7 Common Crypto Tax Misconceptions

With just over a week until the 2021 US tax deadline, it’s time to finalize your return and ensure that any crypto activity is accurately reported. Although the IRS has relatively little guidance on cryptocurrency taxation from the first page of Form 1040, the agency is keeping an eye on cryptocurrencies. Therefore, complying with the existing standards will reduce the likelihood that you will be penalized later.

To help you avoid rookie mistakes, here are some common tax myths, along with the facts to help you file your taxes correctly.

Myth 1: Cryptocurrency is money

The rationale for crypto taxes boils down to one fact: The IRS treats cryptocurrency as property, not currency. This means that cryptocurrencies — virtual assets that facilitate the exchange of value — are more like a house than cash. This treatment has given rise to confusing property tax rules and the “all caps” term you may have seen on Twitter — capital gains.

There are two categories of tax treatment related to cryptocurrencies: (1) income and (2) capital gains or losses.

Income sources include mining, staking, airdrops, and forks. This income is denominated in USD on the date it is received and is taxed at ordinary rates (i.e. your "normal" W2 income).

Cryptocurrency, on the other hand, includes capital gains, which are realized when you sell, trade, or spend your cryptocurrency. Buying cryptocurrency on an exchange is tax-free—it’s only when the substance of that currency changes through a sale, trade, or spending that the IRS comes after you.

Myth 2: Long-term capital gains are not taxed

Here is a simplified explanation of capital gains:

Capital gain (loss) = USD value of cryptocurrency at time of disposal - USD value of cryptocurrency at time of acquisition

Acquiring "value" refers to the cost basis of the money, or how much you spent to acquire it. There is a subtle difference between short-term (<12 months) and long-term (>12 months) capital gains. The former are still taxed at ordinary rates, while the latter are taxed at preferential rates. This means there are benefits to holding an asset for at least a year, but you will still pay tax.

Myth 3: Staking rewards are not taxable

The crypto tax community has been abuzz after a couple sued the IRS for taxing their Tezos staking rewards, and the agency offered them a refund. The plaintiffs argued that their staking rewards were akin to a stock split and were “newly created property” that was not taxable.

Unfortunately, the proposed refund doesn't make much sense because it doesn't set a precedent. If you earn staking rewards by delegating to a validator, or if you earn commissions as a validator, those staking rewards are still taxable. How taxable they are is debatable (you can take a conservative or aggressive tax stance), so it depends on your risk appetite.

To be safe, I recommend treating all staking rewards as regular income. Most token tracking software will have a “treat rewards as income?” option so you can always turn it off if guidelines change.

Myth 4: NFTs are not taxable

2021 is the peak of NFT craze, but many collectors will be surprised when it comes to tax policy. Because purchasing NFTs with cryptocurrency is considered a taxable activity and capital gains rules apply. The same situation will be triggered when selling or exchanging NFTs - you can only avoid NFT tax if you (1) donate the NFT, (2) purchase it with fiat currency, (3) mint it, or (4) give it away (up to $15,000).

Although NFTs are considered Web3 collectibles, they are not yet subject to the rules for “real world” collectibles. Collectibles held for more than a year can be taxed at rates as high as 28%, above the highest capital gains bracket (collectibles held for less than a year are taxed at ordinary rates).

The IRS specifically mentions “coins and works of art” in the collectibles section of the IRC, so expect more clarification once the IRS figures out what an NFT is.

Myth 5: Wash sale rules apply to cryptocurrencies

As Fidelity explains: "The 'wash sale' rules prohibit the sale of an investment at a loss and its replacement with an identical or 'substantially identical' investment within 30 days before or after the sale."

While wash sales typically apply to stocks and securities, cryptocurrency is considered property for tax purposes, meaning this old-school rule does not apply. This means that, technically, you can buy and sell as often as you can to maximize your losses. While taxpayers are limited to a maximum of $3,000 in losses, any excess losses can be carried forward and used to offset future gains from cryptocurrency and other capital assets.

Myth 6: Airdrops are not taxable

It seems like everyone got an ENS airdrop this year. While that seems great, the tax consequences are less so. If you claimed an airdrop in 2021, you earned an amount equal to the trading price on the day you claimed it multiplied by the amount of ENS you had. ENS launched at $43.44 and has since surged to a high of $83.40, so depending on when you claimed it, there will be a definite price tag.

Airdrops are a little tricky because even if you receive a random coin in your wallet, it is considered income and is subject to ordinary tax rates (assuming it has value). If you subsequently dispose of the airdropped asset, you will also be subject to capital gains tax.

To avoid airdrop tax evasion, check your wallet frequently to see if any new tokens magically appear. Taxes don’t kick in until you’re able to “transfer, sell, exchange, or otherwise deal in cryptocurrency,” so check if your exchange account supports the airdropped token. If not, don’t worry about recording income until pricing and market liquidity emerge.

Myth 7: Software can solve all problems

Software certainly helps, but it can’t cover every situation.

While technically all data is on the blockchain, it’s not always simple to extract the data and make it satisfactory. Ethereum-based transactions are easier because most crypto tax software is compatible with the EVM chain. However, if you’re trading on a less popular chain, the data may be sparse and difficult to process. Providers like CoinTracker or Koinly don’t support automatic integration for these assets, which require manual import due to their low transaction volume.

If you’re using a random sidechain, or pursuing multiple chains, it’s best to set up a comprehensive data plan so you’re not scrambling when April 17th rolls around. To avoid last-minute tax confusion, I recommend getting an automated token tracker as soon as possible, and setting aside time each month to review and manually add transactions if needed.

The above tips can help you screen your transactions to see which ones are taxable.