Taxation of Cryptocurrency: Virtual Transactions Bring Real-life Tax Implications

By Mordecai Lerer  |  December 11, 2018

Taxation of cryptocurrency: Virtual transactions bring real-life tax implications

Cryptocurrency is digital currency using encryption techniques, rather than a central bank, to generate, exchange and transfer units of currency. Unlike cash transactions, no bank or government authority verifies the transfer of funds. Instead, these virtual transactions are recorded in a digitised public ledger called a blockchain.

IRS treatment of cryptocurrency

The IRS addressed the taxation of virtual currency transactions in Notice 2014-21, which provides that virtual currency is treated as property for federal tax purposes. Therefore, general tax principles that apply to property transactions must also be applied to exchanges of cryptocurrencies. Notice 2014-21 holds that taxpayers must recognise gain or loss on the exchange of cryptocurrency for cash or for other property. Accordingly, gain or loss is recognised every time that Bitcoin is sold or used to purchase goods or services.

How the gain or loss is recognised depends largely on the type of transaction conducted and the length of time the coin position was held.

Cryptocurrency trading

Settled for cash

Cryptocurrency gains from trading coins held as capital assets are treated as investment income by the IRS, and the same capital gains rules apply. A taxpayer who sells a coin position for cash must report a capital gain on Form 8949. A coin position held for 1 year or less is considered a short-term capital gain, taxed at ordinary tax rates. A coin position held for more than 1 year is considered a long-term capital gain, taxed at capital gains rates.

As with stock trades, capital losses offset capital gains in full, and a net capital loss is limited to US$1,500 ($3,000 for married taxpayers filing jointly) against other types of income on an individual tax return. An 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. However, under certain circumstances, specific identification is allowed. The use of specific identification can drastically reduce the recognised gain on cryptocurrency transactions, since many traders have multiple transactions in the same form of cryptocurrency. However, the use of this method is considered very aggressive.

Exchanged for other coins

Taxpayers who make coin-to-coin trades (e.g. Bitcoin to Ethereum) may mistakenly assume there is no tax liability because they did not receive any actual funds. However, given the IRS’s treatment of digital currency as property, cryptocurrency trades are subject to the same capital gains and losses rules as all other property exchanges.

Some taxpayers and preparers have attempted to delay capital gains income on coin-to-coin trades by classifying the trades as Section 1031 ‘like-kind’ exchanges, whereby they can defer income to the replacement position’s cost basis. While it is possible to argue that cryptocurrency can qualify, there are still problems inherent in the applicability of Section 1031 to coin- to-coin trades, since they may fail to meet certain requirements. The one requirement that the IRS is most likely to challenge if they decide to reject the use of Section 1031 for cryptocurrency trades would be that the coins are not necessarily like-kind (i.e. Bitcoin may not be considered a like-kind property compared to Ethereum). It is also important that if the decision is made to report coin-to-coin trades using Code Section 1031, it must be reported properly using Form 8824 and listing every trade.

To date, the IRS still has not provided guidance on this matter so there is no guarantee that they will accept this treatment for 2017 and preceding years.

The Tax Cuts and Jobs Act of 2017 has eliminated this debate by limiting 1031 like-kind exchanges to real property, not for sale. Starting in tax year 2018, the ability to even consider like-kind exchange for cryptocurrency has been eradicated.

Cryptocurrency mining

Investors also earn cryptocurrency by using their computers to solve a complex mathematical puzzle. As a reward for solving the puzzle, they receive newly ‘minted’ cryptocurrencies. The IRS in Notice 2014-21 states that when a taxpayer successfully ‘mines’ virtual currency, the fair market value of the virtual currency is includible in gross income. Furthermore, an individual who ‘mines’ virtual currency that constitutes 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 Bitcoin on the day it was awarded on the blockchain. This amount also becomes the miner’s basis in the Bitcoin going forward and is used to calculate future gains and losses. For example, assume an investor mines one Bitcoin in 2013. On the day it was mined, the market price of Bitcoin was US$1,000. The investor now has $1,000 of taxable income in 2013. Going forward, the basis in the Bitcoin is $1,000. If the investor later sells it for $1,200, there is a taxable gain of $200 ($1,200 – $1,000).

Payment for goods and services

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 virtual currency instead of in US dollars are taxable to the employee and must be reported on Form W-2. The employee is taxed at the fair market value of the digital currency. 

Payments made to independent contractors for services provided using virtual currency are subject to income tax and self-employment tax and must be reported on Form 1099. Again, the fair market value of the virtual currency establishes the taxable amount.

Any taxpayer who receives virtual currency as payment for goods or services must include the fair market value of the virtual currency in his or her reported taxable income.

Donating cryptocurrency

Instead of selling the cryptocurrency and donating the after-tax proceeds, a taxpayer can donate it directly to their favourite charity. This approach provides significant benefit. The tax deduction will be equal to the fair market value of the donated coin (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. Bear in mind that for this strategy to work, the coin must have been held more than one year.

Questions remain…

The IRS’s guidance in Notice 2014- 21 clarifies various aspects of the tax treatment of cryptocurrency transactions. However, many questions remain unanswered, such as how cryptocurrencies should be treated for international (FBAR and FATCA) tax reporting and whether cryptocurrencies (prior to 2018) are subject to the like-kind exchange rules.

Setting aside these questions, what’s obvious is that cryptocurrency is here to stay, and that scrutiny surrounding its reporting will continue to intensify.

Regardless of market fluctuations, experts predict that the use of cryptocurrency will continue to rise, perhaps even to the point of becoming mainstream. Current technological advances, combined with the promise of lower transaction fees and decentralised authority, are sure to spur more growth in 2018 and beyond.

This article originally appeared in the Q3-Q4 2018 issue of Global Tax Insights by Morison KSi.

About Mordecai Lerer