Cryptocurrencies have gone mainstream.
For example, you can use bitcoin to buy far more than you would think. To see, try googling “What can I buy with bitcoin?” You will get more than 350,000 hits.
But using cryptocurrencies has federal income tax implications that may surprise you.
With the price of bitcoin having gone through the roof (before its recent deadline), and with increasing acceptance of bitcoin and other cryptocurrencies as forms of payment, the tax implications of using cryptocurrencies are a hot-button issue for the IRS. This article explains what you need to know. Here goes.
First Things First: What is Cryptocurrency?
Cryptocurrency is “digital money” usually issued and controlled by software developers and accepted as payment by willing parties.
Also known as virtual currencies, cryptocurrencies can be transferred, stored for future use, held for investment (if you consider making bets to be investing), or traded electronically.
Bitcoin is the most well-known example. Unlike conventional currencies such as the U.S. dollar or the euro, cryptocurrencies are essentially unregulated. It’s the Wild West, baby!
The most common way to obtain cryptocurrencies such as bitcoin is through cryptocurrency ATMs or online exchanges, which typically charge nominal transaction fees.
Some businesses happily accept payment in cryptocurrencies to avoid the transaction fees charged by credit card companies and online payment processing services such as PayPal.
Though cryptocurrencies are basically unregulated, every cryptocurrency transaction is digitally recorded in a distributed public ledger, such as a blockchain. Anyone can download a copy of the blockchain to trace the path of cryptocurrency transactions.
Distributed ledger technology uses independent digital systems to record, share, and synchronize transactions, the details of which are recorded in multiple places at the same time with no central data store or administrative functionality.
IRS Wants to Know about Your Cryptocurrency Transactions
The 2020 version of IRS Form 1040 (the form you recently filed or will file soon) asks whether you received, sold, sent, exchanged, or otherwise acquired — at any time during the year — any financial interest in any virtual currency. If you did, you are supposed to check the “Yes” box.
The fact that this question appears on page 1 of Form 1040, right below the lines for supplying taxpayer information such as your name and address, indicates that the IRS is getting serious about enforcing compliance with the applicable tax rules. Fair warning!
The 2020 Form 1040 instructions clarify that virtual currency transactions for which you should check the “Yes” box include but are not limited to
- the receipt or transfer of virtual currency for free (i.e., without having to pay),
- the exchange of virtual currency for goods or services,
- the sale of virtual currency,
- the exchange of virtual currency for other property, and
- the disposition of financial interest in virtual currency.
Cryptocurrency Transaction Tax Basics
For the rest of this article, we will use the term “cryptocurrency” to describe what some may call “virtual currency”. Onward.
The IRS takes the position that cryptocurrency is “property” for federal income tax purposes. Because it is property, you recognize and report taxable gain or loss when you exchange cryptocurrency for goods or services, U.S. dollars, euros, different cryptocurrencies, or whatever.
If you fail to report cryptocurrency transactions on your Form 1040 and get audited, you could face interest and penalties, and even criminal prosecution in extreme cases.
To arrive at the federal income tax results of a cryptocurrency transaction, the first step is to calculate the fair market value (FVM), measured in U.S. dollars, of the cryptocurrency on the date you receive it and on the date, you use it to pay for something.
The current values of the most popular cryptocurrencies are listed on exchanges. For example, bitcoin and a bevy of other cryptocurrencies are listed on the Coinbase exchange. At the time we began this article, one bitcoin translated into $57,182 according to the Coinbase exchange. So, if you bought one bitcoin with U.S, dollars at that price, your basis in the bitcoin for federal income tax purposes would be $57,182.
As stated earlier, when you exchange cryptocurrency for other property, including U.S. dollars, a different cryptocurrency, services, or whatever, you must recognize taxable gain or loss just as you do when you make a stock sale in your taxable brokerage account.
- You’ll have a taxable gain if the FMV of what you receive exceeds your basis in the cryptocurrency that you exchanged.
- You’ll have a taxable loss if the FMV of what you receive is less than your basis in the cryptocurrency.
