Despite its name, cryptocurrency is not currency. That means that crypto enthusiasts may run into unexpected complications when it comes time to give the tax authorities their due.
Bitcoin arrived on the world stage in 2009. At the time, many of its boosters thought it would upend the existing financial system. Its detractors warned that it would never be taken seriously and that it had no value beyond allowing seedy characters in the dark reaches of the internet to conduct illicit activities. Twelve years on, both groups were at least partially wrong. Today Bitcoin and other cryptocurrencies have largely come out of the shadows.
One of the clearest signs of this shift is the investment of major Wall Street players. Fidelity announced plans to store and trade Bitcoin and Ether as far back as 2018. Last month, Bank of New York Mellon (one of the oldest banks in the U.S.) announced it will hold, transfer and issue cryptocurrencies, including bitcoins, on its clients’ behalf. BNY Mellon’s integrated system will allow clients to manage cryptocurrency holdings the same way they manage traditional assets like U.S. Treasuries or stocks. Other institutions including JPMorgan Chase and Goldman Sachs have indicated interest in offering or expanding services related to cryptocurrencies. In the case of Goldman Sachs, the firm reportedly has restarted its cryptocurrency trading desk.
As financial institutions bring cryptocurrencies in from the cold, some businesses are investing in cryptocurrencies using their cash reserves. Tesla went big, announcing a $1.5 billion bitcoin purchase in February. Firms including MicroStrategy and Square have also made significant purchases. On a smaller scale, PayPal and Square’s Cash App are making it easier for individuals to buy and sell cryptocurrency without navigating third-party exchanges or keeping track of a separate virtual wallet. Mastercard has also said it will start supporting “select” cryptocurrencies on its network in 2021. With Bitcoin’s value again reaching record highs, it is easy to see why individuals and companies alike find it tempting to dive in.
Widespread adoption of cryptocurrencies has meant increased bureaucratic attention. The Internal Revenue Service has stepped up enforcement of its existing reporting requirements as cryptocurrencies – part of a broader category of “virtual currencies” – become more mainstream. The Service announced that it would treat Bitcoin and other cryptocurrencies as property as far back as 2014, but the rules are now becoming relevant to an ever-widening pool of taxpayers. If you hold or plan to hold Bitcoin, Ether or any other cryptocurrency, it is important to understand and comply with IRS requirements, which may not be intuitive for some taxpayers. In addition, if you fail to report cryptocurrency transactions or to pay the associated tax, you may be subject to penalties and interest. Fraudulently hiding taxable transactions can even lead to criminal charges.
Basic Tax Rules For Cryptocurrencies
When you buy a slice of pizza with cash, the IRS is not interested. Other than any state or local sales tax, the event isn’t taxable; you are using currency the way currency is designed to be used. However, because the IRS considers Bitcoin and other cryptocurrencies property and not currency, Bitcoin purchases are more like selling a stock and using the proceeds to buy something. If your pizzeria accepts bitcoins, using them to buy a slice may be a taxable event.
The IRS announced last fall that it would add a newly prominent question about cryptocurrency to the individual income tax Form 1040 for 2020. While the question debuted in tax year 2019, the new placement is designed to make it harder for taxpayers to claim they didn’t know about reporting requirements. If you plan to use cryptocurrency in a transaction, it pays to understand the rules well before you sit down to prepare your income tax return. Buying cryptocurrency generally is not a taxable event. Selling or trading it usually is.
Cryptocurrency consists of digital tokens recorded on a decentralized ledger, such as a blockchain. When you sell or trade cryptocurrency, the transaction may represent a capital gain or a capital loss. To tell, you will need to know your cost basis: What was the cryptocurrency worth when you received it? If you purchased the cryptocurrency with U.S. dollars, then your cost basis is simply the amount you paid, including any commissions and fees. If you acquired the cryptocurrency another way, the calculation involves determining the cryptocurrency’s fair market value.
