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Tax rules for cryptocurrency investors are changing: 'It's the Wild West,' says crypto expert

"As you'll remember with Al Capone, if you have earnings that you don't report, it will raise red flags."

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Twenty/20

When you think of cryptocurrency, images of spurs, Stetson hats, and six-shooters might not come to mind. But talking to experts about regulators' approach to digital currency, one phrase seems to pop up again and again.

"It's the Wild West right now," says Zak Killermann, cryptocurrency publisher for personal finance site Finder.com. "Regulators are still figuring things out, so it's important for investors to stay informed. Things can change really quickly."

Very quickly, in fact. The Senate recently greenlit an overhaul to the way crypto profits are reported, as part of the $1 trillion bipartisan infrastructure bill. Should it pass the House as-is, the bill could make calculating tax liability easier for some crypto investors, while underscoring the importance of tax compliance for others.

Read on to learn how crypto is taxed now, and what the impending changes could mean for your portfolio.  

Cryptocurrencies are taxed like stocks — with an important exception

Bitcoin debuted in 2009 as a decentralized digital currency, one that could operate as an alternative to the existing global financial system. But it wasn't long before investors got involved, earning large sums of money speculating on the value of bitcoin and other digital currencies.

By 2014, the IRS realized that digital currency wasn't just being used for making payments, and issued a new set of rules. "The IRS said that if it's something you can trade real dollars for and make a profit, it's a property — not just a currency," says John Buhl, senior communications manager for the Urban-Brookings Tax Policy Center. "Because it's an asset you can buy, hold, and sell, you have to pay capital gains tax."

That means crypto is mostly taxed like stocks, mutual funds, or ETFs are. Sell it for a profit after holding for less than a year, and the gains will be taxed at the short-term capital gains rate, equivalent to your income tax rate. Hang on for more than a year, and you'll get a more favorable tax rate: 0%, 15%, or 20%, depending on your income.

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As is the case with traditional investments, investors can sell crypto at a loss to offset capital gains, a strategy known as tax-loss harvesting. If your losses exceed your gains in a particular tax year, you pay no capital gains tax, and can deduct up to $3,000 worth of losses from your regular income. Losses in excess of $3,000 can be carried forward into future tax years.

There's one key area where the rules for crypto differ. Because cryptocurrency is taxed as property, it's not subject to the so-called "wash-sale rule," which discourages investors from buying "substantially identical" investments within 30 days of selling a stock or fund for less than you paid to acquire it. Run afoul of this rule, and you won't be able to claim that initial loss for tax purposes.

If you sell shares in Apple at a loss, for instance, you have to wait a month before buying the stock again to avoid a wash sale. If you sell an S&P 500 index fund, all funds that track the index are off limits, not just the one you owned. But with crypto, "if you suffered a loss, you can sell and immediately buy it back," says Killermann. "There's no expiration date on those losses. You can rack them up and bring all of them forward indefinitely."

Why keeping records of crypto transactions is important

Selling crypto for cash isn't the only way to trigger a taxable event. If you own appreciated cryptocurrency, using it to buy goods and services or swapping it for other kinds of digital currencies will mean that you owe capital gains tax as well. Receiving free crypto as part of a marketing promotion, known as an airdrop, also counts as regular taxable income.

In order to take advantage of tax-loss harvesting, you'll have to keep meticulous records of your crypto transactions, says Killermann. Otherwise, the IRS may not believe you. "You have to come in with records of every single transaction — how, where, and when you bought it."

"As much as it is property, because you can use it as a currency, it makes it much more complicated to know how much you started with and how much you made," says Buhl. "There's no central authority tracking this stuff. And for an investor, it's a lot harder than saying, 'I bought this, and I sold that.'"

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How the new legislation affects crypto investors

Even if you're not trying to take advantage of the wash-sale loophole, that's a big deal — one that lawmakers hope to at least partially address with the new legislation. The law aims to make reporting of cryptocurrency trading activity as seamless as it is with stocks, where information about the timing and profitability of your transactions are reported directly to the IRS by your brokerage.

Under the new rules, crypto brokers would be required to report investor transaction information to the IRS. Consternation remains over what the bill, which has yet to pass the House, defines as a "broker," with detractors worrying that the law would require companies on the periphery of the crypto brokerage ecosystem — such as miners and software developers — to report customer information that they don't have.

While major exchanges, such as Coinbase, are likely equipped to report your information to the IRS, the vast majority of crypto owners don't hold their coins on such platforms. In fact, in early July, just 13% of available bitcoin was held on exchanges, according to crypto data tracking site Santiment.

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If you're among the crypto investors who don't invest through an exchange, you may be out of the IRS's spotlight for now. But that doesn't mean you shouldn't try to calculate and pay the tax you owe to the best of your ability, says Buhl.

"You want to be in compliance. The government is emphasizing that you owe these, and it's up to individuals to decide to follow the law or leave it to chance that they won't get audited," he says. "People have made hundreds of thousands of dollars trading crypto. And as you'll remember with Al Capone, if you have earnings that you don't report, it will raise red flags and you can be in big trouble."

If calculating it all on your own sounds onerous, services such as CoinTracker and ZenLedger can keep track of your crypto portfolio and calculate your tax liability for you. For people who frequently transact in crypto, signing up for one of these services is a small price to pay for peace of mind, says Killermann.

"You have to weigh the cost-benefit," he says. "What's a $100 subscription compared with a giant fine you might have to eventually pay the IRS?"

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