For all of excitement around the idea that cryptocurrencies will replace traditional government-issued money, there is an interesting potential roadblock: capital gains taxes. If you buy lunch using dollars, the only taxes you incur are sales taxes. If you buy that same lunch using cryptocurrency, you will also owe taxes on any capital gains on the cryptocurrency that you spend (also see this article and this useful FAQ). Capital gains taxes on the crypto that you use to pay for things may be much higher than sales taxes, so this issue is important.
Let’s imagine that you buy a unit of a cryptocurrency, XYZ, for $100. Eleven months later, XYZ has risen in value to $150. You decide to pay for a new pair of Nikes using your XYZ. When you sell the XYZ, you owe capital gains taxes on the $50 gain. Because you owned the XYZ for less than a year, the $50 is a short-term capital gain, taxed as ordinary income, rather than the lower long-term capital gains rate. A single person with taxable income between $40,126 and $85,525 is in the 22% ordinary income tax bracket, for example. There is also state income tax that typically applies to all forms of income equally. If you are in the 22% income tax bracket and your state income tax rate is 5%, you will owe 27% of the $50 gain in taxes. If the pair of Nikes costs $150 exactly, you will owe the 5% sales tax on the $150 in addition to $13.50 in capital gains taxes (which equates to 9% of the cost of the shoes).
The capital gains tax from paying in crypto is no different than it would be if you paid for a pair of Nikes using a share of stock from your brokerage account. The official U.S. currency is dollars. Any change in the dollar value of a unit of exchange, whether its a crypto coin or a share of Google stock, will be taxed as a capital gain. This tax expense associated with using an alternative unit of exchange gives the official currency an innate economic benefit. In addition to the taxes, there is also an operational cost in having to track the purchase and sale price of every unit or fractional unit of cryptocurrency that you buy and sell so that the capital gains can be calculated.
The capital gains taxes incurred on using cryptocurrency as a medium of exchange are not an extra tax. You would owe the short-term capital gains tax on the $50 of gains if you sell the crypto coin for dollars and then pay for the shoes with dollars. The question is whether selling the coin to buy the shoes is the most tax efficient way to pay. You may be better off if you pay with cash and delay selling the crypto until you have owned it for at least 12 months, thereby shifting the gains into the lower long-term capital gains category.
If I was going to use cryptocurrency to buy things, I’d want to be able to see the tax cost of the transaction on my digital device at the point of sale. This is definitely possible. If I determined that my effective tax rate was high (if, for example, the gains on my longest-owned digital coin was going to be be taxed at short-term rates), it might be cheaper to pay with dollars rather than digital currency.