People who profited from their cryptocurrency investments will have a new challenge to navigate soon: the IRS and taxes.

While real-world monetary authorities may be finding it hard to regulate cryptocurrencies, that does not stop tax authorities from scrutinizing and trying to tax people who made big gains from cryptocoin trading, investments, and dealings.

However anonymous the cryptocurrency market may be, if you’ve made profits from the big spikes in their valuations, then Uncle Sam may be knocking on your door soon to collect a significant share of your profits in the form of taxes.

IRS Wants to Tax Your Bitcoin Gains

One of the world’s largest cryptocurrency exchanges, Coinbase, was ordered by the IRS in late 2016 to hand over transaction-related data on more than 14,000 of its customers involved in buying, selling, sending or receiving more than $20,000 worth of bitcoins (BTC) between 2013 and 2015.

In February 2018, Coinbase disclosed that it has “notified a group of approximately 13,000 customers concerning a summons from the IRS regarding their Coinbase accounts." (For more, see IRS Orders Coinbase to Hand Over User Data.)

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The development has sent chills down the spines of hundreds of crypto traders, investors and users, who are now uncertain about their pending tax liabilities, in addition to any possible penalties, interest, and other charges linked to their past virtual currency transactions.

Under-reporting of Crypto Profits

Last month, a credit score service called Credit Karma reported that “fewer than 100 people have reported gains from cryptocurrency investments out of the 250,000 Americans who have already filed their federal tax returns this year.” (See more: Few People Have Reported Crypto Gains on Their Taxes So Far.)

The IRS seems to be tightening the grip to catch defaulters who are giving a miss to paying their taxes on such profits. Online forums like Reddit are abuzz with posts citing possible scenarios by worried investors about pending tax liabilities for their past dealings in cryptocoins, which may now leave them poorer.

"For Americans, there is no free lunch. If you're richer tomorrow than you were today, it is likely you have some tax burden associated with that," Ryan Losi, a certified public accountant and the executive vice president of Virginia accounting firm PIASCIK, told CNBC.

IRS Eyes Cryptocurrency Deals

In 2014, the IRS issued clear instructions that it considers virtual currency as “property” for federal tax purposes. The cryptocurrency holdings are “NOT treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes.”

Essentially, any dealings an individual makes in tokens like bitcoins – like buying/selling bitcoins using fiat currencies, or receiving them in exchange of goods and services, or paying for a coffee or a laptop in bitcoins – will constitute a taxable transaction. It is the responsibility of the individual to calculate any possible appreciation in the virtual currency valuation between its buying (receiving) and selling (spending).

Possible Tax Rates and Other Expenses

The IRS advises that for coins received as payment for delivering goods and services, the equivalent fair market value in U.S. dollars should be used in computing the gross income of the recipient.

Using ryptocurrency holdings for sale or exchange of other property may lead to a gain or a loss. The IRS states that the “character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer.”

CNBC further adds that if you hold virtual currencies for less than a year, it will be taxed as ordinary income. However, if your holding period is more than a year, it will be taxed as capital gains which could attract a tax rate anywhere in the range of zero to 20 percent.

Add to it the various transaction fees for dealing in cryptocurrencies and the accounting fees, the total of taxes and associated expenses may rise to a high amount, leaving little net profits for the bravehearts who took the dive to invest in cryptocurrencies in the past.

If you are still holding your cryptocoins - that is, you have not sold/transferred any of them after buying/receiving, then there is no tax liability. The taxation triggers only when there is a sale/transfer leading to potential net profit/loss.

Taxation for Miners and Independents

The activity of mining cryptocurrency is considered a special case where a “self-employed” individual receives cryptocoins for his mining work. They are expected to report the fair market value in U.S. dollars of the coins as on the receipt day and it will be treated as gross income. If the mining “constitutes a trade or business,” the miner may be subject to pay self-employment tax.

Other independent workers or contractors who receive bitcoins for their work should treat it as a gross income, and pay self-employment taxes on the same.

Record Keeping

The brokers and exchanges providing cryptocurrency transaction services are currently not mandated to specifically provide tax reports to individuals for their trading activities. However, exchange like Coinbase do provide a “cost basis for taxes” report, which can be used to compute the net profit/loss.

In the end, the onus lies with the individual to maintain records and calculate and file their taxes. If you can't show that you bought a bitcoin for $5,000 in the past, your taxable holdings will be assumed to be of full value as per present day's valuation.

Penalty for Non-compliance

Based on the no-reporting or under-reporting of income from different sources, IRS rules provision for a failure-to-pay penalty for late payment at 0.5 percent of the unpaid tax amount per month, which starts from the month in which the tax amount was due. Though it is capped at a maximum of 25 percent of unpaid taxes, it is still a high figure.

On top of it, there is a second penalty which is for late filing. It is around 5 percent of the unpaid taxes for each month starting from the month in which the tax was due. 

Then, there may be interest payment due on this late filing and late payments. To avoid any possible penalties and charges, the IRS advises individuals, in general, to “file even if you can’t pay.”

Booking Losses in Crypto Deals

While majority of 2017 saw high valuations for cryptocoins, there are participants who bought at sky-high prices and ended up booking loses.

NY Times reports that similar to the tax rules for the stock market, cryptocurrency “ losses can be used to offset capital gains, subject to certain rules, and losses that are not used to offset gains can be deducted — up to $3,000 — from other kinds of income.” Tax rules allow for losses to be carry-forwarded to future years.

Donating Bitcoins to Reduce Tax Liabilities?

A donor-advised fund like Fidelity Charitable received around $22 million last year in bitcoins. Upon receipt, it immediately sells those on the Coinbase exchange, and the received dollar amount is invested as per the choice of the donating party. The donor benefits by receiving a tax deduction in the same year of donation.

However, scenario is a bit hazy with respect to cryptocoin donations, as the rules state that only individuals who itemize their tax returns qualify to deduct their charitable contributions. The new tax code makes way for a lower number of individuals itemizing their items, which indicates that cryptocurrency donations may not allow for any reduction in tax liability in future.

The Bottom Line

A bi-partisan bill called the Cryptocurrency Tax Fairness Act was presented in the Congress in late 2017, which proposes to tax-exempt up to $600 worth of bitcoin transactions. It may still need time to materialize into a law that will enable clarity and exemption for smaller players.

With the recent detail-seeking action by the IRS on Coinbase customers, the tax-collection ball has started to roll. Though questions are being raised about such actions being a breach of privacy, which is the intrinsic feature of the anonymous and decentralized cryptocurrency world, taxation is a necessary evil. The sooner the authorities draft clear rules around cryptocurrency taxation, the better it will be for all parties. (For more, see Bitcoin Tax Guide: An Introduction.)

Investing in cryptocurrencies and other Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns no cryptocurrencies.