Author’s Note: This piece is specifically designed for an audience that deals with cryptocurrency but needs to learn more about how to account for it. Here is the published piece.
The Internal Revenue Service (IRS) has made it clear that the sale of a digital asset for fiat currency (e.g., US Dollars) qualifies as a taxable event that must be reported. And because cryptocurrencies are considered digital assets for tax purposes, the same rules apply. As a result, the sale of cryptocurrency for fiat currency must be reported on tax documents, and any resulting gain or loss must be claimed. Gone are the days when tax regulators turned a blind eye to cryptocurrency investments and profits.
While the tax implications of selling cryptocurrency for fiat currency are now well established, the tax situation surrounding the exchange of one cryptocurrency for another is murkier. In this article, we will directly answer the question of whether trading one cryptocurrency for another is a taxable event, and we will also provide some additional information about the tax treatment of similar cryptocurrency activities. Let’s start with a quick summary before taking a closer look at how the IRS views cryptocurrency transactions generally and cryptocurrency-to-cryptocurrency exchanges more specifically.
Summary
The short answer is that exchanging one cryptocurrency for another cryptocurrency creates a taxable event and must be reported. However, not all crypto-to-crypto exchanges require you to pay taxes. Keep reading below to learn about the regulations governing crypto-to-crypto exchanges as well as the framework you can use to calculate your crypto-to-crypto exchange tax obligations.
IRS Guidance On The Tax Treatment Of Cryptocurrency-To-Cryptocurrency Exchanges
Tax Treatment Of Crypto Assets
Generally speaking, the IRS treats cryptocurrency assets like property rather than currency. In terms of tax treatment, cryptocurrency is most analogous to stocks and bonds. “Like these assets, the money you gain from crypto is taxed at different rates, either as capital gains or as income, depending on how you got your crypto and how long you held on to it.”
Before we get into the details of crypto-to-crypto exchanges, it is important to understand that not every crypto transaction is taxable. In order for a specific crypto transaction or activity to be taxable, a taxable event must occur. “A taxable event is any action or transaction that may result in taxes owed to the government.” So, in order to determine tax liability, crypto investors must first identify if a taxable event has occurred. If a taxable event occurred, then the investor must identify how the cryptocurrency was used in order to determine the amount of taxes owed.
What counts as a taxable event?
There are several kinds of cryptocurrency transactions that do not constitute a taxable event and, therefore, do not trigger tax liability. In general, the following types of crypto transactions are not taxed:
Buying crypto with cash and holding it: On its own, buying crypto with cash and holding it is not taxable because a taxable event has not occurred. Tax liability is only triggered when the crypto is sold or otherwise transferred, exchanged, or disposed of in a manner that creates a taxable event.
Donating crypto to a tax-exempt charity or non-profit organization: Donating crypto to a 501(c)(3) not-for-profit organization is tax deductible in most instances.
Receiving crypto as a gift: Crypto gifts are treated similarly to buying and holding crypto - tax liability generally does not come into play until the crypto is transferred, exchanged, or disposed of in a manner that creates a taxable event.
Giving crypto as a gift: Currently, with some rare exceptions, you can gift up to $16,000 worth of crypto per recipient without incurring any tax liability. While gifting crypto is often tax-free, it should be reported in most instances.
Transferring crypto to yourself: Businesses and active crypto investors generally have multiple wallets and/or crypto accounts. Luckily, you can transfer cryptocurrency to your other wallets and accounts without creating a taxable event. In fact, “you can transfer over your original cost basis and date acquired to continue tracking your potential tax impact for when you eventually sell.”
Unlike the crypto transactions listed above, many common types of crypto transactions do constitute a taxable event. Accordingly, the following type of crypto transactions do incur tax liability and should be reported to the IRS:
Receiving crypto as payment for work: If you are an employee or contractor that gets paid in crypto, you will almost certainly incur tax liability and must report all crypto payments on your taxes.
Receiving crypto as payment for goods or services: Companies and individuals that accept crypto payments for goods and services generally incur tax liability for those payments and must report them to the IRS.
Receiving crypto rewards for crypto mining: Receiving crypto mining rewards often constitutes a taxable event and triggers tax liability. Tax liability is determined by the fair market value of the rewards at the time they are earned.
Receiving staking rewards for crypto staking: Staking rewards are treated similarly to crypto mining rewards in that they are taxed, and tax liability is determined by the fair market value of the rewards at the time that they are earned.
Selling crypto for fiat currency: When crypto is sold for fiat currency, a taxable event has occurred, and any gains or losses must be reported.
