Taxation of Cryptocurrency Mining
There are two taxable events: the receipt and the subsequent sale of the mining reward.
Let’s imagine a scenario where a cryptocurrency enthusiast named Maria decides to start mining Bitcoin as a way to earn some extra income. She sets up a small mining operation in her garage, consisting of a few powerful computers that can handle the complex calculations required for Bitcoin mining.
Over the course of several months, Maria’s mining operation proves to be successful, and she earns a significant amount of Bitcoin as mining rewards. She decides to sell some of her Bitcoin to cover her living expenses and reinvests the rest in her mining operation.
However, Maria soon realizes that she needs to take care of her tax obligations related to her mining income. She researches the IRS regulations related to cryptocurrency mining and learns that she is liable for certain income taxes.
How can we help Maria with her taxes? Here is an overview of the IRS guidelines based on the taxable events above:
Maria engaged in cryptocurrency mining, which is the process of using computer hardware to validate transactions and earn rewards in the form of cryptocurrency.
Cryptocurrency mining is related to the proof of work (PoW) consensus algorithm, which is used by popular cryptocurrencies like Bitcoin. PoW requires miners to solve complex mathematical problems to validate transactions and earn rewards.
It’s important to note that not all consensus algorithms used by cryptocurrencies are based on PoW. For instance, there is also the proof of stake (PoS) consensus algorithm, which is not applicable in Maria’s case.
When Maria received her mining rewards, she became liable for income tax based on the fair market value of the coins at the time of receipt.
Let’s say Maria received 0.5 BTC as a mining reward on January 1st, 2023, and the fair market value of BTC was $50,000 on that day. This means that the fair market value of her mining rewards was $25,000 (0.5 BTC x $50,000).
Assuming that Maria is in the 22% federal income tax bracket, she would owe $5,500 in federal income tax on her mining rewards ($25,000 x 0.22).
In addition to federal income tax, Maria may also owe state income tax depending on where she resides. If she lives in a state with a 5% income tax rate, for example, she would owe an additional $1,250 in state income tax ($25,000 x 0.05).
When Maria sold her mining rewards, she incurred capital gains tax based on the difference between the fair market value at the time of sale and her cost basis, which is the fair market value at the time of receipt.
Let’s say Maria held onto her 0.5 BTC and sold it on June 1st, 2024, when the fair market value of BTC was $60,000.
The fair market value of Maria’s 0.5 BTC at the time of sale would be $30,000 (0.5 BTC x $60,000).
Her cost basis for calculating capital gains tax would be the fair market value of the 0.5 BTC at the time of receipt, which we established as $25,000.
Therefore, Maria would have a capital gain of $5,000 ($30,000 - $25,000) on the sale of her BTC.
Assuming she held onto the BTC for more than a year, this gain would be subject to the long-term capital gains tax rate. If Maria is in the 22% federal income tax bracket, the long-term capital gains tax rate would be 15%. Therefore, she would owe $750 in federal capital gains tax on the sale of her BTC ($5,000 x 0.15).
Again, it’s important to note that state capital gains tax may also apply, depending on where Maria resides.
Maria is not taxed twice on her mining income.
When Maria received her mining rewards, she recognized income based on the fair market value of the coins at the time of receipt. This income became the cost basis in her coins moving forward.
When she sold her coins, she was only subject to capital gains tax on the difference between the fair market value at the time of sale and her cost basis.
Maria should keep track of her mining taxes on an ongoing basis to avoid unexpected tax bills, especially if the value of her cryptocurrency falls significantly.
If Maria runs her mining operation as a business, she can fully deduct her expenses associated with the business, such as electricity, equipment, repairs, and rented space, among others.
If Maria mines cryptocurrency as a hobby, she cannot fully deduct her expenses to reduce her tax bill.