How are Crypto IRAs Taxed?

Crypto-IRA-Tax

How are Crypto IRAs taxed? IRS Notice 2014-21 clearly states that for federal tax purposes, virtual currency is treated as property, such as stocks or real estate. General tax principles applicable to property transactions apply to transactions using virtual currency. In addition, the Notice made it clear that virtual currency is not treated as a currency for tax purposes. 

Notice 2-14-21 provided clarity on the federal income taxation of cryptos.  The Notice clearly stated that cryptocurrency would be treated as a capital asset, such as real estate or stocks. IRS Notice 2014-21 holds that cryptocurrencies, such as Bitcoins will be considered property, which is a capital asset and subject to the capital gains tax rules so long as not held for business purposes. 

Before discussing the IRS tax treatment of a Crypto IRA, lets briefly review the federal income tax treatment of crypto gains from non-retirement accounts.

Taxation of Owning Cryptos in a Non-Retirement Account

Furthermore, so long as one holds cryptocurrencies for personal or investment purposes, any gain/loss from the sale or the cryptocurrency would be subject to the capital gains tax regime.  If the cryptocurrency was held for less than twelve months (short-term capital gains), then ordinary income tax rates would apply.  Whereas, if the cryptocurrency were held for twelve months or more, the favorable long-term capital gains rate would apply. The determination of a taxpayer’s overall net capital gain or loss is based on a netting formula involving all capital (cryptocurrency) transactions during the year, with the short-term gains netted against the short-term losses and the long-term gains netted against long-term capital losses.  However, if one was considered in the business of trading cryptocurrencies or mining cryptocurrencies, they could be subject to ordinary income tax rate.

Capital Gains

The tax law divides capital gains into two different classes determined by the calendar. Short-term gains come from the sale of property owned one year or less; long-term gains come from the sale of property held more than one year. Short-term gains are taxed at your maximum ordinary income tax rate, which is 37% for 2022. Whereas, most long-term gains are taxed at either 0%, 15%, or 20% and can be subject to the additional 3.8% tax under Obamacare.  For low-bracket taxpayers, the long-term capital gains rate is 0%. There are exceptions, of course.  The long-term capital gains rates were not impacted by the Trump tax plan. In order to determine whether your capital gains transaction will be subject to the short-term or long-term capital gains tax rules, you will need to determine their holding period.  The holding period in connection with the capital asset transaction, is the period of time that you owned the property before sale. When figuring the holding period, the day you bought property does not count, but the day you sold it does. Thus, if you bought a Bitcoin on May 1, 2020, your holding period will begin on that day. Therefore, May 1, 2021 would mark one year of ownership for tax purposes. If you sold the Bitcoin before May 1, 2021, you would have a short-term gain or loss. A sale after May 1, 2021 would produce long-term tax consequences, since you would have held the asset for more than one year. The tax rate you pay depends on whether your gain is short-term or long-term.

Capital Losses

As with capital gains, capital losses are divided by the calendar into short- and long-term losses and can be deducted against capital gains, but there are limits. Losses on your investments are first used to offset capital gains of the same type. So, short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other kind of gain. In addition, if you have an overall net capital loss for the year, you can deduct up to $3,000 of that loss against other kinds of income, including your salary and interest income, for example. Any excess net capital loss can be carried over to subsequent years to be deducted against capital gains and against up to $3,000 of other kinds of income.

Under IRS Notice 2014-21 each time you sell or exchange a cryptocurrency for either cash, another cryptocurrency, or for goods or services, the transaction would be considered a taxable event, which would be subject to either, short-term or long-term capital gain/losses based on the basis (what you paid for the crypto), holding period, and the price the cryptocurrency was sold or exchanged for. Moreover, if the transaction was part of a business, such as mining activity, the applicable corporate or ordinary income tax rates would apply.

In sum, so long as one purchases cryptocurrencies for personal or investment purposes any gain/loss from the sale or exchange or the cryptocurrency would be subject to the capital gains tax regime.  If the cryptocurrency was held less than twelve months, then ordinary income tax rates would apply and if the cryptocurrency were held for twelve months or more, the favorable long-term capital gains rate would apply.  The total short-term and/or long-term tax due or loss recognized would be determined based off a netting formula. However, if one is considered in the business of trading cryptocurrencies or mining cryptocurrencies, the taxpayer could be subject to ordinary income tax rates.

Taxation of Cryptos IRA

Since IRS Notice 2014-21 treats cryptocurrencies as property, such as stocks, when one uses an IRA or 401(k) to buy cryptos, there is generally no tax on any of the income or gains.

The IRS tax treatment of virtual currency has created a favorable tax environment for retirement account investors. In general, when a retirement account generates income or gains from the purchase and sale of a capital asset, such as stocks, mutual funds, real estate, etc., irrespective of whether the gain was short-term (held less than twelve months) or long-term (held greater than twelve months), the retirement account does not pay any tax on the transaction and any tax would be deferred to the future when the retirement account holder taxes a distribution (in the case of a Roth IRA or Roth 401(k) plan no tax would be due if the distribution is qualified). Hence, using retirement funds to invest in cryptocurrencies, such as bitcoins could allow the investor to defer or even eliminate, in the case of a Roth, any tax due from the investment. Note – retirement account investors interested in mining bitcoins versus trading, could become subject to the unrelated business taxable income tax rules if the “mining” constituted a trade or business.

Final Thoughts

Starting a Crypto IRA and investing in cryptos can be somewhat risky and volatile. However, using an IRA or 401(k) plan to buy and sell cryptos offers one the ability to gain exposure to an emerging asset class and simultaneously lock in no tax on any of the income or gains.  In other words, using an IRA or 401(k) plan to buy cryptos is the most tax advantages way to take advantage of the expected growth in the crypto market.

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