IRS Warns Taxpayers to Report, Pay Taxes on Virtual Currency Transactions by Tony Gutierrez, CPA
Taxpayers’ increasing use of cryptocurrency as an investment vehicle and form of payment has fallen under the watchful eye of the IRS. Over the past few years, the service has taken several steps to regulate virtual currency, including Bitcoin, Ethereum and Ripple, and legally pursue those individuals who have evaded taxes on transactions using these digital assets.
For federal tax purposes, the IRS treats cryptocurrency as property that is subject to capital gains tax rules when held as an investment and as taxable ordinary income when received as a form payment. As taxpayers get ready to file their 2019 tax returns, they should remember that failure to pay taxes on these non-tangible capital assets can result in significant penalties, interest on unpaid amounts and criminal prosecution. Here are some points to keep in mind when reporting the receipt, sale, exchange, or other acquisition of any financial interest in any virtual currency.
Cryptocurrency as an Investment
Cryptocurrency’s treatment as a capital asset means that taxes will apply whenever an investor does any of the following:
- sells digital currency for a gain
- converts it to cash
- trades it for another digital currency, or
- uses it like cash to buy a product or service at a point in time in which its value is more than the investor initially paid to acquire it.
The applicable tax rate depends upon several factors, including the holding period, which is the amount of time between when an investor acquires the asset and when the taxable event occurs. In general, virtual currency sold or exchanged more than one year after acquisition is subject to long-term capital gains rates.
For example, an investor who bought Bitcoin in 2018 and sold it in 2020 would be subject to a 20 percent long-term capital gain tax on the difference between the his or her adjusted basis in the Bitcoin (the purchase price plus certain expenses, less certain credits or deductions) and the value of Bitcoin at the time of the sale. However, if the same investor cashed in his or her Bitcoin in 2018, the realized gain would be subject to ordinary income tax, which, depending on the investor’s annual earnings and tax bracket, could be as high as 37 percent. Your basis (also known as your “cost basis”) is the amount you spent to acquire the virtual currency, including fees, commissions and other acquisition costs.
It is important that investors consider the wide fluctuations in cryptocurrency value that can occur before making any decision to use, sell or trade their virtual currency tokens. Not only can timing help to minimize tax liabilities when investors sell or cash out their virtual money, it can also help investors avoid the mistakes of incurring taxes and paying outlandish prices when they use cryptocurrency to make purchases.
Cryptocurrency as Payment
Virtual currency that taxpayers receive as wages from employers are subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax. Employers must include this remuneration on employees’ W-2, wage and tax statements. Virtual currency paid to independent contractors are reportable on IRS Form 1099-Miscellaneous Income. Taxpayers who pay for services using virtual currency held as a capital asset will need to calculate the difference between the fair market value of the services they received and their adjusted basis in the virtual currency exchanged to determine whether they have a reportable capital gain or loss.
Taxpayers who receive cryptocurrency as a form of payment for services rendered must report on Schedule 1 of their federal tax returns their basis in that virtual currency, which is the fair market value of the virtual currency, in U.S. dollars, on the date they receive payment. As a result, taxpayers should take steps to maintain detailed records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the virtual currency on the dates of those transactions.
Cryptocurrency as a Gift
Virtual currency received as gift is not recognized as taxable income until the recipient sells, exchanges, or otherwise disposes of that virtual currency. At that point in time, the taxpayer must determine his or her basis in the gift, which varies depending on several factors.
For example, when determining a taxable gain, the taxpayer’s basis is equal to the original donor’s basis plus any gift tax the donor paid on the gift. To establish if the taxpayer has a loss, basis is equal to the lesser of the donor’s basis or the fair market value of the virtual currency at the time the taxpayer received it as a gift. Taxpayers basis is deemed to be zero if they do not have documentation to substantiate the donor’s basis in a gift of cryptocurrency. Similarly, if the recipient of a bona fide gift of cryptocurrency does not have documentation to substantiate the donor’s holding period, then the recipient’s holding period begins the day after he or she receives the gift.
Other Important Factors to Remember
The IRS treats the “mining” of cryptocurrency tokens that are digitally recorded on a distributed ledger or blockchain as taxable wages, self-employment income or business income. The value of cryptocurrency received via transactions facilitated by cryptocurrency exchanges is the amount that is recorded by the cryptocurrency exchange for that transaction in U.S. dollars. If the transaction is facilitated by a centralized or decentralized cryptocurrency exchange but is not recorded on a distributed ledger or is otherwise an off-chain transaction, then the fair market value is the amount the cryptocurrency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it had been an on-chain transaction.
As recently as October 2019, the IRS issued a revenue ruling clarifying that virtual currency received from a “hard fork” or “airdrop” is reportable as ordinary income subject to tax at the receiving taxpayer’s highest marginal tax rate. A hard fork, also known as a blockchain split, occurs when a cryptocurrency undergoes a protocol change that results in the creation of a new cryptocurrency on a new distributed ledger as well as legacy cryptocurrency on the legacy distributed ledger.
The IRS has made it clear that it considers digital money to be a physical asset subject to U.S. income taxes, and it will take all necessary efforts to uncover and criminally pursue digital currency tax evaders. As the IRS and other government agencies focus on regulating cryptocurrency, investors must understand how the tax code treats virtual money, and they must commit to meet their related tax responsibilities or risk criminal prosecution.
About the Author: Tony Gutierrez, CPA, is a director in the International Tax Services practice of Berkowitz Pollack Brant Advisors + CPAs, where he focuses on tax and estate planning for high-net-worth individuals, family offices, and closely held businesses in the U.S. and abroad. He can be reached at the CPA firm’s Miami office at 305-379-7000 or firstname.lastname@example.org.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.