The recent dramatic up-and-down value of bitcoin has created new interest in cryptocurrency — and that’s also led to plenty of questions about owning, trading, and investing in it.
Fundamentals of cryptocurrency
Cryptocurrency — also known as virtual or digital currency — is a medium of exchange that uses encryption techniques (typically blockchain technology) to regulate the currency and verify its existence, transfer, and value. There are more than 1,000 different types, with bitcoin being the most valuable and recognizable.
Virtual currency is a digital representation of value that can be converted to tangible currency by purchase or exchange for U.S. dollars. It can also be used in place of traditional currency to pay for goods and services. In fact, bitcoin payments are now accepted at several companies, including some familiar tech giants like Microsoft, Apple, Amazon, along with everyday retail entities such as Subway and CVS.
It’s important to note that, unlike traditional currencies, virtual currencies do not have legal tender status and are not backed by a government.
Bitcoin and other cryptocurrencies — such as Ethereum, Ripple and Litecoin — have also experienced rapid growth in hype and value for investors. However, the cryptocurrency market is highly volatile and susceptible to extreme swings in value from day to day. Example: In January 2018, the market hit an all-time market capitalization high of about $840 billion, but it dropped to around $280 billion in early February.
In December 2017, bitcoin reached an all-time trading high, exceeding $19,000 per unit. But by early February 2018, bitcoin had dropped to a trading price of about $7,700 per unit. Investing in cryptocurrencies can yield substantial returns, but it also comes at a high risk.
The IRS’s position
Because cryptocurrency functions both as a currency to pay for goods and services and as property for investment, it is critical to understand its different uses and how the IRS currently approaches it.
For federal tax purposes, virtual currency is treated as business, investment, or personal property. Therefore, the general tax principles applicable to property transactions also apply to transactions using virtual currency.
Cryptocurrency transactions are difficult to trace because the entire network of users, including their identities, is encrypted. And since no central authority keeps track of users, that stokes concern at the IRS that taxpayers could be hiding income as virtual currency.
With all the recent excitement surrounding cryptocurrency and the new opportunities it presents, 2018 could be a pivotal year for IRS enforcement of the taxation of virtual currency.
If virtual currency is received as payment for services, it is considered taxable income and will be subject to both income tax and self-employment tax. In fact, some employers now use virtual currency to pay employee salaries. Those wages are taxable income to the employee and reportable by the employer on Form W-2. The amount paid to employees will be their basis in the cryptocurrency, which will be used to determine future gains and losses with virtual currency transactions.
The AICPA in late May asked the IRS for additional information about the taxation of virtual currency. We’re monitoring this matter and will provide updates as information is released.
If virtual currency is used to obtain cash or purchase goods or services, a recognizable transaction has occurred. If the FMV of the property or services purchased with the virtual currency exceeds the taxpayer’s adjusted basis in the currency, the taxpayer has a taxable gain. A loss occurs if the FMV is less than the taxpayer’s basis. Keep in mind that the character of the recognized gain or loss depends on whether the cryptocurrency is a capital asset in the hands of the taxpayer.
The process of earning cryptocurrency is called “mining,” which entails a computer digitally solving complex puzzles to create blocks of validated transactions to add to public blockchain ledgers. The unit of cryptocurrency is the reward for creating these blocks. When a taxpayer successfully mines virtual currency, the FMV of the virtual currency as of the date of receipt is includible in gross income. And if a taxpayer’s mining constitutes a trade or business, the net earnings resulting from those activities are considered self-employment income, which would be subject to self-employment tax.
Here’s an example of the tax consequences involving virtual currency:
James, a sole proprietor, accepts five bitcoins from Sam as payment for services. At the time James received payment, bitcoins were worth $200 each. Therefore, James recognizes $1,000 ($200 x 5) of business income. A month later, when bitcoins are worth $250 each, he uses three bitcoins to purchase supplies for his business. At that time, he will recognize $750 in business expense ($250 x 3) and $150 of gain on the bitcoins [($250-$200) x 3]. Since James is not in the trade or business of selling bitcoins, the $150 gain is capital.
Another variation: The bitcoins are worth $150 each at the time the supplies are purchased. James will now have $450 in business expenses ($150 x 3) and $150 of loss on the bitcoins [($200-$150) x 3]. The loss is a capital loss and is eligible for deduction.
And another variation: James uses three bitcoins worth $150 each to purchase a new TV for his personal use. Since the bitcoins were not used for his trade or business and were not held for investment purposes, the $150 loss is considered a nondeductible capital loss.
Given the instability of the cryptocurrency market, taxpayers should be aware of the unresolved issues that persist. Among the lingering concerns:
- Because virtual currency is considered property, is it eligible for a valuation discount or premium in estate or gift tax situations?
- Should the cost to mine and/or acquire virtual currency be capitalized?
- Are retirement accounts permitted to hold virtual currency?
- The IRS has not yet provided guidance on whether virtual currency is a security and, thus, subject to the dealer rules of IRC Section 475 and the wash sale rules.
- Uncertain exchange rates make it difficult to determine FMV.
- Appraisals for charitable contribution deductions are difficult.
- The IRS has given no guidance on which accounting method must be used to track basis in virtual currency.
Despite the uncertainty, some tax planning around gifting transactions and charitable deductions should be treated as other personal or investment property. For example, if a taxpayer held substantially appreciated virtual currency for longer than 12 months (which is classified as “long-term”), he could consider donating it to a public charity to receive the benefit of the donation at FMV instead of at cost. The public charity would receive a larger donation, and the taxpayer would receive a larger deduction without having to recognize the income from appreciation. Under the new tax reform laws, the charitable deduction limitation increased to 60 percent of AGI, making this type of scenario an even more tax-advantageous possibility.
For taxpayers participating in transactions involving cryptocurrency, it’s essential to maintain detailed records of buying and selling activities and self-report those activities with accurate cost basis and sales proceeds. Keep in mind that companies that handle virtual currency may not be tracking this information or providing users with detailed statements or Forms 1099. The IRS is exploring its options to address the lack of required reporting for these transactions. Until mandatory reporting is required, taxpayers should make certain they are keeping those records personally and self-reporting those activities to the IRS on their tax returns.
Virtual currency is still considered a new market and uncharted territory to some extent because the IRS has yet to issue substantial guidance about it. There are many questions about cryptocurrency that we don’t yet have answers for, making tax planning and structuring difficult.
If you’d like to discuss the potential tax implications of using or investing in cryptocurrency, please reach out to your KraftCPAs tax advisor. We’d be happy to help.