Cryptocurrency & Tax Implications
Cryptocurrencies such as Bitcoin have drawn significant public attention since December 2017 when the prices of these digital currencies spiked immensely. Investors of such digital assets are learning that they may owe a significant amount in taxes as a result of their gains, depending on their unique taxpayer profiles. Some may find themselves in situations in which they’ve realized cryptocurrency gains and have already paid their fair share of tax. However, there are others who are still unaware of their tax liabilities as they relate to cryptocurrency transactions and can potentially be subject to significant penalties and interest. In March 2018, the IRS issued a press release (IR-2018-71) and guidance (IRS Notice 2014-21) to address some of the “gray areas” related to cryptocurrency. The purpose of this blog is to summarize that guidance; and additional information will be written as the laws governing cryptocurrencies evolve.
SELLING CRYPTOCURRENCY FOR FIAT CURRENCY
In 2014, the IRS confirmed that cryptocurrency should be treated as property for tax purposes and that the tax principles that apply to property transactions will generally apply to transactions related to cryptocurrency. The most straightforward application of taxation of crytpocurrency asserts that whenever one sells crytpocurrency for USD or any other legal tender, the IRS considers this event taxable. This type of transaction is treated as a capital gain or loss, similar to selling a stock. The taxpayer must pay taxes on the gain, which is equal to the amount of appreciation of the cryptocurrency’s value in USD from the time of initial purchase date to the date of sale. (That gain might be ordinary or capital, depending on the taxpayer’s holding period, may be long or short term capital gain.)
PURCHASING GOODS WITH CRYPTOCURRENCY
If a taxpayer receives something of economic value, regardless of the fact that the receipt shows that it’s in exchange for something other than money or services for his or her cryptocurrency, the taxpayer may realize gross income. Notice 2014-21 clarifies that a taxpayer who receives cryptocurrency as payment for goods or services must account for the fair market value (FMV) of the cryptocurrency when calculating gross income, measured in USD, as of the date that the cryptocurrency was received. A taxpayer’s basis in the cryptocurrency is the FMV of the currency in USD as of the date of receipt. The FMV is determined by the exchanges and exchange rate established by the supply and demand of such currency; the FMV is determined by converting the cryptocurrency into USD or into another form of currency which in turn can be converted into USD at the exchange rate, in a reasonable manner that is consistently applied.
EXCHANGING ONE CRYPTOCURRENCY FOR ANOTHER
Beginning January 1, 2018, Congress amended the like-kind exchange rules to no longer apply to cryptocurrencies or any other property other than real property. According to IRS Notice 2014-21, taxpayers must report gain or loss anytime they sell their virtual (crypto) assets in exchange for other types of property, including other forms of cryptocurrencies. If the FMV of the cryptocurrency received exceeds the taxpayer’s adjusted basis of the cryptocurrency sold, the taxpayer has a taxable gain and the reverse is true when calculating a loss.
When calculating the gain or loss on these digital assets, the taxpayer must use reasonable and consistent methods. Even if the IRS determines the taxpayer owes additional tax and interest, the taxpayer can avoid penalties by acting reasonably in the view of the IRS.
The taxpayer should always keep detailed and accurate records of his/her transactions, but having complete and accurate record keeping is by far the toughest part of maintaining these currencies and their related transactions. The default position in a scenario of missing trades is to assume a cost basis of zero, which can really be disadvantageous for the taxpayer who is investing in these currencies—especially when the taxpayer may have sold these assets when values were much higher.
Large cryptocurrency exchanges, such as Coinbase Inc., will often keep some sort of record of the investors’ transactions; however, some users have found that their data output can be quite cumbersome and their raw data outputs often need to be modified to calculate an accurate gain or loss for the investors’ sales.
WAGES EARNED IN CRYPTOCURRENCY
If a taxpayer earns income through any cryptocurrency, the employer is required to report the fair market value in USD at the time the employee receives such assets, and the employer must document and disclose the wages paid. The FMV of cryptocurrency paid as wages is subject to federal income tax withholding, FICA tax, and FUTA tax and as a result must be reported on Form W-2, Wage and Tax Statement. In other words, payments made using cryptocurrencies are subject to the same information reporting requirements to the same extent as any other payments made in cash or other properties.
