Updated March 11, 2021
Cryptocurrency, now synonymous with virtual currency, has been in the news as of late due to increased retail investor interest, volatility, and overall mainstream visibility. In addition, public figures, such as Elon Musk, have made significant investments in cryptocurrencies through their business holdings which has created even more interest in cryptocurrency trading. The increased mainstream visibility of Cryptocurrency has led to heightened concern by government regulatory bodies, including the IRS, the Treasury Department, and the Department Of Justice. Therefore, before investing in cryptocurrency it is prudent that we review the Federal taxation of cryptocurrencies.
By way of background, a cryptocurrency, the most popular of which is Bitcoin, is an electronic payment system that utilizes blockchain technology to facilitate peer to peer transactions. A blockchain is a decentralized ledger of all transactions in a network. The decentralized nature of blockchain technology coupled with the use of cryptography allows every user to simultaneously access and view the information on the blockchain. Ultimately, consensus verification is achieved by participants confirming modifications with one another. Users who contribute computing power to a network are referred to as “miners.”
One of the initial alluring features of crypto was the anonymity afforded by holding the cryptos, as opposed to a country’s currency. However, it is important to note that while the owner of a Bitcoin address may be obscured, Bitcoin transactions are not anonymous and can often be connected to a person. The Internal Revenue Service (“IRS”) has used one of several blockchain analysis services to connect personal identities with Bitcoin addresses. In addition, similar to the John Doe summons used to discover U.S. citizens holding funds at the Swiss bank UBS, the IRS served a summons on Coinbase, Inc., a virtual currency exchange, seeking information regarding U.S. persons who at any time during the period January 1, 2013 through December 31, 2015, had conducted transactions in a convertible virtual currency. This type of information can be used to connect personal identities to crypto holdings and transactions.
Guidance from the IRS regarding taxation and reporting has been lackluster at best and was limited to Notice 2014-21. More recently, the IRS released Revenue Ruling 2019-24 and a list of Frequently Asked Questions (the “FAQs”) that bolstered the guidance set forth in Notice 2014-21. The IRS has made it clear that for federal income tax purposes, Cryptocurrency is classified as property. It is further understood that the general tax principles applicable to property transactions apply to transactions using virtual currency.
It follows then that taxpayers must recognize gain or loss on the sale of cryptocurrency for cash or other property, subject to any limitations on the deductibility of capital losses. If you held the virtual currency for one year or less before selling or exchanging the virtual currency, then you will have a short-term capital gain or loss. If you held the virtual currency for more than one year before selling or exchanging it, then you will have a long-term capital gain or loss. The period during which you held the virtual currency (known as the “holding period”) begins on the day after you acquired the virtual currency and ends on the day you sell or exchange the virtual currency. Your gain or loss will be the difference between your adjusted basis (generally what you paid) in the virtual currency and the amount you received in exchange for the virtual currency. This transaction should be reported on your Federal income tax return in U.S. dollars. Tax filers will use Form 1040 Schedule D and Form 8949 to report capital gains and losses.
The available guidance also establishes that cryptocurrency that is received as employee wages is taxable to the employee and must be reported on Form W-2. The employee is taxed at the fair market value of the cryptocurrency on the date received. Payments made to independent contractors for services provided using cryptocurrency are subject to income tax and self-employment tax and must be reported on Form 1099. Additionally, since cryptocurrency is considered property and not currency, if you pay for services or goods using cryptocurrency, you will have a capital gain or loss at the time of payment. Your gain or loss is the difference between the fair market value of the services you received and your adjusted basis in the cryptocurrency used as payment.
It is also worth noting that donating appreciated crypto to a qualified charity can provide significant upside to the donor and the charity. As long at the coin was held for more than one year, the donor will not have to pay tax on the gain and the charity will receive the full value of the donation.
In addition, the IRS’s guidance available thus far fails to specifically address how cryptocurrencies should be treated for international tax reporting [e.g., Report of Foreign Bank and Financial Accounts (FBAR) & Foreign Accounts and Tax Compliance Act (FATCA) reporting]. There are also nuances as to whether cryptocurrency held in a “wallet”, which allows cryptocurrency holders to store and retrieve their crypto holdings, is considered a foreign account.
Lastly, we have all seen headlines in the news stating that a cryptocurrency investor has lost a password to their crypto wallet and thus cannot access their crypto holdings. Unlike other property losses, lost passwords to digital wallets are not subject to casualty, disaster, or theft losses. This leaves the investor with limited options to recoup their investment.
As a follow-up to our blog post concerning the federal tax implications of cryptocurrencies, the IRS’s FAQs concerning cryptocurrency were recently updated. The update was in response to confusion regarding the question posed on page 1 of Form 1040, which asks “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
The IRS has affirmatively stated that if a taxpayer’s only transactions involving virtual currency during 2020 were purchases of virtual currency with real currency, then the taxpayer is not required to answer yes to the Form 1040 question. Real currency, in this case, is defined as the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance.
If you would like to schedule a conference call or video meeting, to discuss any specific questions relating to cryptocurrencies, Lara Chwat or Varun Kathait can be reached at: Lara@katzchwat.com, firstname.lastname@example.org.
Stay safe, and do not hesitate to reach out to us with any questions.
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