You read the headlines, you hear the news, you see the bitcoin buzz….Cryptocurrency is capturing everyone’s attention. With recent tax reform enacted by the Tax Cuts and Job Act and the looming tax deadlines approaching, now is the time to learn about the potential tax implications to investors and taxpayers.
In March of 2014, the IRS issued Notice 2014-21, providing guidance on the tax treatment of virtual or cryptocurrencies (Bitcoin, Ripple, Litecoin and Ethereum, among others). The Notice characterized cryptocurrency as property for Federal income tax purposes. General tax principles apply to gain or loss derived from the sale or disposition of cryptocurrency. The Notice also stated that cryptocurrency is not treated as foreign currency and therefore the sale of a cryptocurrency does not result in Section 988 gain or loss (ordinary income or loss tax treatment).
With general tax principles applying to cryptocurrency transactions, a taxpayer will recognize gain or loss whenever he exchanges cryptocurrency for cash or other property. The gain or loss will be measured by the fair market value of the cash or property received less the taxpayer’s basis in the cryptocurrency surrendered. The character of the gain or loss is dependent upon whether the cryptocurrency surrendered is a capital asset or not a capital asset in the hands of the taxpayer.
If the cryptocurrency is a capital asset to the taxpayer (including cryptocurrency held for investment purposes), the result is a capital gain or loss. When it is a capital gain or loss, the character is determined by the holding period rules with the preferred 15% and 20% rates applying to long-term capital gains for individuals and trusts.
In situations where the cryptocurrency is not a capital asset owned by the taxpayer (generally property held in connection with a trade or business), the resulting gain or loss is generally ordinary. The deductibility of a loss is typically based on whether the cryptocurrency was held in connection with a trade or business or for investment (i.e. with a profit motive) or if it was held for personal purposes. Losses on transactions entered into for personal purposes are not deductible.
Determining when a cryptocurrency transaction results from investment motives or personal motives, can be difficult. For example, Taxpayer 1 opens a cryptocurrency account or virtual “wallet” with the motive of holding it for investment purposes. After incurring losses in the account, Taxpayer 1 liquidates his holdings, realizes the loss, takes the proceeds and purchases a car. This loss is a deductible capital loss since the cryptocurrency was held for investment purposes. Taxpayer 2 holds the same cryptocurrency in an account and uses it on a regular basis to make purchases of goods and services for personal purposes. Taxpayer 2 liquidates his account, realizes a loss and uses the proceeds to purchase the same model car as Taxpayer 1. The loss is a non-deductible personal loss. The same result would apply if Taxpayer 2 purchased the car directly with the cryptocurrency. Despite the fact that these two taxpayers held the same cryptocurrency in similar accounts and ultimately used it to purchase the same type of asset, the tax results are very different.
Every time a taxpayer buys and then sells cryptocurrency, he will incur a gain or loss for tax purposes. When a taxpayer uses cryptocurrency as a means of payment for goods or services, he will also incur a gain or loss for tax purposes. The nature of that gain or loss is determined by the status of the cryptocurrency in the hands of the taxpayer (capital asset or not) and the underlying purposes of the transaction (trade or business vs. personal). Given the recent volatility in cryptocurrencies, a taxpayer who regularly uses cryptocurrency as a form of payment will likely realize numerous gains and losses. Taxpayers are required to keep cost basis records for each lot of cryptocurrency that they purchase and sell. For taxpayers regularly using and accepting a cryptocurrency as a form of payment, this could be a challenging endeavor.
When a taxpayer purchases cryptocurrency, his basis is the amount paid in US dollars. When a taxpayer sells cryptocurrency, the amount of proceeds equals the US dollars received (or the US dollar equivalent in other cryptocurrency received as discussed in the next section). When a taxpayer receives cryptocurrency as payment for the sale of goods or in exchange for providing services, his basis in the cryptocurrency is its fair market value as of the date the cryptocurrency is received. This same fair market value represents the US dollar value of the proceeds from the sale of such goods or amount of taxable income earned in exchange for services. Cryptocurrencies are generally traded on an exchange with quoted prices routinely available. Notice 2014-21 states that where a cryptocurrency is traded on an exchange and an exchange rate is determined by market supply and demand, the fair market value of the cryptocurrency is determined by converting it into US dollars using the exchange rate “in a reasonable manner that is consistently applied”. Since many cryptocurrency markets trade around the clock, this provision seems to allow flexibility in determining the time of day at which a taxpayer can select the exchange rate to use, so long as he does so consistently.