DISTRIBUTIONS TO HOLDERS OF CRYPTOCURRENCIES WITH HARD FORKS AND/OR AIRDROPS
On August 1, 2017, Bitcoin Cash was created after a “hard fork” in the Bitcoin blockchain (in simple terms, a “hard fork” in in blockchain technology is when a single cryptocurrency splits into two. This occurs when an existing cryptocurrency’s code is changed, resulting in both an old and a new version). As a result, anyone who held Bitcoin at the time of this hard fork became owners of Bitcoin Cash. Additionally, there have been dividend-like distributions (known as “airdrops”) given to holders of cryptocurrency paid in other cryptocurrencies. From a taxpayer’s perspective, these types of transactions could be treated similarly to stock splits or dividends, or even another alternative, depending on how the IRS construes these events. The IRS has not yet provided guidance on these transactions and there has been much debate amongst tax practitioners as to whether or not these are taxable events. There has also been some debate on the amount of basis one has in the new forked cryptocurrencies; the conservative approach to this is to report the hard forks and airdropped cryptocurrencies as ordinary income and take that amount as the new basis going forward in the cryptocurrency the taxpayer is holding.
The mining of cryptocurrencies involves the process of verifying and adding to the public ledger, known as blockchain, and it also provides the means through which new coins are released. Any miners who have access to stable internet connections and suitable hardware can participate in mining. If a taxpayer is involved in mining cryptocurrencies and this mining constitutes a trade or business—and the mining activity is not undertaken by the taxpayer as an employee—the net earnings from self-employment resulting from mining constitute self-employment income and are subject to self-employment taxes. These miners are required to report self-employment income in the amount equivalent to the USD value of such cryptocurrencies mined minus related expenses including utilities.
This also implies that taxpayers who mine cryptocurrencies may be liable for quarterly estimated tax payments. It is essential that the taxpayer maintain proper books and records to track the income and expenses related to mining. Mining-related expenses such as computer equipment and electricity can be extremely high and are sometimes deductible as operating business expenses.
The timing of a miner’s cryptocurrency sale can affect the character and tax rate of the sale proceeds. Proceeds from currency mined and held for over a year should be considered long term capital gains, while currency held for less than a year and sold should be considered short term gains (which may be taxed at higher tax rates). This is another incentive for the taxpayer to keep proper records and dates showing when the currency is sold.
EXCHANGE OF CRYPTOCURRENCY FOR BUSINESS PROPERTY
In cases in which taxpayers enter into bartering transactions (i.e. a taxpayer exchanges a cryptocurrency for a piece of equipment), the taxpayer will need to know the basis of the cryptocurrency and its FMV on the day of the exchange in order to determine the gain or loss from the disposition of such currency, and the holding period. Whether the cryptocurrency in the hands of a business is considered a capital asset or not will determine the character of such gain or loss. If the cryptocurrency is not held by a business, one can assume the currency is either an investment asset or a personal-use asset for the holder; when held by a business taxpayer, however, the answer might not be as clear. The business taxpayer can hold the currency for investment purposes or it can use the currency for purposes of conducting a business with customers or paying employees and suppliers. At first, it appears that cryptocurrencies may be intangibles in the hands of businesses and amortizable. Generally, though, cryptocurrencies are not wasting assets and function more like cash (which is not amortizable).
Cryptocurrencies such as bitcoin are likely to remain a hot topic, and the growing number of people investing and engaging in cryptocurrency transactions is sure to force clearer regulatory guidance into play. Financial institutions, accountants and advisors are already preparing for the evolving regulations governing such currencies (and what they mean to taxpayers), but much remains to be seen with regards to how the IRS and other government agencies will treat and control cryptocurrency transactions. For more information about this topic, or our services, please contact us at email@example.com or 212-245-5900.
Samuel Kang, CPA, MST has 9 years of experience in public accounting as a tax practitioner with expertise in high net worth individuals, closely held businesses, trusts, partnerships, and S-corporations.