Most of us are familiar with some forms of digital currency. We make payments via the internet using services such as PayPal. We transfer funds to others through Venmo. These systems are provided by centralized financial institutions requiring integration with a bank account or credit card. On the other hand, cryptocurrency, such as Bitcoin, is a type of digital currency that is decentralized. It is not controlled or regulated by financial authorities or government agencies. However, cryptocurrency transactions can still be taxable just like cash transactions. If you receive virtual currency in exchange for goods or services, you have to report the income on your tax return. Holding cryptocurrency as an investment can have tax consequences. Purchasing cryptocurrency with US dollars is not a taxable event, but trading cryptocurrency into regular currency is a taxable event. Cryptocurrency is treated as property, so you are required to report capital gains and losses from sale or exchange. The IRS has started a virtual currency compliance campaign, and virtual currency is an ongoing focus area for IRS Criminal Investigation. If you have cryptocurrency investments or transactions, be sure to discuss with your LBMC tax professional.
What is cryptocurrency?
Cryptocurrency is a medium of exchange, like the US dollar, but unlike most currencies it has no physical form. It exists only in the blockchain, where it is created and stored electronically.
Blockchain is the technology behind cryptocurrency. It is a decentralized ledger of all transactions across a peer-to-peer network and functions to eliminate the need for a central clearing authority. Encryption techniques are used to verify the transfers and control the creation of units.
Launched in 2009, Bitcoin is the first and most widely known cryptocurrency.
What’s the hype behind cryptocurrency?
Despite the challenges and uncertainty, cryptocurrency continues to gain attention worldwide. It can be used as an investment asset or electronic payment for goods or services. Cryptocurrency simplifies currency exchanges, reduces transaction fees, and provides an instant transfer of funds, both domestic and internationally.
How does the IRS classify virtual currency?
In 2014, the IRS issued Notice 2014-21, which declared for federal tax purposes virtual currency is treated as property and general tax principles applicable to property transactions will apply to transactions using virtual currency.
What is the basis of virtual currency and how is it determined?
Fair market value (FMV) in US dollars must be used to determine a taxpayer’s basis in virtual currency. Notice 2014-21 determines FMV can be calculated by converting the virtual currency into US dollars (or another currency which can be converted to US dollars) at the exchange rate, in a reasonable manner which is consistently applied.
Does the taxpayer have a gain or loss upon exchange of virtual currency for other property?
Yes – each time a taxpayer exchanges virtual currency for other property, there will be a gain or loss recognized on the transaction. The tax treatment of the gain is contingent on the character of the virtual currency to the taxpayer.
When does a taxpayer have gross income?
Rev. Rul. 2019-24 determined a taxpayer does not have gross income as a result of a hard fork of cryptocurrency owned by the taxpayer if the taxpayer does not receive units of a new cryptocurrency.
However, if the taxpayer receives new units of cryptocurrency from an air drop following a hard fork, the taxpayer will have ordinary income. The amount included in gross income will increase the taxpayer’s basis in the new units of cryptocurrency.
It’s important for an owner of cryptocurrency to be familiar with the unique concepts and be able to identify hard forks, as they may not be notified when a hard fork has taken place.
Tax planning for cryptocurrency
- Cost Recovery Method
According to the IRS guidance, it is up to the taxpayer to consistently apply a reasonable cost recovery method for cryptocurrency. Specific identification provides an increased opportunity for tax planning around cryptocurrency but requires the taxpayer to track the individual cost basis of each unit or coin. A basis tracking software such as CoinTracker or Zen Ledger is recommended.
- Wash Sale Rules and Loss Harvesting
If you incur a capital loss rather than a gain on your cryptocurrency trading, you can use those losses to offset other capital gains. This practice is known as loss harvesting. IRC Section 1091 rules apply to the sale of a security when the taxpayer sells or trades for a loss and within 30 days repurchases a “substantially identical” security. The wash sale rules apply to the security sold and the loss is not allowed.
However, because the IRS classifies virtual currency as property and does not consider it to be defined as a security, the loss sale rules would not apply. Without further guidance stating otherwise, currently virtual currency may be sold at a loss and repurchased within 30 days, and the wash sale rules would not disallow the loss. The IRS rules regarding cryptocurrency are ever-evolving, and the application of wash sale rules are still open to changes in tax policy.
- Charitable Giving Strategies
Virtual currency can be donated to a charity without having to recognize the income or loss on the donation. If the currency was held for more than a year, the value of the donation is equal to the fair market value on the date of donation. If the currency was held for one year or less, the value of the donation is equal to the lesser of the taxpayer’s basis or currency fair market value at contribution.
As with all non-cash charitable contributions, it is not beneficial to donate loss property and a qualified appraisal is required for amounts over $5,000.
Form 1040, Schedule 1 was updated for the 2019 tax year to ask the following yes or no question in regards to cryptocurrency:
“At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
In October of 2020, the IRS issued further guidance on the question with the release of the 2020 draft Form 1040, which clarified a taxpayer is not required to report “yes” to the question if there was no transaction involving the currency. According to the IRS,
“A transaction involving virtual currency does not include the holding of virtual currency in a wallet or account, or the transfer of virtual currency from one wallet or account you own or control to another that you own or control.”
The question moved to the top of the first page on the final 1040 for 2020, but it is still unclear on how the question should be answered for virtual currency held in pass-through entities and how compliance will be imposed. A similar question is answered on Schedule B concerning foreign assets and financial interest and sets a precedent of what to expect regarding compliance enforcement. The IRS and Department of Justice have pursued both criminal and civil penalties against taxpayers who did not correctly answer the question on Schedule B.
Cryptocurrency regulation is complex and evolving. Consult your tax advisor if you are considering a purchase or trade.
Cryptocurrency – encrypted digital or virtual currency not controlled or regulated by financial authorities
Blockchain – technology using database on multiple computers for blocks of digital transaction records
Hard Fork – blockchain split branches the chain into two parts which may result in a new cryptocurrency
Airdrop – coins or tokens delivered to crypto wallets for free or in exchange for promotional service
Crypto Wallet – program or app that stores digital assets