The tax code does not treat every stream of income the same way. If you are a cryptocurrency user, it is important to know about these different types of income because they can dramatically impact your post-tax return on your investment. With the right knowledge, you can carefully plan your investment decisions around these income types and save on taxes as well.
Capital gains are the most common type of cryptocurrency income. When you sell cryptocurrency for USD, for another cryptocurrency, or or use cryptocurrency to buy a product or service, you have to pay taxes on the resulting capital gains income. There are two types of capital gains: long-term capital gains (for crypto held over one year) and short-term capital gains (for crypto held for one year or less. Short-term capital gains are taxed at a relatively higher ordinary income tax rate, while long-term gains are subject to preferential rates (0%, 15% & 20%).
If you are a cryptocurrency “Trader” per IRS rules and you make the section 475(f) tax election, your trading gains are taxed as ordinary income. This treatment is beneficial for traders because it allows them to write off an unlimited amount of losses (without being subject to $3,000 net capital loss limit) against trading income.
Ordinary income for traders is taxed at ordinary income tax rates. Note: traders who receive ordinary income from trading activities are NOT subject to the additional 15.3% self-employment taxes.
Self-employment (SE) income comes from having your own business which you are actively involved with. This type of income is not desirable because it is subject to ordinary income taxes and an additional 15.3% self-employment tax.
If you are running a cryptocurrency mining operation and actively involved with the operations (as a single member LLC or a partnership tax structure), your income is SE income. Although SE income is subject to a higher tax rate, one benefit is that you get to write off mining related expenses such as internet fees, equipment cost, rent, utilities, etc. against this income to reduce your tax burden.
Staking rewards you receive when you stake a cryptocurrency like Tezos are technically classified as rental income. While it may seem strange, this is because cryptocurrencies are treated as property per IRS 2014-21; when “property” produces income, its rental income from tax perspective.
There are a lot of DeFi and centralized platforms where you can lend your crypto assets and earn periodic rewards similar to interest income (an argument could also be made that this is in fact rental income because you are lending property as opposed to money). It is important to note that you cannot write off any expenses against interest income.
Section 1256 Income
If you trade regulated cryptocurrency futures, those gains will be taxed as a hybrid 60% long-term capital gains and 40% short-term capital gains, irrespective of how long you hold the futures. This treatment is applicable only to regulated crypto commodities & futures products which are slowly coming into the market. For example, if you have $1,000 of net future gains from a regulated crypto futures contract, $600 will be taxed as long-term capital gains and $400 will be taxed as short-term capital gains (regardless of how long you held the contract).
Disclaimer: this post is informational only and is not intended as tax or investment advice. For tax or investment advice, please consult a professional.
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