With the rise in the value of some cryptocurrencies such as Bitcoin and Ethereum, and the popularity of non-fungible tokens, we, as a firm, have received many inquiries from cryptocurrency traders and investors regarding the tax ramifications of these types of investments. With the Internal Revenue Service (“IRS”) stepping up enforcement efforts, even those who hold the currency — let alone trade it — need to make sure they are aware of the current tax laws.
What is Virtual Currency?
Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments, it operates like “real” currency (i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance), but it does not have legal tender status in the United States. Cryptocurrency is a type of virtual currency that utilizes cryptography to validate and secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.
Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as “convertible” virtual currency. Bitcoin is one example of a convertible virtual currency. Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.
The sale or other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences that could result in tax liability.
IRS Treatment for Cryptocurrency
Per IRS Notice 2014-21, cryptocurrency is considered “property” (as opposed to cash) for federal income tax purposes and, for most investors, the IRS treats it as a capital asset. As a result, cryptocurrency taxes are no different than the taxes paid on any other gain realized on the sale or exchange of a capital asset.
When a taxpayer purchases a capital asset – be it a stock, bond, house, Dogecoin, Bitcoin, or other investment – they establish a basis equal to the cost to acquire it. When they sell, they compare their sales proceeds to the basis to determine whether they have a capital loss or a capital gain. If the proceeds exceed their basis, they have a capital gain. If reversed, they have a capital loss. Accordingly, gain or loss is recognized every time that cryptocurrency is sold or used to purchase goods or services. How the gain or loss is recognized depends largely on the type of transaction conducted and the length of time the position was held.
With a bank or brokerage account, the taxpayer (and the IRS) will typically get a Form 1099 reporting the income received during the year. That may not be the case with cryptocurrency.
But the lack of a Form 1099 won’t let you escape any tax liability, and you’ll still have to report your gains and pay tax on them.
A taxpayer who sells a coin position for cash must report a capital gain (or loss) on Form 8949. A coin position held for one year or less is considered a short-term capital gain, taxed at ordinary tax rates; a position held for more than one year is considered a long-term capital gain. As with stock trades, capital losses offset capital gains in full, and a net capital loss is limited to $3,000 ($1,500 for married taxpayers filing separately) against other types of income on an individual tax return. Any excess capital loss is carried forward to the subsequent tax year.
Under IRS rules, the default for stock transactions is the first-in, first-out (“FIFO”) method of accounting. Under certain circumstances, however, specific identification is allowed. The use of specific identification can drastically reduce the recognized gain on cryptocurrency transactions, since many traders have multiple transactions in the same form of cryptocurrency.
The gain is also considered investment income for purposes of the Medicare contributions tax introduced in the Affordable Care Act. As a result, taxpayers with modified adjusted gross incomes over $200,000 ($250,000 for married taxpayers filing jointly) are subject to the 3.8% additional Medicare tax on any cryptocurrency gains.
Taxpayers who make coin-to-coin trades (e.g., Bitcoin to Ethereum) may assume there is no tax liability because they did not receive any actual funds. Given the IRS’s treatment of cryptocurrency as property, however, cryptocurrency trades are subject to the same capital gains and losses rules as all other property exchanges.
Investors can earn cryptocurrency by using computers to solve a complex mathematical puzzle. As a reward for solving the puzzle, they receive newly “minted” coins. Notice 2014-21 states that when a taxpayer successfully mines cryptocurrency, the fair market value of the coins mined is includible in gross income. Furthermore, an individual whose mining operations constitute a trade or business is subject to self-employment tax on the income derived from those activities.
The amount of this income equals the market price of the coins on the day they were awarded on the blockchain. This amount also becomes the miner’s basis in the coins going forward and is used to calculate future gains and losses.
If a taxpayer mines cryptocurrency as a business they can also deduct their expenses, as a typical business would. Revenue is the value of what they produce. But you have to be running a trade or business to qualify. You can’t operate your mining rig as a hobby and enjoy the same deductions as an actual business.
Cryptocurrency as Payment
Notice 2014-21 also provides guidance on the taxation of cryptocurrency that is received as employee wages, independent contractor payments for services provided, and other payments for goods or services. Wages paid to employees in cryptocurrency are taxable to the employee and must be reported on Form W-2. The employee is taxed at the fair market value of the cryptocurrency on the date of the payment.
Payments made to independent contractors for services provided using cryptocurrency are subject to income tax and self-employment tax and must be reported on Form 1099. Again, the fair market value of the cryptocurrency establishes the taxable amount. Thus, any taxpayer who receives cryptocurrency as payment for goods or services, either as an employee or an independent contractor, must include the fair market value of the cryptocurrency in his reported taxable income.
Instead of selling the cryptocurrency and donating the after-tax proceeds, a taxpayer can donate it directly to a charity. This approach provides significant benefits: the tax deduction will be equal to the fair market value of the donated coins (as determined by a qualified appraisal), and the donor will not pay tax on the gain. This also results in a larger donation because, instead of paying capital gains taxes, the charity will receive the full value of the donation. For this strategy to work, the coins must have been held for longer than one year.
If a taxpayer has given cryptocurrency to someone, perhaps a younger relative as a way to spark interest, the gift will be treated the same way as any similar gift would be. So it will only be subject to the gift tax if it’s over $15,000 (in either 2020 or 2021). And if it comes time for the recipient to sell the gift, the cost basis remains the same as the giver’s cost basis. That said, there are some ways to escape the gift tax, even if you go over the annual threshold, such as taking advantage of the lifetime exemption.
Inherited cryptocurrency is treated like other capital assets that are passed from one generation to another. They may be subject to estate taxes if the estate exceeds certain thresholds ($11.58 million and $11.7 million in 2020 and 2021, respectively). Furthermore, like stock, cryptocurrency enjoys a stepped-up cost basis to the fair value on the day of death.
Page one of Form 1040 now asks taxpayers: “At any time during 2020, did you receive, sell, send, exchange, to otherwise acquire any financial interest in any virtual currency?” The IRS focus on cryptocurrency is relevant to both taxpayers who buy and sell cryptocurrency, as well as businesses or individuals that transact with such taxpayers. Taxpayers need to be familiar with the IRS positions on the tax treatment of cryptocurrency transactions.