How Governments Tax Crypto from Exchanges and Determine Profits. What Then Happens If You Are On Decentralized Exchanges?? A Read.

Cryptocurrency is becoming a growing sector, and governments worldwide are working to regulate and tax it efficiently. In most countries, cryptocurrencies are treated as assets, and the income or profits derived from them are subject to taxation. However, one of the major questions arises: how do governments tax crypto from exchanges, and how do they determine profits?

1. Classification of Cryptocurrency for Tax Purposes

Most governments treat cryptocurrency as property or capital assets, similar to stocks or real estate. In this framework, any profits or losses resulting from the sale, trading, or exchange of cryptocurrencies are treated as capital gains or capital losses.

Some countries, however, may treat cryptocurrencies as currencies or even commodities, depending on their legal definitions. The tax implications differ depending on how the asset is classified, and governments adjust their taxation policies accordingly.

2. How Governments Track Crypto Transactions

Cryptocurrency exchanges often have a role in assisting governments in tracking taxable events. Here’s how governments track and tax transactions from exchanges:

Know Your Customer (KYC) and Anti-Money Laundering (AML) Requirements: Most exchanges are required to comply with KYC and AML regulations, which means they collect identification information about users. This allows governments to know who is transacting on these platforms.
Mandatory Reporting: Some countries, like the United States, require exchanges to provide tax reports for users. In the U.S., exchanges issue a 1099 form to users and the Internal Revenue Service (IRS), detailing users’ transactions and profits.
Blockchain Transparency: Blockchain technology itself is transparent, which means that every transaction is recorded on a public ledger. While addresses are pseudonymous, governments can use tools and work with exchanges to identify individuals based on the public keys used in transactions.

3. Determining Crypto Profits for Taxation

Governments determine crypto profits by calculating the difference between the purchase price (cost basis) of the cryptocurrency and the sale price (proceeds) when the asset is sold or exchanged. Below is a breakdown of how profits are determined:

Capital Gains/Losses: When you sell or trade cryptocurrency, the capital gain or loss is calculated based on the difference between the price at which you acquired the crypto and the price at which you disposed of it. If the sale price is higher than the purchase price, you incur a capital gain, which is taxable. If it’s lower, you incur a capital loss, which may offset other gains.
FIFO vs LIFO Methods: In determining the cost basis for crypto, governments may allow the use of First-In-First-Out (FIFO) or Last-In-First-Out (LIFO) methods. This method determines whether the oldest or newest cryptocurrency purchased is sold first, which impacts the taxable gain or loss.
Short-Term vs Long-Term Gains: Many countries, such as the United States, differentiate between short-term and long-term capital gains. Crypto held for less than a year and sold for a profit is considered a short-term gain and is taxed at ordinary income tax rates. If the crypto is held for over a year, long-term capital gains tax rates apply, which are usually lower.

4. Tax Events in Crypto

Governments recognize several “taxable events” in the world of cryptocurrency. Here are the most common ones:

Selling Cryptocurrency for Fiat: When you sell your cryptocurrency for fiat currency (e.g., US dollars, euros), any profit made is taxable as capital gains.
Trading Cryptocurrency for Other Cryptocurrencies: Even when trading one crypto asset for another, such as Bitcoin for Ethereum, this is considered a taxable event. The fair market value of the cryptocurrency on the day of the trade is used to calculate gains or losses.
Using Cryptocurrency for Purchases: If you use cryptocurrency to purchase goods or services, it is considered a taxable event. You would need to determine the fair market value of the cryptocurrency at the time of the purchase and compare it to your original purchase price to calculate gains or losses.
Receiving Cryptocurrency as Income: If you are paid in cryptocurrency (for example, as part of a salary or a reward from mining), this is considered ordinary income, and the fair market value of the crypto at the time you receive it is your income for tax purposes.

5. What Happens if You Don’t Use Centralized Exchanges?

When users bypass centralized exchanges and transact directly in cryptocurrencies using decentralized exchanges (DEXs), peer-to-peer (P2P) transactions, or other private wallets, things become more complicated for tax authorities.

Decentralized Nature: Decentralized exchanges (DEXs) don’t require KYC or AML processes, allowing users to transact anonymously. This makes it harder for governments to track transactions and determine the identity of the traders.
Peer-to-Peer (P2P) Transactions: When users transact directly using private wallets, the transaction still appears on the blockchain, but unless connected with a known identity, it can be difficult for governments to link the wallet address to a real-world person.
Tax Obligations Remain: Even when using decentralized methods, the tax obligations remain. In most countries, failing to report these transactions can result in tax evasion charges. Governments are increasingly employing blockchain analysis tools to trace these transactions and link them to individuals through a combination of on-chain and off-chain data.
Self-Reporting: If you’re using decentralized exchanges or transacting solely in crypto without converting to fiat, you are still legally required to report your transactions and profits in your tax filings. The responsibility lies with the individual to accurately track and report these activities.

6. Challenges in Taxing Crypto

Governments face significant challenges in taxing crypto due to the following reasons:

Decentralized Nature: Cryptocurrencies operate on decentralized networks, making it difficult to track transactions that do not occur on centralized exchanges.
Unregulated Platforms: Not all exchanges are regulated, which allows some users to trade without disclosing their identities or providing tax reports.
Valuation Fluctuations: The value of cryptocurrencies can be highly volatile, which creates challenges in determining the fair market value at the time of each transaction.

7. How Governments Can Improve Crypto Taxation

To ensure they collect taxes effectively from crypto activities, governments are adopting several strategies:

Increased Regulations for Exchanges: By enforcing stricter reporting regulations for exchanges, governments can ensure that crypto transactions are reported accurately for tax purposes.
Blockchain Analysis Tools: Some tax authorities use blockchain analysis tools to track cryptocurrency transactions on the blockchain and identify non-compliant taxpayers.
International Cooperation: Since cryptocurrencies operate across borders, governments are beginning to collaborate on international standards for taxation and tracking of crypto activities.

Conclusion: Crypto and Taxes in Kenya

As Kenya moves toward regulating cryptocurrency, exchanges operating in the country will likely face requirements to report users’ transactions for tax purposes. The Kenyan government may adopt similar policies seen in other countries, such as requiring KYC compliance and mandatory transaction reporting.

With the increasing possibility of crypto ETFs and more sophisticated financial products entering the Kenyan market, the tax framework around crypto is expected to evolve. This will provide clarity for traders and investors, while ensuring the government benefits from the growing crypto economy.

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