It is hard to imagine that a cryptocurrency holding will be classified for federal income tax purposes as anything other than a capital asset — even if you use it to conduct business or personal transactions, as opposed to holding it for investment. Therefore, the taxable gain or loss from exchanging a cryptocurrency will be a short-term capital gain or loss or a long-term capital gain or loss, depending on how long you held the cryptocurrency before using it in a transaction.
|Example 1. You use one bitcoin to buy tax-deductible supplies for your booming sole proprietorship business. On the date of the purchase, bitcoins are worth $55,000 each. So you have a business deduction of $55,000.
But there’s another piece to this transaction: the tax gain or loss from holding the bitcoin and then spending it.
Say you bought the bitcoin in January of this year for only $31,000. You have a $24,000 taxable gain from appreciation in the value of the bitcoin ($55,000 – $31,000). The $24,000 gain is a short-term capital gain because you did not hold the bitcoin for more than one year.
Tax Treatment of Cryptocurrency Payments to Employees and Independent Contractors
If you use cryptocurrency to pay employee wages, the FMV of the currency counts as wages subject to federal income tax withholding, FICA tax, and FUTA tax. As with any other wages paid to employees, you must report the wages to the employee and to the IRS on Form W-2.
If you use cryptocurrency to pay an independent contractor for performing services for your business, the FMV of the currency is subject to self-employment tax for the contractor. You’re required to report the payment on Form 1099-NEC if payments to that contractor during the year amount to $600 or more.
As explained earlier, you may also have a tax gain or loss due to appreciation or decline in the value of the cryptocurrency during the time you held it before paying it out as wages or for services from an independent contractor. Because you’re not in the business of buying and selling cryptocurrencies, the gain and loss will be a capital gain or capital loss (and will be short-term or long-term, depending on how long you held the cryptocurrency).
Tax Treatment of Cryptocurrency Receipts
If you accept cryptocurrency for goods or services, you must determine the FMV of the currency on the transaction date to convert the deal into U.S. dollars. Then calculate your taxable income or gain.
|Example 2. You sell a valuable painting that you restored for two bitcoins. On the date of sale, bitcoins are worth $55,000 each. Your tax basis in the painting is $47,000. To report this transaction on your Form 1040, convert the two bitcoins into U.S. dollars ($55,000 X 2) = $110,000
The taxable gain on the sale of the painting is $63,000 ($110,000 – $47,000). Report the $63,000 as income or gain on your Form 1040.
You also have to figure and report your gain or loss on the two bitcoins.
|Example 3. You are a self-employed professional. You operate your business as a single-member LLC that’s treated as a sole proprietorship for tax purposes. You accept one bitcoin as payment from a major client.
On the date of receipt, bitcoins are worth $55,000 each according to the Coinbase exchange. You must recognize $55,000 of taxable income for services rendered.
Because you are a self-employed independent contractor, the $55,000 is also subject to the dreadful self-employment tax.
It’s good that you read this article because ignorance of the cryptocurrency rules is not an excuse for failure to comply with the federal tax rules.
Detailed records are essential for compliance. Your records should include
- the date when you received the cryptocurrency,
- its FMV on the date of receipt,
- the FMV on the date you exchanged it (for U.S. dollars or whatever),
- the cryptocurrency trading exchange that you used to determine FMV, anf
- your purpose for holding the currency (business, investment, or personal use).
With this information, you and/or your tax pro can determine the federal income tax consequences of your cryptocurrency transactions.
There may be state income consequences too.
IRS Opine on Taxation of Cryptocurrency Hard Forks
According to recently issued IRS Chief Counsel Advice (CCA), the receipt of a new cryptocurrency unit after a “hard fork” is taxable to the recipient taxpayer if the taxpayer has dominion and control over the new unit as evidences by the ability to sell, exchange, or transfer the new unit. The CCA also commented that the way the taxpayer receives the new unit — whether by “airdrop” or otherwise — does not affect the tax outcome.
A hard fork occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the existing distributed ledger. A hard fork can create a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger.
Following a hard fork, transactions involving the new cryptocurrency are recorded on the new distributed ledger, and transactions involving the legacy cryptocurrency continue to be recorded on the legacy distributed ledger.
An airdrop is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.
The recent CCA cites a 2019 Revenue Ruling where the IRS lookes at two cryptocurrency scenarios. The Revenue Ruling concluded that when a taxpayer receives units of a new cryptocurrency via an airdrop after a hard fork, the taxpayer has taxable gross income as long as the taxpayer actually or constructively receives the new cryptocurrency.