A lot has changed for cryptocurrency and its investors since the launch of Bitcoin in 2009. A decade in and the number of cryptocurrencies available has climbed to over 5,000. The market has experienced huge fluctuations with some investors winning big and others losing it all. Bitcoin, Ethereum, and Litecoin have emerged as some of the largest players. And virtual currency is now getting mainstream media attention and being accepted as payment by thousands of retail establishments.
This new and rapidly evolving landscape can make it difficult to keep up on the government regulations being enacted. To help add clarity, this article will focus on individual investors and what we believe are important tax topics for them to be aware of.
What is Virtual Currency?
In general, virtual currency is a digital representation of value that functions as a medium of exchange or a store of value. In some environments, virtual currency operates just like “real” currency (aka, fiat money) — i.e., the coin and paper money of the United States designated as legal tender — but it does not actually have legal tender status in the U.S.
Virtual currency that has an equivalent value in fiat, or that acts as a substitute for fiat, 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, or other virtual currencies.
There are many ways taxpayers earn and use virtual currency: miners, investors, and blockchain companies all use it in their daily operations. As the market has grown larger and virtual currencies have gained in mainstream adoption, government agencies around the world, including the Internal Revenue Service, have begun to monitor and regulate the tax collection related to virtual currency created income. The IRS has stated that virtual currency is one of the main areas of focus for 2019 tax filings.
The IRS’ History with Virtual Currency
To understand where the IRS is with virtual currency now, it is helpful to know where they have been in the past. Notice 2014-21 was the first guidance issued by the IRS on this topic. The notice was very basic, but it aimed to answer the most pressing issues at the time.
The notice stated that virtual currency is considered property, not currency. It also made clear that sales or exchanges of virtual currency are to be treated as taxable events and reported as such on income tax returns as well as information and payroll tax forms. There were some AICPA comments on this notice in 2016 requesting more clarification, but nothing was formerly issued until late 2019.
Examples of Virtual Currency Transactions
Since 2014, the virtual currency market has seen growth, volatility, and transactions that have not been historically contemplated by the IRS or the Internal Revenue Code. Individuals are facing complicated and nuanced situations with their virtual currency transactions, and the IRS has released minimal guidance on how to handle and report them.
For the sake of clarity, let’s look at some virtual currency transactions and how to handle them. To start, we’ll use the example of a taxpayer who mines Bitcoin. On the date the Bitcoin is mined, the value of the Bitcoin is $100. As a result, the taxpayer would include in their self-employment income $100 as gross income subject to both federal income taxes (and potentially B&O tax in WA or other state taxes). The taxpayer is allowed to reduce the business income by their expenses incurred to mine the Bitcoin.
Taking this example one step further, the taxpayer holds onto the Bitcoin for three weeks before deciding to use that Bitcoin to buy Ethereum. At the time of conversion (from BTC to ETH), the amount is now worth $150. Thus, at the time of exchanging Bitcoin for Ethereum, the taxpayer has a gain of $50.
The same situation would hold true if the individual purchased the Bitcoin with fiat for $100 originally. In the miner’s case, there are two taxable events. One, when the miner receives the Bitcoin in exchange for their services of mining. And, two, when the miner then either sells the Bitcoin for fiat, exchanges it into another virtual currency, and/or uses the Bitcoin to buy products (cars, pizza, etc).
Areas of Uncertainty: Hard Forks, Airdrops, and Like-Kind Exchanges
The 2014 guidance left a few uncertain areas with respect to virtual currency. Some of the questions left unaddressed involved hard forks, airdrops, and like-kind exchanges.
Hard forks and airdrops have become very common in the virtual currency space. A hard fork occurs when a blockchain splits into two incompatible separate chains. This is a consequence of using two incompatible sets of rules trying to govern the system. In the past, some had likened it to a stock split, but this was not clear in the 2014 guidance. Air drops have also become quite common. With regards to virtual currency, an airdrop is a procedure for distributing tokens by awarding them to existing holders of a particular virtual currency.
