How is crypto taxed? Here’s what you need to know

Cryptocurrency is classified as property by the IRS. This means that crypto income and capital gains are taxable and crypto losses may be deductible.

Last year, many cryptocurrencies lost more than half of their value and major crypto exchanges – such as FTX – collapsed. The advantage is that you may be able to reduce your 2022 tax burden if you lost money in crypto.

CNBC Select spoke with Shehan Chandrasekera, head of tax strategy at CoinTracker, a crypto tax software company, about how cryptocurrency is taxed and what you need to know if your crypto exchange filed for bankruptcy.

Many of cryptocurrency’s most passionate advocates emphasize the decentralization of the blockchain, but it’s important to remember that the federal government keeps track of who earns how much when it comes to crypto and taxes.

“The biggest misconception in this space in general is that people think that crypto is invisible to the regulators. But that’s not the case,” says Chandrasekera. There is a permanent record of all your activity on the blockchain, and many crypto exchanges report to the IRS.

For the most part, the IRS treats crypto as an asset subject to its rules capital gains and losses, corresponding to shares. When you buy cryptocurrency or shares, the original purchase price of the asset becomes the cost basis. When you sell that asset, you are taxed based on the difference between the cost basis and the selling price.

Capital gains and capital losses are based on the net sum of all transactions in that year. If you sold five different assets for a total gain of $10,000 and three other assets for a total loss of $15,000, you have $5,000 in capital loss.

You can deduct up to $3,000 a year in capital losses from your taxable income and can be carried forward losses in excess of that annual limit to future years. For example, if you had $5,000 in capital losses in 2022, you can reduce your taxable income by $3,000 in 2022 and use the remaining $2,000 in losses to 2023.

Capital gains are taxed differently based on how long you hold an asset before selling. Short-term capital gains tax applies to assets you’ve held for a year or less, and long-term capital gains tax is calculated when you sell an asset after owning it for more than a year.

Your exact capital gains rate depends on several factors, but long-term capital gains are generally taxed at a lower rate than short-term gains. And you may not have to pay any capital gains tax at all, depending on your filing status and taxable income.

If you use digital currency for day-to-day transactions, you may want to seek help from a tax professional. For everyone else, tax software provided by companies like H&R Block, TurboTax, TaxSlayer can help you file taxes when you have taxable crypto transactions.

In most cases, capital gains and losses apply to your crypto transactions. However, there are cases where cryptocurrency is taxed as income, in which case it is subject to a marginal tax rate of up to 37% depending on your income level and filing status.

Below we examine how each type of crypto transaction is classified for tax purposes:

1. Sale of cryptocurrency (capital gains)

Every time you sell cryptocurrency, the gain or loss in value has tax consequences. These types of transactions tend to be straightforward, especially if you don’t often buy and sell crypto, and are classified under capital gains.

2. Exchanging one cryptocurrency for another (capital gains)

A crypto exchange is when you directly exchange one cryptocurrency for another without exchanging crypto for cash.

Chandrasekera points out that many people mistakenly overlook these types of transactions when it comes to taxes because no cash was realized. However, if you exchange Bitcoin for Litecoin or Ethereum for Bitcoin, it is a taxable event.

3. Use of crypto for goods or services (capital gains)

Using crypto to buy goods or services has the same tax implications as selling it. “It could be as little as going to Starbucks and spending a fraction of a Bitcoin to buy something, and that could result in a taxable gain,” says Chandrasekera.

When you buy something with crypto, the taxable gain or loss is based on what you paid for the cryptocurrency and its value at the time of the transaction.

4. When you earn cryptocurrency (income)

When you earn cryptocurrency it is considered taxable income based on the value of the coins at the time of receipt. This includes crypto earned from activities such as:

• Mining of cryptocurrencies
• Crypto stake income
• Returns on crypto accounts
• Crypto earned as regular salary or bonuses

5. Anytime You Receive Free Coins (Income)

There are cases where you can receive free crypto and the value of the digital coins you receive is considered income.

Two common scenarios where you can receive free crypto are airdrops and hard forks. An airdrop is when cryptocurrencies are given away for free and it is usually used as a marketing tool for new cryptocurrencies.

A hard fork is a bit more complicated, but to put it simply, it’s essentially when a cryptocurrency splits into two types of tokens or coins. When this happens, you will have your original coin and a new coin, with a separate value. The value of the cryptocurrency you receive from a hard fork is taxable income.

Last year, a crash in the crypto markets saw a number of crypto firms declare bankruptcy – most notably FTX, which at its peak was valued at $32 billion.

Stay tuned for CNBC Select’s in-depth coverage of personal economy, technology and tools, wellbeing and more, and follow us on Facebook, Instagram and Twitter to keep up-to-date.