Cryptocurrency: Real Enough to be Taxed
Ryan J. McDonell Tax Supervisor, CPA
16 January 2018
Cryptocurrency. If you’re lost already, then you haven’t been following the rise of convertible virtual currency over the last decade. Cryptocurrencies seem to be here to stay – at least for now. Accordingly, the IRS has provided guidance, albeit not all-encompassing, that tax professionals and cryptocurrency enthusiasts and critics alike should be aware of.
The IRS defines virtual currency as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. Because of cryptocurrencies’ ability to be purchased for or exchanged into U.S. dollars and other forms of fiat money, Bitcoin and other similar cryptocurrencies are convertible virtual currency. In a simple sense, cryptocurrency is a digital medium of exchange using encryption to secure the generation of units of digital currency and to conduct transactions.
A standout feature of cryptocurrency is that it is decentralized. Consider the U.S. dollar, which exists in a centralized currency system that may regulate the supply of currency, ensure its value, and has a centralized server – like banking ledgers, whereby transactions are posted and validated by a governmental entity or bank. Conversely, mediums such as Bitcoin and other cryptocurrencies are decentralized. The transaction ledger is effectively a collection of ledgers from all users in a peer-to-peer network, of which must all sync and agree.
When users request a transaction, such as sending cryptocurrency to another user, the information is sent to all other network participants to be validated before it may be permanently saved. Network participants with high computing power, called miners, validate the pending transactions by solving complex algorithms. Miners are incentivized to validate the transactions because they receive cryptocurrency as a reward for doing so. Groups of validated transactions, called blocks, are then added to the blockchain, the ledger, after which point the transactions become permanent. Ultimately, a decentralized cryptocurrency achieves consensus by all users for all transactions and account balances using a peer-to-peer network, without the need for a central entity or authority.
Congratulations, you are now a slightly-more educated layman in cryptocurrency!
‘Cause I’m the Taxman
In the IRS, nothing can be said to be certain except taxes and more taxes – cryptocurrency is no exception. A few years ago, the IRS issued Notice 2014-21 to provide for the application of existing tax principals to virtual currency. The IRS considers virtual currency to be property for Federal purposes. Selling or exchanging as well as being the payor or payee in a goods or services transaction may all result in a taxable situation.
Taxpayers that hold cryptocurrency as an investment, like stocks or bonds, are considered to hold capital assets. Accordingly, the sale or exchange of cryptocurrency held as an investment is subject to capital gain rates and capital loss limitations. For taxpayers that do not hold cryptocurrency as a capital asset, but rather as property held for sale to customers in trade or business or as inventory, recognize gains and losses at ordinary tax rates. Cryptocurrency miners must include the fair market value of the currency at time of receipt in gross income and may be subject to self-employment tax in cases where mining is considered a trade or business for the taxpayer.
Cryptocurrencies are traded on various exchanges, such as Coinbase, which thereby serve as a real-time measurement of certain cryptocurrencies in USD. Other websites, such as Coindesk which is popular with Bitcoin users, also provide historical pricing data. Basis in cryptocurrency is determined as the fair market value measured in U.S. dollars at the time of purchase or receipt. Similarly, in calculating any gain or loss on property exchanged for cryptocurrency, taxpayers use the fair market value of the currency at the time of sale or purchase. Some trading websites, such as Coinbase, have begun rolling out tools for users to determine transaction history, including cost basis reports and potentially 1099’s.
It’s Like-Kind of Tax-Free, Right?
Like-kind exchanges, under Section 1031 of the Internal Revenue Code, allow taxpayers to avoid recognizing gains or losses on exchanges of like-kind properties if both are held for productive use in a trade or business or for investment purposes. Some cryptocurrency users take the position that this code section allows for tax-free exchange of one cryptocurrency for another – such as Bitcoin for Litecoin. Other more conservative users and advisors suggest that the exchange of different cryptocurrencies are not protected under IRC 1031. Unfortunately, without any guidance from the IRS and no existing benchmark cases, there is no clear answer on whether a cryptocurrency swap would be a like-kind exchange. Beginning in 2018, under the recently passed Tax Cuts and Jobs Act tax reform legislation, like-kind exchanges will only apply to real estate property, thereby explicitly excluding cryptocurrency. For those that do take the tax-free stance in 2017, consider reporting the transactions on the required Form 8824 and be sure to document, document, document your transactions in case the IRS comes knocking.
Vendors or contractors that accept cryptocurrency as a form of payment for products or services include the fair market value at time of receipt in gross taxable income. Payors are subject to the 1099-MISC filing requirements whereby payments to non-corporate entities for $600 or more must report payment to the IRS and payee on the form 1099. Similarly, if an employer has an arrangement to pay an employee in the form of cryptocurrency, the employer must provide a form W-2 for fair market value of currency paid, and withhold applicable taxes on payments. Third party services that act as intermediaries for cryptocurrency transactions, like credit card companies, must issue Form 1099-K to merchants in cases where payments to merchants are $20,000 or more.
In 2017, the surging value of cryptocurrencies brought Bitcoin and other competitors further into the mainstream. Cryptocurrencies are usable for online and in-person transactions. Currency holders actively monitor and trade their cryptocurrencies on market exchanges. Miners compete vigorously for their next crypto-rewards. If these factors alone aren’t enough to sway the skeptics, proponents of cryptocurrencies merely need to wave their tax bill in the face of the nay-sayers. For these crypto-fanatics, hopefully, the legitimacy established in paying in a share of their profits helps to cool the burn of their looming tax liability.
Cryptocurrencies and the related tax consequences are emerging and sometimes confusing areas. Please contact O’Connor & Drew or our IT audit and security division, OCD Tech, to discuss how these rules may affect you.