WHAT DOES THE IRS THINK ABOUT CRYPTOCURRENCY?
The IRS defines cryptocurrency or virtual currency as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Although the IRS admitted that cryptocurrency may operate like currency—money of any country that is legally recognized, customarily used, and commonly accepted form of payment—it concluded that cryptocurrency is not currency.
The IRS has determined that transactions in cryptocurrency shall be treated as transactions in property; that is, like almost everything we own and use, cryptocurrencies are capital assets. Consequently, the gains or losses associated with cryptocurrency transactions are treated as capital gains or capital losses.
HOW DOES ONE CALCULATE A CRYPTOCURRENCY CAPITAL GAIN OR CAPITAL LOSS?
When dealing with capital assets, like cryptocurrencies, a capital gain or capital loss occurs when an asset is sold. To determine your capital gain or capital loss, you need to determine the difference between your adjusted basis in the asset and the price at which the asset was sold.
For example, let’s say Andrew bought five GLG-coins (5-GLG) for a total of two-hundred dollars ($200). Andrew’s adjusted basis in his 5-GLG would be $200—every 1-GLG having a basis of $40. Now let’s say that Andrew took 4-GLG, having a combined basis of $160, and sold them for a $400. Because his basis is less than the amount realized from the sale, Andrew will recognize a capital gain equal to the difference between his basis ($160) and the sale price ($400). Therefore, Andrew would recognize a capital gain of $240, which would be taxable.
WHAT IF I HAVE SOME CAPITAL LOSSES?
At the end of the year, go through all of your transactions and determine the combined total of capital losses and gains generated by the sale of cryptocurrency or other assets. Why? Because capital losses reduce your capital gains figure, which then lessens your tax liability. Furthermore, if your capital losses exceed your capital gains, you can claim up to $3,000 of additional losses—reducing the amount of your ordinary income subjected to taxes.
WHAT TAX RATE APPLIES TO CAPITAL GAINS?
Firstly, capital gains can manifest as long-term capital gains or short-term capital gains. When a particular capital asset is bought and sold over a year, the capital gain or loss is short term. Accordingly, when a particular capital asset is bought but held for longer than one-year before being sold, the capital gain or loss would be considered long-term. Notably, short-term gains are taxed at the same rate as ordinary income, but long-term gains are taxed at 0%, 15%, or 20% depending on your tax bracket.
Additionally, traders of cryptocurrency are required to classify the timing aspects of capital-gains or capital-losses with one of the following two-methods of accounting: (1) First-In-First-Out (FIFO), or (2) Last-In-First-Out (LIFO). These two-methods function as one would imagine. Under FIFO, the first coin bought is the first coin sold, and, under LIFO, the last coin bought is the first coin sold. The choice between FIFO and LIFO dictates the basis of the coin you are selling and determines the amount of capital-gain or capital-loss from the sale. Initially you may elect to utilize either method; however, there are numerous restrictions about subsequently changing from one method to the other.
Crypto traders should take some time to analyze their transactions and perform accounting due-diligence. Typically, the IRS allows traders to amend their tax returns from the previous 3-years; however, once this period elapses, you may be stuck using the less favorable accounting method. When reconciling substantial transaction histories, we commonly find the difference between FIFO and LIFO to be well over $100,000 in taxes.
Throughout 2017, it was not clear whether cryptocurrencies could undergo a 1031 “Like-Kind-Exchange”; however, under the Tax Cuts and Jobs Act, only real estate transactions qualify for a tax deferred Like-Kind-Exchange in 2018 and forward. However, in earlier years the requirements for Like-Kind-Exchange make it impractical for this treatment to be applied to most (if not all) exchanges from one cryptocurrency to another. Accordingly, in the area of tax law, when you exchange one cryptocurrency for another, the transaction is deemed to be a sale of the former and a purchase of the latter.
HOW DOES THE IRS TREAT TRANSACTIONS BETWEEN CRYPTOCURRENCIES?
Imagine that Andrew has 100-GLG and his friend Michael has 10-ETH. Andrew and Michael want to diversify their portfolios, so they decide to make a trade. Andrew agrees to give 50-GLG in exchange for Michael’s 10-ETH. They complete the transaction. Now, Michael has 50-GLG and Andrew has 50-GLG and 10-ETH. However, for tax purposes, what actually happened should be broken into two stages.
Firstly, we pretend that Andrew sold 50-GLG to the market, and that, at the same time, Michael sold 10-ETH, also to the market. In exchange for their coins, Michael and Andrew receive the appropriate amount of US Dollars. Then, Michael takes his US Dollars and buys 50-GLG while Andrew takes his US dollars and buys 10-ETH. The friends will then use the US Dollar amount to determine the basis of their purchases and to calculate any capital gains or losses on their sales.
A similar pattern occurs when such transactions are made through online Exchanges, although many of the current exchanges also charge a fee.
WHAT ABOUT FEES?
When an exchange or other service charges some amount of cryptocurrency (say .0002 BTC) as a transaction fee, such amount must be treated like a sale; that is, we must again calculate the capital gain or loss, and pay the required taxes. Additionally, if using one cryptocurrency to buy another crypto currency, then the fair-market-value of the fee (in USD) can be added to your basis in the acquired Cryptocurrency.
Notably, both the size of the fee and the currency in which it is applies varies significantly between exchanges and other services; accordingly, when preparing your taxes special care should be given to ensure that you satisfy your tax obligations without overpaying on your capital gains.
WHAT ARE THE TAX IMPLICATIONS OF A HARD-FORK?