If the cryptocurrency is listed on an exchange, determining fair market value is relatively easy. The IRS only requires using an exchange rate “in a reasonable manner that is consistently applied.” The calculation becomes more complicated if you get it directly from another individual – what the IRS calls a “peer to peer” transaction – or in some other way that did not involve an exchange. In that case, the fair market value is determined as of the date and time the transaction is recorded on the distributed ledger: the centralized, public recording of a particular cryptocurrency’s transactions. The IRS will accept evidence of the value at that time from a cryptocurrency or blockchain explorer, which analyzes global indices of a given cryptocurrency. These tools can calculate a cryptocurrency’s value at an exact time and date. If you want to establish basis as something other than the explorer value, the burden of establishing that the value you assign is accurate rests with you.
If you receive cryptocurrency as payment for goods or services, you must include its fair market value in your gross income when you file your income tax return. For freelancers, such payments are also subject to self-employment tax. If you use cryptocurrency to pay someone else for goods or services, you will likely need to report that transaction too. Whether you are paying a freelancer for their work, paying rent to a tech-minded landlord or just buying some coffee, if you use a cryptocurrency, the IRS wants to know. Property exchange rules also apply if you are exchanging one form of cryptocurrency for another – say, Ethereum for Bitcoin. I will discuss such exchanges in more detail later in this article.
Capital Gains And Losses
When you sell cryptocurrency, any difference between the payment you receive and your cost basis may be taxable as a capital gain. Like any other capital gain, you should report it on IRS Schedule D and Form 8949. As with other appreciated investments, your tax rate will depend on whether you have held the asset for more or less than one year, and you can offset capital gains with capital losses. So far, so good. However, because of cryptocurrencies’ unique characteristics, the question of how to report gains can become complicated.
Part of the complication comes from determining which lots of your virtual currency you wish to sell. Say you acquired your current collection of bitcoins in three different transactions. Your basis will vary depending on bitcoin’s fair market value the day it entered your digital wallet. The IRS rules for capital transactions default to a “first-in, first-out” method, which is sometimes abbreviated FIFO. In this approach, any bitcoins you sell are assumed to be those you acquired longest ago – day one of your three transactions. However, under certain circumstances, you may prefer to sell your bitcoins using a specific identification method to identify lots with the highest cost basis. This can reduce your recognized capital gain on a given transaction, especially with a highly volatile asset like Bitcoin.
However, to do this you must have a consistent and recognized way to track separate lots of cryptocurrency. Cryptocurrency, by design, can be subdivided nearly infinitely. These subdivisions do not automatically carry unique lot identifiers. If a unit of cryptocurrency does not have a unique digital identifier, the taxpayer will need to keep records showing transaction information for each unit held in a single digital wallet. These records should include the date and time the account holder acquired the cryptocurrency, as well as its basis and fair market value on that date. There are also services that manage these records for you, such as Coin Tracker or Zen Ledger. In the absence of detailed records, the IRS will default to assuming a FIFO approach, which could lead to you recognizing more income – and thus owing more tax – than you expected.
Taxpayers should also bear in mind that gains on cryptocurrency count as net investment income. If your modified adjusted gross income for the year surpasses $200,000 (or $250,000 for married couples filing jointly), such gains are subject to an additional 3.8% Medicare tax. (For more on this tax, see my colleagues’ article on the subject.)
Forks
Cryptocurrency transactions are recorded in a digital ledger, often a blockchain. In some cases, a cryptocurrency’s blockchain splits. This process is known as a “hard fork” and results in two cryptocurrencies where there used to be one. If a cryptocurrency you own goes through a hard fork and you don’t receive any new cryptocurrency as a result, it is not a taxable event. But if you receive a transfer, potentially through an “airdrop” where cryptocurrency flows to multiple individual ledgers, you may have to report taxable income. Just as if you purchase cryptocurrency or receive it in payment, your taxable income will reflect the cryptocurrency’s fair market value on the day you receive it. In this case, that is the day it is recorded on the distributed ledger, assuming you can transfer or sell it that same day.
