense deductions are only allowed to the extent they are higher than 2% of the taxpayer total income for the year, which is usually a very limiting threshold. We will call it a 2% threshold.
Zooming in
Here is the list of various ways of generating income in the cryptosphere:
1. Holding cryptocurrency as a long or short term investment.
When a cryptocoin is purchased for dollars, it acquires a “tax basis” equal to the purchase price. Later, when the coin is exchanged for another digital asset or is used to pay for services or any other non-digital asset, its value on that day, expressed in dollars, is the selling price. The difference between such price and the cost basis is either gain or loss, whatever the case may be. If the coin was held for at least one year and one day, then it’s Lote, if even a nano second less, then it’s a Shote. In both cases, related expense deductions are available, subject to the 2% threshold.
Example 1: Dr. Bittax purchased $1,000 worth of bitcoin. In one year and one day, the value rose to $10,000, and he decided to diversify into three other coins by trading all of that bitcoin for those coins. He recognizes the gain in the amount of $9,000, which is taxed as Lote. If he was not sufficiently patient, and did not wait that one extra minute, then he would have had a Shote and paid, on average, 14% more in taxes on that gain.
Please, do read my previous post Trapdoor Arithmetic. It describes a year end trap where in volatile markets it is not impossible to be trapped into selling one’s assets on the cheap in order to pay taxes. Thus, if you think that you are selling on top of a market, then consider hedging the diversification by converting some of it to USD.
2. Actively trade crypto assets on exchanges either using bots or manually or act as a dealer (buying in bulk directly from the coin issuers and selling the coins to the general public).
There is a mark to market election available. The election must be made in the beginning of a calendar year or if a new taxpayer (new business entity), when it comes to existence. If election is made, the expense deductions are available and not subject to limitations.
If no election, then the taxation is the same as in 1 above. There might be additional opportunities for dealers, so check with your tax pro, I might cover it in later posts as well.
Example 2: Dr. Bittax decided to trade some crypto. He set up a special exchange account for this, invested $1,000 and made a timely election. At the end of the year, the total value is $5,000. Because of the mark to market, he recognizes $4,000 ($5K less $1K) in OI. An advantage here is that all his expenses related to this trading are also deductible without imposition of the 2% threshold.
3. Mining coins by buying an expensive piece of hardware, earplugs, and an air conditioner or through less intrusive screensavers. Staking coins by keeping the wallets open day and night.
If the operation is run as a business, that is in a serious profit seeking manner, then the net income would have been subject to BI tax scheme, after all relevant expenses allowed full deduction. If it is more like a hobby, then OI, but expenses related to this activity can be deducted only subject to the 2% threshold.
Example 3: Dr. Bittax buys the accessories for hot and loud mining. He gives it his best and by the end of the year $3,000 is earned. Associated expenses are $1,000. The BI tax will apply on the $2,000. If instead he chose an elegant screensaver solution and hardly made any effort during the year, while still earning the same modest amount, then he is taxed at OI rates but could not deduct much of the associated expenses.
4. Lending coins to other coin holders, lending to smart websites that pay back.
Lending any crypto assets in any shape or form: via lending them to organizations to trade or to master node for staking in exchange for an interest, or “trading,” or “speculating,” - that would be taxed as an OI investment income. The same applies to buying “mining” contracts. With the only difference that you are allowed to recover your investment basis before any amounts are subject to tax on the profits. Related expense deductions are subject to the 2% threshold.
Please, keep a sharp eye on timing here, remember the CORE doctrine. As soon as the coins and/or accrued interest is available for withdrawal, that’s your money, - whether or not you take it out, - and the tax is due.
Example 4: Dr. Bittax bought an unlimited mining contract at a website for $1,000. By the end of the year, $1,500 was earned on the contract. He decided that it is a good deal and reinvested all the earnings before the end of the year in another such contract. He realized $500 in net income for that year from this activity.
5. Develop crypto personalities, post videos, blogs, affiliate links, forage for faucets and look for airdrops.
These activities shall be analyzed exactly like in 3 above. If it is a real business with perseverance and hopes for profits, then BI, if just a free time hobby-adventure, OI.
Example 5: Dr. Bittax receives a large, undisclosed amount as a tip for his sound advice and keen perspectives. Because most of his posts are directly related to his trade, he will include the proceeds into his income as a BI.
6. Look for accidental collisions, break into wallets, or engage in other unsavory activities in order to gain access to crypto assets and be able to spend them is NOT RECOMMENDED and HIGHLY ILLEGAL. However, it is still subject to tax under the same rules as 3 and 5 above. No examples will be given.
7. Issue your own token or coin in an ICO.
Very generally… When ICO is organized as a sale of a fresh crypto asset to the public with proceeds going directly to the company issuing it, such proceeds are included into income of the company. If, on the other hand, voluntary contributions are going to a non-profit foundation for further development of that wonderful new coin, then neither foundation nor issuing company pays any tax currently. Instead, the tax is paid when foundation may be paying the company for development and support of the project. This is outside the scope of this presentation, and we will eventually do a post focusing specifically on the ICOs’ tax results.
For personal investments (1,2, and 4 above) you can avoid any taxation by investing via your retirement plan. More about how to do it in the later posts.
I am hoping that the above presentation shed some light on the possible tax outcomes of various ways that people are profiting in the cryptosphere. If you found it useful, interesting, if you had any comments, questions or even disagreements, please post your comments.