Hard forks create a new cryptocurrency, and the IRS has a long history of treating new, unearned sources of wealth as taxable income. For example, the IRS also treats lottery winnings, gameshow-prizes, and buried treasure as taxable income. That cryptocurrency generated by a hard-fork is taxable income requires only a brief analysis. However, the issue of how much income you received can be more complex.
Notably, analysts use a couple of methods for valuating new cryptocurrencies. Firstly, if you receive the cryptocurrency after it started being traded on an exchange then you should use the Fair-Market-Value at the time of receipt. Alternatively, if exchanges have not begun to support the cryptocurrency, you may be able to determine the value by finding its price on a futures market. Ultimately, recipients of “free” cryptocurrency will be alright if they make a good-faith effort to establish the FMV by some reasonable method.
HOW DOES TAX LAW APPLY TO MINING ACTIVITY?
According to the IRS, any earnings that result from successfully validating blocks (i.e. anything received from mining the cryptocurrency), must be included in your gross income calculation, reported as the FMV in U.S. dollars. Additionally, if a miner is self-employed, certain expenses may be deductible from their gross income; however, earned income from self-employment may be subject to the self-employment tax.
WHAT SHOULD I DO IF MY JOB PAYS ME IN A CRYPTOCURRENCY?
When you receive a cryptocurrency as payment, you must report the amount as ordinary income. Generally, the are two ways quantify the value of such income, which will also be your basis in the cryptocurrency. Firstly, if your employment agreement specifies a payment amount in a fiat currency, such as U.S. dollars, then you simply use that value.
Alternatively, you should determine the value of the cryptocurrency from a common exchange and use that value for your income and basis. Assuming you are using a cash-based method of accounting then the value received would be the value of the coin at issuance. However, if you use an accrual method, then the value of each coin must be determined when the coin is earned, which is a more complex process.
WHAT IF USE MY CRYPTO HOLDINGS TO PAY FOR GOODS OR SERVICES?
If you provide crypto in exchange for basically anything of other than cash, the IRS considers the transaction a barter that must be included in income. Essentially, the IRS finds bartering with crypto to be comprised of a sale of the crypto for cash and a subsequent cash purchase. Specifically, the IRS views purchases of services and goods with crypto as a sale the relevant crypto. Notably, this approach is not limited to crypto—as the same outcome occurs when exchanging stock for goods and services.
This means that if you do trade your crypto for goods and services, you have to report every exchange as a sale of your crypto and calculate the gain/loss from that sale, as if you had sold the crypto for cash.
CAN I AVOID TAXES IF I TRADE ON EXCHANGES OUTSIDE OF THE UNITED STATES?
Exceptions exist, but in most cases, offshore cryptocurrency holdings are subject to stateside taxation. The IRS has a history of winning John Doe warrants that compel foreign banks to hand over identifying information about U.S. holders.
In some cases, crypto holdings may be subject to Foreign Bank and Financial Accounts Reporting (FBAR) and/or FATCA (Form 8938) requirements. Failure to file can result in serious fines — and in extreme cases, even jail.
DO I NEED TO WORRY ABOUT THE IRS IF I ONLY TRADE IN SECURE-COINS (E.G. MONERO)?
Ultimately, you have an affirmative duty to accurately report your income to the IRS and to pay the appropriate tax on such income. Although a cryptocurrency may be “anonymous,” a taxpayer that chooses to omit income from such sources exposes a taxpayer to hefty penalties on top of the initial tax and may even face criminal penalties. Moreover, exchanges are beginning to file reports to the IRS on behalf of active traders, this makes it even more likely that the IRS would become aware of unreported income. One may recall, Al Capone was incarcerated for tax evasion, for failing to pay taxes on unreported income.
WHY IS THE GOVERNMENT LASER-FOCUSED ON CRYPTOCURRENCY?
The Internal Revenue Service cares about one thing — collecting as much tax as possible. Cryptocurrencies are on the rise, and the IRS wants its share.
In addition to tax revenue, the Justice Department seems concerned about digital monetary system’s money laundering potential. Since digital tokens don’t have material-backing, authorities feel it is ripe for white collar criminal activity. However, evidence has yet to bear fruit.
Lastly, the SEC fears that fraudulent ICOs may trick honest investors out of funds they need to survive. Since the average person does not fully understand the technology, officials seem to believe that the only way to protect the good-folks from bad-apples is to require their registration as a security. Although the SEC has not issued a formal decision, we are monitoring this issue closely. Notably, securities regulations can reach far beyond the issuers of an ICO, which the SEC appears to think is a security, and may even be used to go after individuals that deal in such cryptocurrencies.
WHY ARE SOME BITCOIN HOLDERS LOOKING FOR OFF-SHORE “CRYPTO HAVENS”?
Cryptocurrencies are skyrocketing. With an upward trajectory, many a millionaire has been made. However, the market’s volatility has led wary investors to search for exit-strategies that do not come with colossal tax penalties. Vehicles are popping up, seemingly constructed with Bitcoin Millionaires in mind. Small island tax shelters, like Vanuatu, have developed Bitcoin-for-citizenship programs, and individuals with a crypto-heavy portfolio are engaging in various bitcoin-loan agreements that have beneficial tax implications.
Moreover, US taxpayers can find opportunities for reduced tax rates, in places such as Puerto Rico. It is a complex space, but opportunities do exist.
CONNECT WITH A CRYPTO-TAX LAWYER
Cryptocurrencies are quickly becoming part of the mainstream marketplace. If you’re concerned about adequately reporting virtual currency gains — as an individual or for a business — give us a call. As both tax and Internet law attorneys, we understand every angle of the cryptocurrency tax puzzle. Many exchanges don’t issue 1099s, which means every investor is responsible for their calculations. Let’s figure out how best to report your cryptocurrency holdings and craft a way to save you money.