Decrypting Taxation of Cryptocurrency
The most well-known cryptocurrency, Bitcoin, was launched in 2009. Other cryptocurrencies include Lifecoin, Darkcoin, and Dodgecoin.
What Is Cryptocurrency?
Cryptocurrency is not as cryptic as it may come across; in essence, it is virtual currency. According to the Internal Revenue Service, “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.” IRS Notice 2014-16, I.R.B. 938 (2014). Like traditional government issued and backed currencies, like the US Dollar or the Euro, cryptocurrency may be exchanged as payment for goods or services or held as an investment, but it is not legal tender and thus does not have to be accepted as a form of payment. Id. Cryptocurrency, which is convertible into government-backed (or fiat) currency, can have an equivalent value in such currency, i.e., a US Dollar value. Id.
How Does Cryptocurrency Work?
“In brief, the Bitcoin system is a public ledger. It denotes who owns each unit of Bitcoin available. Transactions amount to debiting one address and crediting another. And public key cryptography ensures transactions are secure.” William J. Luther, Demystifying Bitcoin (Feb. 15, 2017). The public ledger is known as the “blockchain.” Notably, transfers may be done almost anonymously, somewhat like cash changing hands in the physical world, but transfers of cryptocurrency occur in the virtual world and are all recorded in the blockchain.
A cryptocurrency “miner” uses “computer resources to validate Bitcoin transactions and maintain the public…transaction ledger.” IRS Notice 2014-16. Cryptocurrency exchanges facilitate cryptocurrency transactions.
Who Uses Cryptocurrency?
Regular people like you and me use cryptocurrency. There are many companies that accept payments in the form of Bitcoin, including Microsoft, Virgin Galactic, Dish Network, and many others listed on 99bitcoins.com, as of January 2018. But some cryptocurrencies are used on the so-called dark web by terrorists, drug traffickers, human traffickers, and other criminals.
According to the IRS, How Is Cryptocurrency Taxed?
Cryptocurrency is property for federal income tax purposes, according to the IRS. So, “General tax principles applicable to property transactions apply to transactions using virtual currency.” IRS Notice 2014-16. When a taxpayer gets paid with cryptocurrency, they have gross income in the amount of the cryptocurrency’s fair market value at the listed exchange rate value. Id.
“[W]hen a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.” Id. Income resulting from mining cryptocurrency would be self-employment income. Id.
As with any exchange of property for property, a taxpayer may recognize gain or loss on the exchange of cryptocurrency for other property, depending on the taxpayer’s adjusted basis in the cryptocurrency. The character of that gain or loss depends on whether the cryptocurrency is an ordinary asset (e.g., held for sale to customers in a trade or business) or a capital asset (e.g., held for investment). Id.
Can Cryptocurrency Be Exchanged Tax-Free?
Prior to the federal Tax Cuts and Jobs Act of 2017 and assuming that cryptocurrency is property, then a swap of cryptocurrency treated as a business or investment asset for like-kind property may have qualified as a tax-free like-kind exchange under Section 1031 of the Internal Revenue Code of 1986, as amended. Of course, a taxpayer would have needed to claim 1031 treatment on IRS Form 8824, Like-Kind Exchanges. The 2017 Tax Act, however, now limits 1031 treatment to real property.
Are There Federal Tax Information Reporting Requirements for Crypocurrency?
Receipts of cryptocurrency in transactions are subject to information reporting, e.g., Form 1099, to the same extent as the receipt of any other payment made in property. Id. Other reporting requirements may possibly apply, e.g., Form 8938, Statement of Specified Foreign Financial Assets (filed with the IRS), FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR) (filed with Financial Crimes Enforcement Network (FinCEN)). The IRS has reportedly stated that virtual currency is not reportable on IRS Form 8938 or FinCEN Form 114.
Is the IRS Taking Measures Focused on Compliance by Cryptocurrency Users?
The IRS has a keen interest in cryptocurrency transactions, similar to its interest in cash dealings. This is due to the perception that such transactions are anonymous and not readily traceable when IRS reporting rules are not followed (e.g., Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business).
Consistent with its interest in cryptocurrency transactions, the IRS obtained an order from a U.S. District Court in California against Coinbase, Inc., a virtual currency exchange, to enforce a summons for account records for over 10,000 Coinbase customers, each with $20,000 or more in annual trades during 2013 to 2015. United States v. Coinbase, Inc., et al., Case No. 17-cv-01431-JSC (N.D. Cal. Nov. 28, 2017). The Court found that the “summons as narrowed by the Court serves the IRS’s legitimate purpose of investigating Coinbase account holders who may not have paid federal taxes on their virtual currency profits.” Id.
Are There State Tax Issues to Consider?
If you think of cryptocurrency as intangible personal property, then the state income tax issues parallel the federal income tax issues, i.e., taxability of the transactions and character thereof, reporting, etc. If cryptocurrency is exchanged for nonexempt, taxable tangible personal property or services, then sales tax would seem to come into play as it would in transactions involving fiat currency or property. In this regard, one could think of cryptocurrency as a form of third-party facilitated bartering.
Probably the hardest thing to wrap your head around in trying to understand cryptocurrency is the fact that it exists in the virtual world and there is no physical manifestation of it as there is with a US Dollar, for example. Once you get around that, one may think of cryptocurrency as intangible personal property, and generally the tax consequences follow.
This is a modified version of Mark A. Loyd’s regular column, Tax in the Bluegrass, “Decrypting taxation of cryptocurrency” which appeared in Issue 1, 2018 of the Kentucky CPA Journal.