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You probably know someone who owns cryptocurrency, a decentralized digital coin that most people use as an investment tool. It is completely legal to own cryptocurrencies in the United States. However, you need to pay taxes every time you sell, exchange or mine a cryptocurrency at a profit.

Cryptocurrency as an investment

The Internal Revenue Service (IRS) considers virtual currencies as capital assets rather than a currency because most people treat them as an investment tool and not as a currency per se. Another reason why they don’t qualify as a currency is because they use blockchain technology to record and validate transactions.

The IRS taxes capital assets, like stocks and bonds, when sold or exchanged at a profit. The same applies to cryptocurrencies. If you buy a cryptocurrency, and then its value increases, you will be left with a profit when you purchase something with the increased value. Then, you would have a capital gain. The difference between the cryptocurrency’s original value and its value when sold or exchanged would be the amount taxed.

If you gain something out of the transaction, you will have to pay taxes. As the rule focuses on profits, the same principle will apply for mining, rewards and payments made with cryptocurrency.

Taxation

How much the IRS will tax you depends on your annual income and the holding period. The holding period is the time you held the virtual currency. The tax rate will depend on whether the capital gain is short-term or long-term:

  • Short-term capital gain: the IRS will tax you at your normal income rate if you sell it before you’ve had the cryptocurrency for a year.
  • Long-term capital gain: the IRS will tax you at a lower rate if you’ve had the currency for more than a year.

The holding period starts the day after you acquire the currency and ends on the day you sold or exchanged it.

Paying your taxes

If you sell, exchange, or buy something with cryptocurrency, you will need to report the amount you received in exchange for the virtual currency in your federal tax income return. For this, you will need to file Form 8949 to report the transaction and then summarize the capital gains and losses with Form 1040.