Cryptocurrency Can No Longer Hide From the IRS

Houston Holmes, CPA

Senior Tax Manager

May 30, 2018

Chances are you’ve heard of cryptocurrency and how much money people have made (or lost) by investing in the most well-known cyptocurrency, Bitcoin. Unfortunately, we’re not the only ones who have heard about cryptocurrency. The IRS is keenly aware of its presence and has been taking steps to identify those U.S. taxpayers who are profiting from their investments, so that they can get their share of the taxes on the gains.

What Exactly is Cryptocurrency?

First of all, cryptocurrencies are still fairly new, with the first being Bitcoin which was created in 2009. Bitcoin set the standard upon which many new and interesting forms of cryptocurrency have evolved.  To provide some background and context, let’s look at the basics of Bitcoin as it is the most popular and similar concepts will likely apply to other forms of cryptocurrency.

Bitcoins are created by mining, a process of using computing power to solve complex problems. Once the problem is solved, the miner is rewarded with a newly issued bitcoin.  These bitcoins can then be sold, traded on an exchange, or used to buy goods or services.  It’s important to keep in mind there is no physical/tangible form of a Bitcoin – all of the transactions take place virtually using “cryptographics,” with each bitcoin having a coded Internet address that the holder stores in a virtual wallet.  Unlike historical forms of currency, bitcoins are not backed by any government or bank, and no one can be forced to accept them.  They are, however, being accepted by more and more businesses today.

How are Cryptocurrencies Currently Taxed in the U.S.?

Now that we have a better understanding of what cryptocurrency is, let’s take a quick look at how bitcoins and other cryptocurrencies are taxed in the U.S. and a few things to be aware of.

The IRS provided guidance in 2014 in the form of Notice 2014-21.  In summary, the notice states that virtual currency or “cryptocurrency” is considered property for federal tax purposes because it does not have legal tender status in any jurisdiction.   What this means is that the length of time the currency is held may determine the tax rate at which any gains should (or could) be taxed.  If held longer than a year, the profits are typically long-term capital gains.  The tax rate is 0%, 15%, or 20%, plus a 3.8% surtax in some cases, and these rates depend on the total income of the owner.  However, if the currency is held for a year or less, then profits are considered short-term gains and taxed at the owner’s ordinary income tax rate which is typically higher than the long-term capital gains rates.

Basis in cryptocurrency is the fair market value (FMV) of the currency on the date the currency is received. To determine FMV one should use the value of the cryptocurrency compared to the U.S. dollar as quoted in an online cryptocurrency exchange if “the exchange rate is established by market supply and demand.” The receipt of cryptocurrency in exchange for goods and services is a taxable event with the amount realized equating to the U.S. dollar value of the currency received. If obtained through mining, the basis would then be the FMV on the day the cryptocurrency was received.  Additionally, if mined, the FMV as of the day earned should be included in gross income of the taxpayer as the miner has exchanged services for the cryptocurrency (self-employment tax may also be due if in the business of mining).  The abstraction of bitcoin is also a taxable event with the gain or loss being determined by change in value (compared to the U.S. dollar) between the date of acquisition and the date of disposal.

The IRS is Cracking Down.

Cryptocurrencies have proven to be extremely volatile, which makes tracking basis important as gains and losses can vary greatly from day to day. The IRS has been silent on the inventory method to be used when tracking basis.  The default rule for tracking basis in securities is first-in, first-out (FIFO).  There are other options available which include last-in, first-out, average cost, or specific identification.  The general opinion is that any of these methods should be available for property that does not qualify as a security (i.e. cryptocurrency) and that taxpayers should use the method that is most beneficial to them.   However, no direct authority supports this position.

While it may currently be difficult for the IRS to track or identify who made the transaction, a majority of cryptocurrencies transact on blockchain technology which typically means there is a public (and permanent) ledger of every transaction ever made.

Near the end of 2017, the IRS took a popular cryptocurrency exchange, Coinbase, to court and demanded transaction information for users of the exchange. Coinbase surrendered to some of the demands and will provide taxpayer IDs, names, and cryptocurrency transaction records for those with $20,000 or more in initiated transactions through Coinbase between 2013 and 2015.

We believe this increased regulation will continue as the popularity of cryptocurrency continues to grow, thus making it even more important to understand the tax consequences of owning and using cryptocurrency – stay tuned!

Stay Up-to-date