Prior to the passage of the Tax Cuts and Jobs Act (2017 Tax Act) in December of 2017, there was debate and uncertainty as to whether a taxpayer could defer the taxable recognition of gain on one cryptocurrency by exchanging it for the same cryptocurrency or for another cryptocurrency (for example an exchange of Bitcoin for Ripple) through a like-kind exchange under Section 1031. In Notice 2014-21, the IRS states that cryptocurrencies are “property”. Pre 2017 Tax Act Section 1031 applied to “property”. Accordingly one could make the argument that an exchange of cryptocurrency for cryptocurrency could qualify for gain deferral under Section 1031. The IRS has not ruled directly on this point. However, it is important to note that coin-to-coin trades executed on coin exchanges do not constitute a direct two-party exchange and coin exchanges are likely not qualified intermediaries in a multi-party exchange. The IRS has issued past rulings stating that gold exchanged for gold (for example gold bullion for South African Krugerrands) qualified as a like-kind exchange under Pre-2017 Tax Act Section 1031, but gold exchanged for silver did not. By analogy, one could conclude the exchange of one cryptocurrency for another would not qualify while the exchange of a cryptocurrency for the same cryptocurrency would. In either event, the debate becomes moot for exchanges occurring after December 31, 2017, as the 2017 Tax Act changed Section 1031 to only apply to real property. The issue remains for the 2018 tax filing season for 2017 transactions reported on 2017 tax returns. Taxpayers should consult their tax advisor regarding such cryptocurrency transactions.
It is estimated that millions of U.S. taxpayer Bitcoin transactions have occurred, yet the IRS has stated that only 800 to 900 taxpayers reported their Bitcoin gains from 2013 through 2015 by electronically filing IRS Form 8949 (the IRS form used for reporting sales and other dispositions of capital assets). IRS Criminal Investigation Division believes that virtual currency has increasingly become a tax evasion issue.
In connection with its investigation of alleged under-reporting of income and failure to pay taxes on cryptocurrency transactions, on November 29, 2017, it caused the U.S. District Court for the Northern District of California U.S. v. Coinbase 17-01431 to issue an order enforcing a “John Doe Summons” to the Coinbase virtual currency exchange. Coinbase, as one of the world’s largest platforms for exchanging virtual currencies, has approximately 5.9 million customers and has facilitated approximately $6 billion exchanged to Bitcoin. The Coinbase summons seeks a wide variety of records including, for example, taxpayer identities for all of its customers who have bought, sold, sent or received cryptocurrency worth $20,000 or more in any tax year from 2013 to 2015, transaction logs and correspondence.
As far as information reporting requirements go, payments made in virtual currency appear to be subject to the same information reporting requirements as payments made in property, real currency or instruments denominated in real currency. For example, gains and losses attributable to virtual currency transactions may need to be reported on Form 8949 that is attached to Schedule D of Form 1040; payments made by a person engaged in a trade or business to an independent contractor using a virtual currency for the performance of services may require reporting of such payments to the IRS and to the payee on Form 1099 MISC; or if an employer exchanges cryptocurrency with an employee as payment of wages, the employee must report the fair market value of the virtual currency measured in U.S. dollars as compensation income as of the date of the payment, and the employer must report that value on a Form W-2. The fair market value of cryptocurrency paid as wages is also subject to federal employment taxes paid by the employer and income tax withholding and FUTA.
Questions remain as far as whether virtual currencies need to be reported on FBARs (foreign bank account reports). A U.S. taxpayer’s accounts at a foreign binary Bitcoin options exchange or a foreign Bitcoin options exchange could be reportable on an FBAR as a foreign financial account and on IRS Form 8938. In 2014, however, the IRS issued a statement, saying, “The Financial Crimes Enforcement Network, which issues regulatory guidance pertaining to Reports of Foreign Bank and Financial Accounts (FBARs), is not requiring that digital (or virtual) currency accounts be reported on an FBAR at this time but may consider requiring such accounts to be reported in the future.” The IRS’s position hasn’t changed to date.
As evidenced by the Coinbase case, cryptocurrency transactions have the attention of taxing authorities around the world, and as in any new industry, tax compliance can be an area of challenge. For those participating in virtual currency transactions of any kind (i.e., purchasing, selling, receiving, sending), it is important to inform your tax return preparer and other tax advisors so that these transactions can be reported properly.