How it’s done: Most trading, through short selling, is done by acquiring cryptocurrency, selling it, and then repurchasing it quickly at a lower price. This obviously is only successful when the investor believes that the price of the crypto will fall quickly. Most acquire crypto inventory for short selling by borrowing it from a broker. Because it is difficult to find a broker willing to let you borrow it, what often happens is people accumulate cryptocurrency for themselves, and then do hedging to protect themselves from dips and rises in the market.
As opposed to short-selling, a “buy and hold” strategy can avoid the short-term volatility. Crypto has proven to have tremendous long-term potential for growth. Requires identifying which crypto assets are stable and will be around for the long term.
Example: Let’s say you owned a Bitcoin worth $1,000 and you believe that short-term volatility could impact their value. Rather than selling your bitcoins, you decide to hedge against them. You make a “bet” that the value of the bitcoin type you have will go down $100 in a month. If, after that month, the value goes down by $100, the value of your Bitcoin is $900, meaning you have a $100 unrealized loss. But, because you won your “bet”, you made a profit of $100, and that offsets that unrealized loss.
- Reporting: similar to stock, except with one major caveat: ease of reporting. As stocks are traded mainly through brokerage houses who have been dealing with tax reporting for decades, they have streamlined the process for investors, providing detailed Forms 1099 each year. You won’t see this with crypto trading. Crypto companies may provide transaction records, but this leaves it up to the investor to determine how to treat and report the transactions on the tax return.
- Capital Gain Treatment: The IRS issued Notice 2014-21 on March 25, 2014, which, for the first time, set forth the IRS position on the taxation of virtual currencies such as bitcoin. According to the notice, “Virtual currency is treated as property for U.S. federal tax purposes.” The notice further stated, “General tax principles that apply to property transactions apply to transactions using virtual currency.”
In other words, the IRS treats income or gains from the sale of a virtual currency as a capital asset that’s subject to either short-term or long-term capital gains tax rates if the asset is held for more than 12 months. If it’s held for more than 12 months, the asset is taxed at either:15% or 20% based on your adjusted gross income. The IRS increases the long-term capital gain tax percentages for taxpayers in higher income tax brackets. An additional 3.8% net investment income tax (NIIT) may also be applicable given a taxpayer’s adjusted gross income level; this is applied on short-term and long-term held virtual currency.
- Difficulty in Cost Basis Record-keeping: By treating bitcoin and other virtual currencies as property instead of currency, extensive record-keeping rules are imposed, and significant taxes may apply. For record keeping purposes, an individual’s cost basis is what they pay for the cryptocurrency, and the spread is taxable when they use or sell the cryptocurrency assuming it’s appreciated in value since purchase. If the value declined since purchase, then it’s a capital loss.
Staking and Lending
How it’s done: Your crypto currency isn’t just currency. It’s also an answer key. All crypto transactions occur on the internet. Just like with any other transaction, it must be recorded somewhere. With regular money transactions, your bank serves as the validator, making sure that it was you who actually made the purchases on your account. In cryptocurrency, there are people, called “miners,” who do the job of validation. One such group of miners is the Proof of Stake network.
Staking is a way of validating crypto transactions. If you are staking, you own coins but you don’t spend them. Instead, you lock the coins in a cryptocurrency wallet. A Proof of Stake network then uses your coins to validate transactions. You receive rewards for doing so. In essence, you are lending coins to the network. This allows the network to maintain its security and verify transactions. The reward you receive is similar to the interest a bank would pay you for a credit balance.
You can also choose to lend coins to other investors and generate interest on that loan. Many platforms facilitate crypto lending.
Tax Issues: Staking benefits create opportunities to recognize interest income, as well as lending. Thus, it must be considered in analyses of Net Investment Income tax, Interest expense limitation under section 163(j), and all other issues related to passive income.
How it’s done: Cryptocurrency mining is the process by which new cryptocurrency is entered into circulation; it is also the way that new transactions are confirmed by the network. “Mining” is performed using sophisticated hardware that solves an extremely complex computational math problem. The math problem is how the cryptocurrency is secured- think of it as a long, complicated password. Once the password is discovered (by a computer), the new currency is officially in circulation or the transaction becomes official. Miners essentially compete to find these passwords. The first computer to find the solution to the problem is given an award for verifying the currency and/or transaction.
To mine, you need technical expertise and upfront investment in specialized hardware.
Tax issues: Mining is a business enterprise. Thus, tax planning should be done similarly with any other business. A solo miner should report on a Schedule C, offset income with expenses related to the mining activity, as well as depreciate any assets used in the mining business. Mining requires high-powered computers that are able to perform demanding amounts of work at high speeds. Therefore, the cost outlay should be very high and present opportunities for bonus depreciation, section 179, etc.