Public enthusiasm for cryptocurrencies means IRS scrutiny will only grow in the future. Cryptocurrency enthusiasts must take care to give tax authorities no reason to cry foul.
By ReKeithen Miller, Tax and Financial Planner
Cryptocurrency enthusiasts may run into unexpected complications when it comes time to give the tax authorities their due. You, or your clients, have a complex tax landscape to navigate if you choose to dive into crypto.
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. In early 2021, Bank of New York Mellon announced it would hold, transfer and issue cryptocurrencies, including bitcoins, on its clients’ behalf. BNY Mellon’s integrated system allows clients to manage cryptocurrency holdings the same way they manage traditional assets. Other institutions including JPMorgan Chase and Goldman Sachs have indicated interest in offering or expanding services related to cryptocurrencies. 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 this year.
The widespread adoption of cryptocurrencies has meant increased government 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 becoming relevant to an ever-widening pool of taxpayers. If you or your clients hold or plan to hold Bitcoin, Ether, or any other cryptocurrency, it is important to understand and comply with IRS requirements. In addition, failure to report cryptocurrency transactions or to pay the associated tax may trigger penalties and interest. Fraudulently hiding taxable transactions can even lead to criminal charges.
Cryptocurrency and Taxes: Basic Tax Rules
When someone buys a slice of pizza with cash, the IRS is not interested. Other than any state or local sales tax, the event isn’t taxable; the buyer is 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 a pizzeria accepts bitcoins, using them to buy a slice may be a taxable event.
In the fall of 2020, the IRS announced that it would add a newly prominent question about cryptocurrency to the individual income tax Form 1040. While the question debuted in tax year 2019, the updated placement makes it harder for taxpayers to claim they didn’t know about reporting requirements. It pays to understand the IRS rules for cryptocurrency transactions well before sitting down to prepare an income tax return. Buying cryptocurrency generally is not a taxable event. Selling or trading it usually is.
Determining Cryptocurrency’s Fair Market Value
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. 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 (FMV).
If the cryptocurrency is listed on an exchange, determining FMV 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 the cryptocurrency 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 FMV 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. To establish basis as something other than the explorer value, the burden of establishing that the value you assign is accurate rests with the taxpayer.
This calculation may also be important for those who receive cryptocurrency through divorce proceedings. Under Internal Revenue Code Section 1041, transfers incident to a divorce are nontaxable, and the receiving spouse takes the cost basis of the transferring spouse. So in the case of cryptocurrencies, your clients should be aware that the tax complexities and liabilities travel with the asset.
Anyone who receives cryptocurrency as payment for goods or services must include its FMV in their gross income when filing their income tax return. For freelancers, such payments are also subject to self-employment tax. Payers will often need to report business and real estate transactions in which they use cryptocurrency to acquire property, goods, or services. Property exchange rules also apply if you are exchanging one form of cryptocurrency for another – say, Ethereum for Bitcoin. We’ll look at such exchanges in more detail later in this article.
Cryptocurrency and Taxes: Capital Gains and Losses
When an individual sells cryptocurrency, any difference between the payment received and the cost basis may be taxable as a capital gain. Like any other capital gain, the taxpayer should report it on IRS Schedule D and Form 8949. As with other appreciated investments, the tax rate will depend on whether the taxpayer has held the asset for more or less than one year. Capital gains can also be offset with capital losses as usual. 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 virtual currency the holder wishes to sell. Say Paul acquired his current collection of bitcoins in three different transactions. Paul’s basis will vary depending on bitcoin’s FMV the day it entered his digital wallet. The IRS rules for capital transactions default to a “first-in, first-out” method, sometimes abbreviated FIFO. In this approach, any bitcoins Paul sells are assumed to be those he acquired longest ago – day one of his three transactions. However, under certain circumstances, Paul may prefer to sell his bitcoins using a specific identification method to identify lots with the highest cost basis. This could reduce his recognized capital gain on a given transaction, especially with a highly volatile asset like Bitcoin.
However, to do this Paul 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, Paul will need to keep records showing transaction information for each unit held in his digital wallet. These records should include the date and time he acquired the cryptocurrency, as well as its basis and FMV on that date. There are also services that manage these records, 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 Paul recognizing more income – and thus owing more tax – than he 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.
Hard and Soft 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 goes through a hard fork and a taxpayer doesn’t receive any new cryptocurrency as a result, it is not a taxable event. But if the taxpayer receives a transfer, potentially through an “airdrop” where cryptocurrency flows to multiple individual ledgers, he or she may have to report taxable income. Just as if the taxpayer purchases cryptocurrency or receives it in payment, the taxpayer’s taxable income will reflect the cryptocurrency’s FMV on the day he or she receives it. In this case, that is the day it is recorded on the distributed ledger, assuming the recipient can transfer or sell the cryptocurrency 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, the cryptocurrency holders’ position does not change, and so they 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 the same person, also is not a taxable event.
Gifts and Charitable Contributions
If someone receives cryptocurrency as a gift, they will not owe tax on it. The recipient’s cost basis in the gift equals the giver’s basis for the purposes of determining whether the recipient recognizes a capital gain when selling the gifted assets. To determine whether the recipient recognizes a capital loss, his or her basis is the giver’s basis or the FMV of the cryptocurrency when the recipient received it, whichever is less. When giving cryptocurrency to someone else, gift tax concerns may apply if the giver’s total gifts for the year exceed the annual gift tax exclusion amount, which is $15,000 per recipient at this writing.
The IRS treats a gift of cryptocurrency to a charitable organization just like any other donation of appreciated assets. If the giver plans to deduct the donation, that deduction generally equals the FMV of the cryptocurrency when it was donated. Those with philanthropic goals who have held their cryptocurrency for at least a year may find this an effective strategy. If the donor has held the cryptocurrency for less than a year, he or she can still give it to a charitable organization, but the deduction will be the lesser of the gift’s FMV or the donor’s cost basis.
“Like Kind” Exchanges of Cryptocurrency
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 those who exchange 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 taxpayers hold cryptocurrency on an exchange based overseas, do they have to report it the way they 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 tax planning and reporting. In addition, I have only touched on issues for people buying, selling, and trading; cryptocurrency mining may create even more complications. Anyone who holds cryptocurrency should keep detailed records and be sure to comply with IRS reporting requirements. Cryptocurrency holders may also want to file an amended return if they realize that they should have reported transactions in past years.
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.
ReKeithen Miller, CFP®, EA, is a client service manager based in the Atlanta office of Palisades Hudson Financial Group LLC. His practice areas include tax and financial planning, investment management, cross-border tax planning issues, and estate tax preparation and planning. He is a contributing author to the firm’s two books, The High Achiever’s Guide To Wealth and Looking Ahead: Life, Family, Wealth and Business After 55. www.palisadeshudson.com
A version of this article originally appeared on www.palisadeshudson.com.
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