Historically, some believed that the exchange of one currency for another would be considered a “like-kind exchange” and thus not taxed until converted back to fiat. It was unclear whether this would qualify under the IRS rules for like-kind exchanges, but it was indirectly clarified in the Tax Cuts and Job Act of 2017 when all property besides real estate was disqualified for exchange.
Clarification from the IRS
The 2014 guidance left many open questions for holders of virtual currency. Due to the heightened focus surrounding virtual currency, and the many requests from practitioners for clarity and guidance, the IRS issued Revenue Ruling 2019-24 and additional frequently asked questions in October 2019 to assist with some of these rules
The highlights of the notice relate to taxation of hard forks, air drops, record keeping, donating virtual currency, and foreign filing requirements.
The guidance offered limited clarity on hard forks. It did confirm that a hard fork is not the same as stock splits. Rather, the guidance indicates that an airdrop of new currency following a hard fork results in ordinary income to the taxpayer, when they have a right to exercise dominion and control over the virtual currency. However, not all air drops are similar to a hard fork that creates a new currency as a result, so there are some areas of uncertainly here.
In terms of record keeping, FAQ 45 addresses the requirements, but they are also fairly vague. The IRS states that “regulations require taxpayers to maintain records that are sufficient to establish the positions taken on the return.” The guidance goes on to say that you should maintain records documenting receipts, sales, exchanges, or other dispositions. But it does not say what types of records are sufficient for the IRS.
Our clients typically use third-party tracking software to assist with their record keeping. These applications can work well when you are trading on a similar exchange, but they can be much more cumbersome if you use multiple exchanges and trade/send back and forth. Anything beyond basic investing would need a much more sophisticated approach.
In terms of tax reporting, the new guidance emphasizes that virtual currency is a capital asset and should therefore be treated as such for tax purposes. In terms of determining basis for sales, FAQ 38 specifically notes that the first-in, first-out method should be used and that last-in, first-out is not allowed.
The guidance also addressed donations of virtual currency, most notably that you will not recognize gain or loss upon donation to a qualified charity, and the value of the donation is generally equal to the fair market value at the time of donation (if held for more than one year). If the donation will be over $5,000, the charity should provide a Form 8283 to the donor so they can substantiate the donation properly.
Lastly, the new guidance also loosely addressed foreign filing requirements around virtual currency accounts. IRS statements from 2014 indicated that, in most cases, there usually isn’t a filing requirement for virtual currency (primarily referring to cold storage) unless the virtual currency exchange account is offshore. The most recent guidance doesn’t clarify much more than that affirmatively so, when in doubt, disclose.
Where We Are Now
We share all of these highlights with you to emphasize the IRS’ new and intense focus on the virtual currency tracking and reporting efforts. It’s been likened to the scrutiny foreign bank accounting reporting underwent a decade ago. Through data and information received from the U.S. v. Coinbase, Inc. case in late 2017, we know the IRS has issued over 10,000 letters to virtual currency holders. They plan to issue more as part of this new focus.
The IRS also added a new question to the 2019 Form 1040. Schedule 1 of the Form specifically asked if the taxpayer had any virtual currency transactions in 2019. This may have snuck up on taxpayers in 2019, but it is part of the IRS’ effort in raising awareness and gathering information.
In the words of IRS Commissioner Charles Rettig in July of 2019, “If you received a letter from the IRS reminding you that taxpayers must pay taxes on virtual currency transactions, you’d better take action before the IRS does.”
To help mitigate your risk and ensure you are in compliance with all current IRS guidance on your virtual currency investments, here are some tips for virtual currency investors:
- Create a record-keeping system.
- Keep track of acquisition dates, sell dates, and cost basis information.
- Report dispositions on Schedule D and Form 8949 each year, as applicable.
- Use regular capital gains strategies: offset gains with losses, time dispositions to qualify for long-term treatment.
- Watch tax rates: short-term v. long-term capital rates; gains subject to the 3.8% net investment income tax.
- Disclose on Schedule 1, as necessary.
- Disclose on foreign bank and asset reporting, as necessary.
If you have additional questions, please let us know and we’d be happy to assist you.
In our next article for this series, we will discuss the impacts to a business from a federal income tax, state income tax, and an internal book accounting (GAAP) reporting.