What tax issues arise with cryptocurrencies?
By now, it’s likely you know someone who is invested in virtual currency, is collecting virtual currency in exchange for services or product or is involved in virtual currency mining. Virtual currency and blockchain are buzzwords that have become popular topics of conversation in both business and social settings, spanning across all generations.
Before diving into the tax issues surrounding the various uses of virtual currency, it’s important to understand the blockchain technology behind it. Blockchain is essentially an open ledger that records transactions between parties in a verifiable and permanent way, allowing the information to be distributed but not copied. This decentralized ledger allows participants to confirm transactions without a need for a central clearing authority (for fiat such as U.S. dollar, this would be a bank).
The most popular use of blockchain so far has been the creation of virtual currencies, though the tech community also has begun finding other uses for the technology, such as voting verification, supply chain management, digital identities, distributed cloud storage and smart contracts, just to name a few.
The first virtual currency (bitcoin) was started in 2009, and today, there are over 1,600 types (and counting). Some investment firms recently have started setting up virtual-currency-based exchange-traded funds. Congress is focused on this emerging asset class and most seem to agree there is a need for a regulatory framework. Securities regulators also have taken an interest in the activity.
As blockchain and virtual currency continue to increase in popularity, many investors and users are still confused about the tax ramifications. Though the Internal Revenue Service (IRS) has released limited guidance as it relates to virtual currency, the IRS did issue a 2014 notice in which it stated virtual currency will be treated as property for federal income tax purposes. Outside of the HODL (hold on for dear life) investor segment that holds onto the virtual currency through wild price swings, many investors are buying and selling on a regular basis. This leads to questions as to what events are taxable and how gains and losses are calculated.
The 2014 IRS notice did note Form 1099-K and 1099-MISC reporting may be required for some virtual currency transactions. Events that are considered taxable events include a coin-to-fiat sale, a coin-to-coin swap, purchases made by coin and the receipt of coin for services. Nontaxable events may include the purchase of coin via fiat, transferring fiat out of an exchange, moving exchange to exchange and moving from an exchange to a wallet.
When the virtual currency activity occurs in an investing capacity, the taxable gains or losses are generally considered capital gains or losses; short-term holdings held less than one year are taxed at ordinary rates, and long-term holdings held more than one year are taxed at the reduced capital gains rates. Because the IRS considers virtual currency as property, the wash sale rules that apply to stock or securities do not appear to apply. There are conflicting opinions regarding the availability of like-kind exchange treatment as it relates to virtual currency for 2017 and earlier tax years. Like-kind treatment will not be available for 2018 and future tax years, as the recently passed federal tax overhaul repealed like-kind exchange treatment for personal property. The online exchanges make it very easy to convert from one virtual currency to another, so as investors filed their 2017 tax returns, many were surprised to realize the exchanges created short-term gains or losses if the like-kind exchange regulations and reporting requirements were not met.
Hard forks also can occur; this is when a single virtual currency splits into two such as bitcoin/bitcoin cash. One possible tax treatment may be similar to a stock split, in which the new coin has zero or an allocated tax basis, and there will be capital gains or losses when sold. Of course, any tax treatment is dependent on the facts and circumstances of the transaction.
Some investors are involved in mining virtual currency, which is the process of verifying transactions to the blockchain and being rewarded with virtual currency. The receipt of virtual currency in exchange for providing the mining services will be taxed as ordinary income at the value of the virtual currency on the date received. This, in turn, becomes the tax basis, and selling the virtual currency at a later date may generate short-term or long-term capital gain or loss dependent upon the value on the date sold.
Many businesses already have begun accepting cryptocurrencies in exchange for their services or products, and many more are starting to consider doing so. Not only is it important to consider the tax ramifications of doing so, it also is vital to understand the nontax implications. From a tax standpoint, the treatment is similar to mining in which the receipt of the virtual currency is taxed as ordinary income at the value of the virtual currency on the date received and selling the virtual currency at a later date can generate gains or losses as compared to the value at the date received.
Because the value of most virtual currencies historically has fluctuated wildly, the business must consider the market risk of holding the virtual currency after receipt, as well as the fees that must be incurred to convert to a fiat currency such as USD. These risks must be weighed against the fact virtual currency truly appears to be here to stay, and accepting payments in the form of virtual currency may become a necessary business decision in the near term.
In order to ensure proper income tax reporting, it is important to keep a detailed record of all purchases and sales in order to accurately report realized gains and losses on any required income tax return filings. As the whole concept of blockchain revolves around the idea of keeping data on a shared and continually reconciled database, the records of the transactions likely can be traced by the IRS in the event of an audit or examination.
The IRS recently won a court-ordered release of certain taxpayer records from Coinbase, a U.S. exchange. As virtual currency continues to increase in popularity, it is likely the IRS will require additional third-party reporting in the future. Additional tax reporting requirements may exist beyond reporting and paying the income tax on taxable sales or exchanges. If the virtual currency is held on a non-U.S. exchange, a FinCEN 114 report (foreign bank and financial account reporting required by the Financial Crimes Enforcement Network) and FATCA (Foreign Account Tax Compliance Act) reporting enacted in 2010 under legislation that aims to prevent tax evasion by U.S. taxpayers using offshore investment vehicles may be required. Substantial penalties and fines can be assessed for not compiling with these required filings.
It is expected additional guidance on tax-related issues will continue to be issued by the IRS with respect to virtual currency, so investors and businesses will need to regularly monitor this guidance and to seek the advice of professional tax and legal advisers to ensure the appropriate tax reporting of their transactions in virtual currency.
Kelli Olson is senior manager at BDO USA LLP. The views expressed above are those of the author and not necessarily those of BDO USA LLP. The comments are general in nature and not to be considered specific tax or accounting advice or relied upon for the purpose of avoiding penalties. Readers are urged to consult with their professional advisers.