Using crypto to pay for goods and services: As discussed earlier, the IRS treats crypto like property rather than currency for tax purposes. So if you pay for goods and/or services with crypto, the IRS treats the transaction similarly to other instances where property or assets are used as a form of payment. As a result, using crypto to pay for goods or services constitutes a taxable event, and any gains or losses must be reported. Determining fair market value of the crypto can become somewhat difficult due to the nature of this type of transaction.
Converting or exchanging one type of crypto for another (cryptocurrency-to-cryptocurrency exchanges): Exchanging one type of crypto for another is considered a taxable event and must be reported even if no fiat currency is involved in the transaction. In terms of tax treatment, it’s as if the first type of crypto was sold for USD, and then USD was used to purchase the second type of crypto.
Earning other crypto income, rewards, incentives, etc.: In addition to the taxable crypto transactions discussed above, there are also many other ways to trigger tax liability when dealing with crypto. Some common examples include earning interest from holding crypto, receiving crypto as a reward or incentive (e.g., referring a friend to a crypto company), receiving crypto via airdrop, and receiving crypto as a result of a hard fork.
Tax Treatment Of Cryptocurrency-To-Cryptocurrency Exchanges
How much do you owe on your taxes for cryptocurrency-to-cryptocurrency exchanges?
As discussed above, a cryptocurrency-to-cryptocurrency exchange constitutes a taxable event and creates a tax liability. However, the tax rate for crypto-to-crypto exchanges can vary depending on several additional factors, such as holding time and fair market value. As a result, “The amount of tax owed depends on how long you owned the asset and how much profit you took. If you own crypto for a year or more, you’ll owe long-term capital gains tax when you swap it.
You will pay short-term capital gains tax rates on exchanges of crypto assets you have owned for less than a year. You pay higher tax rates on short-term capital gains because they follow the same rate as ordinary income.”
When one type of crypto is exchanged for another type of crypto within a year from the original purchase date of the first type of crypto, standard income tax rates apply. This means that any gains that you make from short-term crypto-to-crypto exchanges will be taxed at a rate that corresponds to your individual, joint, or business income tax rate. For reference, the federal income tax rates for individuals in the tax year 2022 are listed below:
On the other hand, if you hold your crypto for longer than one year, you will benefit from the federal long-term capital gains tax rate. In most instances, the long-term capital gains tax rates are appreciably lower than individual income tax rates. In fact, individuals with a high annual income can save as much as 17% on capital gains taxes simply by holding the crypto asset for longer than one year.
Most businesses will pay similar tax rates on capital gains to those listed above because of the pass-through provisions written into the tax code. Pass-through entities such as S-corporations, sole proprietorships, partnerships, and limited liability corporations “...pay taxes on any realized capital gains from their businesses the same as any capital gains realized from their personal investments. Short-term capital gains are treated as ordinary income and subject to the taxpayer’s nominal tax rate, while long-term gains – those held longer than a year – are subject to long-term capital gains tax rates of 0, 15, or 20 percent depending on the taxpayer’s filing status and income.” C-corporations, on the other hand, do not receive a preferential tax rate for long-term capital gains because they are not pass-through entities. Currently, C-corporations pay a flat 21% income tax rate, which is the same rate that they pay for capital gains.
How do you calculate capital gains or losses for cryptocurrency-to-cryptocurrency exchanges?
Capital gains or losses in crypto-to-crypto exchanges can be found by calculating the difference between the cost basis (e.g., purchase price of the original crypto asset in USD) and the fair market value of the crypto being acquired (e.g., purchase price of the second crypto in USD).
Determining cost basis for the original crypto is fairly straightforward in most instances. However, there are some situations where cost basis can be a bit more complicated. “When you buy cryptocurrency, your cost basis is generally determined by how much you paid for it. However, if you received crypto from mining or staking, your cost basis is determined by the fair market value when you received it. Your cost basis for gifted crypto will depend on both the basis the person who transferred it to you had and the fair market value when you received it.”
After determining the cost basis, the next step in calculating the capital gain or loss involves the purchase price of the acquired crypto asset. The capital gain/loss in crypto-to-crypto exchanges equals the price of the acquired crypto asset minus the cost basis (purchase price or fair market value of the original asset when you received it). For example, if you purchased Bitcoin worth $2,000 that increased in value to $3,000 by the time you exchanged it for Ethereum, then your total capital gain would be $1,000 ($3,000 - $2,000 = $1,000). In that scenario, you would report a capital gain of $1,000 and pay tax on that amount at a federal tax rate determined by the holding time of the original asset and/or your tax filing status (individual, married, general partnership, C-corporation, etc.).
Are there instances where cryptocurrency-to-cryptocurrency exchanges are not taxed?