In contrast, a “soft fork” represents a change to a distributed ledger that does not divide the ledger or create a new cryptocurrency. In this case, your position does not change, and so you have not received any taxable income in the eyes of the tax authorities. Transferring cryptocurrency between accounts or digital wallets, as long as all accounts involved belong to you, also is not a taxable event.
Gifts And Charitable Contributions
If you receive cryptocurrency as a gift, you will not owe tax on it. Your cost basis in the gift equals the giver’s basis for the purposes of determining whether you recognize a capital gain when you sell the gifted assets. To determine whether you recognize a capital loss, your basis is the giver’s basis or the fair market value of the cryptocurrency when you received it, whichever is less. If you are the one giving cryptocurrency to someone else, gift tax concerns may apply if your total gifts for the year, to any recipient, exceed the annual gift tax exclusion amount, which is currently $15,000.
The IRS treats a gift of cryptocurrency to a charitable organization just like any other donation of appreciated assets. If you plan to deduct your donation, the deduction generally equals the fair market value of the cryptocurrency at the time you donate it. If you have philanthropic goals and have held your cryptocurrency for at least a year, this can be an effective strategy. If you have held the cryptocurrency for less than a year, you can still give it to a charitable organization, but your deduction will be the lesser of the gift’s fair market value or your cost basis.
“Like Kind” Exchanges
As I mentioned previously, exchanging one type of cryptocurrency for another is usually subject to the same tax rules as any other exchange of property. At one point, some cryptocurrency enthusiasts tried to argue that these are “like kind” exchanges and therefore should be classified as Section 1031 exchanges, so named for the corresponding portion of the Internal Revenue Code. These exchanges allow taxpayers to delay recognizing capital gains if they sell appreciated property and reinvest the sale’s proceeds in the same type of property within a certain amount of time. Section 1031 exchanges are most often used in real estate investing. Some professionals initially took the position that exchanging Ether for bitcoins, for example, could use the same mechanism.
This position became untenable for future transactions due to the Tax Cuts and Jobs Act of 2017. That tax reform package explicitly limited Section 1031 exchanges to real property. As of Jan. 1, 2018, treating cryptocurrency exchanges this way is no longer viable, even in theory. Whether trades prior to 2018 can be characterized this way is less clear.
Foreign Account Reporting
Not every cryptocurrency exchange is based in the United States. If you hold cryptocurrency on an exchange based overseas, do you have to report it the way you would a foreign bank or investment account? The rules are in flux. For now, the government’s Financial Crimes Enforcement Network, or FinCEN, does not consider a foreign account holding virtual currency a reportable account for purposes of FinCEN Form 114, Report of Foreign Bank and Financial Accounts (often referred to as the FBAR). There are, however, suggestions that the agency may amend the rules to include such accounts in the future. In the case of Form 8938, Statement of Specified Foreign Financial Assets, the IRS has not made a definitive statement on its stance. Given the nuances in this area, taxpayers who hold cryptocurrency in accounts based outside the U.S. should stay alert to reporting requirement changes and consult a knowledgeable tax professional whenever reporting obligations are not clear.
This article does not cover every possible scenario, but it should make clear that cryptocurrency can complicate your tax planning and reporting. In addition, I have only touched on issues for people buying, selling and trading; if you engage in cryptocurrency mining, you may face even more complications. If you hold cryptocurrency, you need to keep detailed records and be sure to comply with IRS reporting requirements. You may want to file an amended return if you now realize that you should have reported transactions in past years. A tax professional can help you determine what you need to do to stay compliant.
Public enthusiasm for Bitcoin and other cryptocurrencies means IRS scrutiny will only grow in the future. Taxpayers should take care to give tax authorities no reason to cry foul.
