Contributed by: KristineS, FreeTaxUSA Agent, Tax Pro
If you buy, sell, swap, hold, exchange, or receive virtual currency -- often referred to as a digital asset or cryptocurrency -- you may need a little help understanding the terminology and potential tax implications. This article is designed to make things clearer.
FreeTaxUSA has created a list of the 25 most commonly used words and transactions for virtual currency, along with their definitions, and most importantly, their tax treatment, if applicable.
You might also like to read any of the several other articles FreeTaxUSA has published on virtual currency including scams, bankrupt exchanges, and mining as gig work.
The following list is not all inclusive. The IRS hasn’t given clear rules on some types of transactions, such as a swap. For each entry, we provide a simple definition of each word and, if available, its tax treatment by the IRS. For instance, staking is a way to earn rewards and is considered taxable income to be reported, while blockchain is a description referring to technology and isn’t reported or taxed.
You may need to do additional research to fully understand a word or its tax treatment.
Airdrop
- Definition: Free cryptocurrency given to users.
- Treatment: Taxable ordinary income when you receive and can use it.
Altcoin
- Definition: Any coin that is not Bitcoin.
- Treatment: Selling, swapping, or spending it is a taxable event.
Basis (Cost basis)
- Definition: What you paid (in U.S. dollars), or the value the day you received it.
- Treatment: You must track your basis to calculate the gain/loss.
Bitcoin
- Definition: The first digital money that lives on the internet. It’s managed on the blockchain instead of being printed or controlled in a bank.
- Treatment: Considered property, and if you sell, swap, or spend it, it’s a taxable event.
Blockchain
- Definition: A secure digital list of transactions, like a notebook everyone can see or a public ledger with time-ordered transactions.
- Treatment: The technology isn’t taxed; but your transactions on the Blockchain may be.
Bridging / Wrapping
- Definition: Moving tokens across blockchains (bridging) or changing a token format (wrapping) such as using Bitcoin on the Ethereum network.
- Treatment: Depends. Wrapping and bridging may be non-taxable. You’ll need to do more in-depth research on these and keep good records as bridging may be taxable or non-taxable depending on facts and circumstances.
Coin
- Definition: A coin such as Bitcoin on the blockchain.
- Treatment: A coin itself is not taxable; what you do with the coin may create a taxable event you report.
Cold storage
- Definition: A method to keep your cryptocurrency off the internet, like a safe in your home instead of leaving it in your wallet on the kitchen table.
- Treatment: Moving cryptocurrency to storage is not a taxable event. Taxes only apply when you sell, swap, or spend your cryptocurrency.
Cryptocurrency
- Definition: A type of digital asset like Ethereum or Bitcoin.
- Treatment:
- Paid as wages: Ordinary income; subject to withholding and income tax.
- Paid as contract income: Self-employment (SE) income subject to SE tax.
- Given as gift: No income to giver or recipient, basis/original price carries to recipient.
- Donated to charity: May be deductible; special appraisal rules can apply.
- Scam/Theft/Fraud: Personal losses from not-for-profit transactions are generally not deductible.
DeFi (Decentralized Finance)
- Definition: An online bank, without a brick-and-mortar bank. Uses computer programs on a blockchain so people can borrow, trade, and earn interest by themselves.
- Treatment: Interest or fees earned are taxable as ordinary income.
Digital asset
- Definition: Any digital item with value recorded on a blockchain, like Bitcoin or NFTS.
- Treatment: Considered property rather than money for tax purposes, so property rules apply.
Ecosystem
- Definition: A network of people, tools, and technology in the virtual currency world. Just like the ecosystem in nature has plants, water, and animals.
- Treatment: The network itself is not taxable. Actions taken, however, may be taxable.
Exchange (CEX/DEX)
- Definition: Places to buy/sell cryptocurrency (centralized or decentralized).
- Treatment: Sales/trades are taxable.
Hard fork
- Definition: A big change or split that creates a new coin.
- Treatment: The fork itself is not taxable. If you receive new coins from the fork, it’s taxable income.
Liquidity pool (LP)
- Definition: Depositing tokens into a pool to earn fees/rewards.
- Treatment: Depositing tokens is not taxable. Earning fees/rewards will be a taxable event.
Mining
- Definition: Using computers to earn new cryptocurrency. This can be a job or side-hustle.
- Treatment: Taxable as ordinary income when you receive coins for payment and may also be subject to self-employment tax if it’s earned through a trade or business. Selling mined coins can trigger capital gains/losses.
NFT (Non-fungible token)
- Definition: A unique digital item (art, collectible, etc.) on the blockchain.
- Treatment:
- Selling or swapping can lead to capital gains.
- Earnings (airdrop/reward) are ordinary taxable income.
Private key
- Definition: A secret password that lets you use your cryptocurrency.
- Treatment: No direct tax rule; keep private and secure. Don’t lose it!
Public key
- Definition: A public code where people can send you cryptocurrency.
- Treatment: No direct tax rule.
Soft fork
- Definition: A small change to a blockchain that doesn’t create a new coin.
- Treatment: No income if no new coins are received.
Stablecoin
- Definition: Cryptocurrency linked to a stable value (like U.S. dollars).
- Treatment: Property; gains/losses are taxable.
Staking
- Definition: Locking cryptocurrency to help the network and earn rewards.
- Treatment: Rewards are taxable as ordinary income when received.
Token
- Definition: Built on an existing blockchain.
- Treatment: Taxable and follows property rules.
Virtual currency
- Definition: Money that exists only online. It has no physical properties like a dollar bill or physical coins. Used to buy things or trade with other people.
- Treatment: Just having it isn’t taxable. Selling, swapping, or spending it is taxable.
Wallet
- Definition: Just like it sounds, except it’s an app or device that stores your cryptocurrency instead of a wallet in your purse or pocket. You can hold it yourself or have a custodian hold it.
- Treatment: Holding isn’t taxable; selling, swapping, or spending it is taxable.
Worthless coin
- Definition: Just like it sounds, a worthless coin that might still exist on the blockchain, but nobody wants to buy. Often associated with scams or a market crash.
- Treatment: You might be able to claim a capital loss on Form 8949. It’s treated as property that has lost all value.