The vast majority of all cryptocurrency-to-cryptocurrency exchanges are subject to taxation. However, there are a few instances that exist in a grey area where tax payments can be avoided or initially appear as though tax payments can be avoided. We will discuss a few of these scenarios below.
Crypto Gifts
As mentioned above, crypto gifts to individuals that are below a certain dollar amount in value are not subject to taxation. Neither are crypto gifts to non-profit organizations. While it may appear as if taxation has been avoided, there has yet to be a crypto-to-crypto exchange. The ownership of the crypto has been exchanged, but the crypto itself remains the same. If anything, the potential tax liability has been passed on to the individual or non-profit organization receiving the crypto as a gift. If the receiver later exchanges the gifted crypto for another type of crypto, they will have to pay taxes on any capital gains.
Transferring Crypto To Yourself
When crypto is moved from one account to another, it is being transferred rather than exchanged or swapped. As a result, no crypto-to-crypto exchange has occurred. While taxes are avoided, this situation does not generally involve a crypto-to-crypto exchange.
Capital Losses
In general, crypto-to-crypto exchanges that result in a capital loss do not require tax payments. They do, however, still need to be reported on your tax filings. These types of transactions are not immune from taxation; strictly speaking, it’s just that there is no income to tax. In certain situations, investors can still use capital losses to their benefit by employing a strategy called crypto tax-loss harvesting.
Like-Kind Exchanges
Like-kind exchanges are a type of “...tax-deferred transaction that allows for the disposal of an asset and the acquisition of another similar asset without generating a capital gains tax liability from the sale of the first asset.” While this definition might seem simple at first glance, there is a great deal of legal nuance and history necessary in order to determine whether an exchange of crypto assets qualifies as a like-kind exchange.
26 U.S. Code section 1031 established the basic parameters of a like-kind exchange. Prior to the year 2017, section 1031 was thought to apply to various different types of property and assets, potentially even crypto-to-crypto exchanges. However, when Congress passed the Tax Cuts and Jobs Act of 2017, section 1031 was amended and now only applied to exchanges of real property. While crypto exchanges could no longer qualify as like-kind exchanges going forward, the question remained as to whether crypto-to-crypto exchanges could still qualify as like-kind exchanges if the transaction occurred prior to the new law going into effect in 2018.
Until recently, the question of whether crypto-to-crypto exchanges could qualify as like-kind exchanges had never been addressed by the IRS. As a result, investors were left to decide for themselves whether pre-2018 crypto-to-crypto exchanges qualified as like-kind exchanges. Some investors took a conservative approach and concluded that pre-2018 exchanges did not qualify as like-kind exchanges and that taxes must be paid. Other investors took an aggressive approach and decided that pre-2018 crypto exchanges did qualify as like-kind exchanges, and no taxes needed to be paid. The IRS finally resolved the question in 2021 and decided that pre-2018 crypto-to-crypto exchanges did not qualify as like-kind exchanges. Accordingly, all investors who did not pay taxes on pre-2018 crypto-to-crypto exchanges now owed the IRS back taxes on their capital gains.
All of this complexity has left many investors with the misunderstanding that crypto-to-crypto exchanges are not taxable so long as the original crypto and the acquired crypto are sufficiently similar. Unfortunately, that is not true. Crypto-to-crypto exchanges are taxable even though it may have appeared in the past that taxes could be avoided.
Tips For Tracking And Reporting Cryptocurrency-To-Cryptocurrency Exchanges On Your Tax Return
Recordkeeping requirements for cryptocurrency transactions
Most businesses and active crypto investors keep several wallets and use multiple accounts while trading throughout the year. And their investments are rarely limited to just one blockchain network. When it comes time to file taxes, investors must reconcile all of their activity from these various sources in order to have accurate records.
As we have discussed, crypto-to-crypto exchanges can be particularly thorny from a record-keeping perspective because investors need detailed information in order to calculate capital gains and losses. For example, you need to know the cost basis for every token or coin gifted, bought, exchanged, or sold throughout the tax year. And in order to determine cost basis, you must have information on the date of each transaction and the fair value of the crypto in question on that particular date. The information required for crypto-to-crypto exchanges can span several years depending on the length of time assets are held. Needless to say, if you were to try and assemble all of this information on your own after the fact, you would be in a world of hurt.
Resources for tracking and reporting your cryptocurrency trades
Bitwave is the solution you have been searching for! We offer a highly configurable way to record cost basis and exchange rates so you can easily account for all of your digital assets in one place. And our software boasts over 200 integrations, allowing you to track your activity everywhere you buy, sell, and hold your crypto. Simply put, Bitwave makes tax tracking for crypto-to-crypto exchanges a breeze. Request a demo, and let us show you how we can tackle your toughest DeFi tax challenges.