Despite the name, cryptocurrencies are not “currencies” at all for tax purposes. The IRS treats virtual currency as property (i.e., assets). General tax principles applicable to property transactions apply to purchase and sale of virtual currencies.
As an asset, the taxable income from the sale of a cryptocurrency unit is determined by subtracting the sales price minus the basis.
If purchased, the basis is the cost at with the units were purchased. If received as payment for goods or services, the basis is the fair market value of the virtual currency in U.S. dollars as of the date of receipt.
If mined, then when a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.
The character of the gain or loss depends on whether the virtual currency is a capital asset in the hands of the taxpayer. For most individuals, it will be a capital asset. Inventory and other property held mainly for sale to customers in a trade or business are examples of property that is not a capital asset. Cryptocurrency dealers would therefore report ordinary gain or loss.
Cryoptocurrency transactions can be challenging, especially where there are numerous purchase and sale transactions. Unlike with U.S. securities accounts, cryptocurrency exchanges do not track your gain and loss, and it falls upon the investor to calculate those.
From U.S. based exchanges, you’ll likely receive a 1099-K that will include your total proceeds but will provide no information regarding cost basis.
- 1 Exchange of cryptocurrency is a taxable event
- 2 Reporting cryptocurrency currency transactions
- 3 Determining your basis: FIFO vs. LIFO
- 4 Deferring gain through IRC section 1031 (like-kind exchanges)
- 5 Cryptocurrency IRS enforcement efforts
Exchange of cryptocurrency is a taxable event
Many taxpayers report sales and dispositions of virtual currency, but fail to report exchanges. An exchange of a virtual currency includes: the use of the virtual currency to pay for goods, services, or other property, including another virtual currency such as exchanging Bitcoin for Ether.
Example 1: Bob purchases $1,000 of internet goods with Bitcoin. He initially purchased the Bitcoin for $250. Bob has a $750 reportable capital gain.
Example 2: Bob exchanges $1,000 of Bitcoin for $1,000 of Ether. He initially purchased the Bitcoin for $250. Bob has a $750 reportable capital gain.
Reporting cryptocurrency currency transactions
Virtual currency is considered property for federal income tax purposes. Generally, U.S. taxpayers must report all sales, exchanges, and other dispositions of virtual currency.
This obligation applies regardless of whether the account is held in the U.S. or abroad. You must report virtual currency transactions on your return, regardless of whether you received a payee statement for the transaction (such as a Form W-2, Form 1099, etc.)
Common schedules for reporting virtual currency transactions include the following:
If you were an independent contractor and received payment in virtual currency, you must report it in gross income for the amount of the virtual currency’s fair market value, measured in U.S. dollars, as of the date and time you received the virtual currency. Gross income derived by an individual from a trade or business, carried on by the individual as other than an employee, is reported on Schedule C. This constitutes self-employment income and is subject to the self-employment tax.
If you sold, exchanged, or disposed of virtual currency (e.g. Bitcoin, Ether), or used it to pay for goods or services, you have engaged in a reportable transaction and may have a tax liability. These transactions may be reportable on Schedule D. On the tax return, report the virtual currency received at its fair market value, measured in U.S. dollars, as of the date and time of the transaction.
If you received supplemental income in the form of virtual currency, including income from rental real estate, royalties, partnerships, S corporations, estates, trusts, and residual interests in REMICs, you may need to report this on Schedule E. On the tax return, report the virtual currency received at its fair market value, measured in U.S. dollars, as of the date and time of the transaction
FBAR and Form 8938
As of date, the IRS and FinCen have not indicated whether FBARs or Forms 8938 are required to be filed. Curiously, none of the new cryptocurrency compliance letters mention FBAR or Form 8938 filing requirements. The IRS’ silence on this issue could be interpreted to mean these forms are not required for virtual currency accounts. It’s unlikely that the IRS would penalize taxpayers for a missed filing requirement that both taxpayers and practitioners are unclear about, assuming that all income has been property reported.
Determining your basis: FIFO vs. LIFO
Gain is generally the sales price minus the cost at which you purchased an asset. Determining the cost basis of cryptocurrencies can be a challenge. Some examples to illustrate this:
You purchase a collectible baseball card for $1,000 and later sell it for $3,000. You may have purchased other cards, but it’s easy to know which one you sold because they’re distinguishable. Your cost basis is $1,000 and you have a gain of $2,000. This method of identifying cost is called “specific identification.”
Cyptocurrencies, on the other hand, cannot be distinguished from other cryptocurrencies of the same type. Let’s say you purchase 10 units of Bitcoin for $1,000 in 2015 (cost of $100 per unit), and 8 units in 2016 for $1,000 (cost of $125 per unit). You sell 5 units in 2018 for $1,500. Because there’s no way to distinguish one cryptocurrency unit from another, what do we use as the cost basis for this sale – $100 per unit or $125 per unit? If the Bitcoin was kept in separate wallets, it might be possible to use specific identification.
In the absence of specific identification, your other options are FIFO (First-In, First-Out) or LIFO (Last-In, Last-Out).
Under FIFO, the cost basis would be $100 per unit. Under LIFO, the cost basis would be $125 per unit.
While the IRS has not promulgated the appropriate method, the most conservative approach is to use FIFO. It is important to be consistent year-after-year whichever method you end up choosing.
Switching methods later would require a change in accounting method which would require a recalculation of prior years. Electing LIFO is irrevocable; you’ll need permission from the IRS to switch to FIFO.
Deferring gain through IRC section 1031 (like-kind exchanges)
For tax periods 2017 and earlier, it was possible to defer tax on the disposition of cyptocurrency through a like-kind exchange. However, the recent Tax Cuts and Jobs act limits the ability to apply IRC Section 1031 to real property only.
Cryptocurrency IRS enforcement efforts
In 2016 Coinbase was served with a John Doe summons to produce the records of U.S. account holders between 2013 and 2015. After almost a year of legal challenges, the scope of the summons was narrowed. However, Coinbase is still required to turn over information regarding some 9 million Coinbase transactions and nearly 14,000 accounts to the IRS. The IRS estimated that only 800 or 900 account holders actually reported their bitcoin sales during the periods covered by the summons.
It’s likely that taxpayer non-compliance identified from the Coinbase summons will be addressed through audits and criminal investigations. Depending on the IRS’ success in those cases, we’ll likely see additional enforcement efforts and perhaps additional John Doe summons issued to other crypto exchanges. Or in the case of foreign exchanges, the Justice Department would request summons enforcement pursuant to a tax treaty.
The IRS recently announced in a tax conference in New York City that its criminal investigators will soon be undergoing mandatory enforcement training. However, the task force would be primarily focused on prosecuting individuals who commit tax-related crimes using cryptocurrency.
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