In 2014, the IRS announced that the use of convertible virtual currency to pay for goods or services in a real-world transaction has tax consequences.[1]Those consequences may result in a tax liability for the consumer. As a result—particularly in light of the IRS’s efforts to crackdown on failures to report cryptocurrency transactions, see here and here—it’s important to understand how cryptocurrency transactions are treated for federal tax purposes.
Discussion
The IRS published its 2014 guidance detailing how existing general tax principles apply to transactions involving virtual currency.[2]Other than this 2014 directive, however, there has been no other authoritative IRS guidance with respect to cryptocurrency.
The IRS provides that virtual currency or cryptocurrency “is treated as property for U.S. federal tax purposes.” Thus, “[g]eneral tax principles that apply to property transactions apply to transactions using virtual currency.”[3]
A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value (FMV) of the virtual currency, measured in U.S. dollars, as of the date the virtual currency was received.[4]
Thus, rather than creating a special set of rules for taxing bitcoin and similar cryptocurrencies, the IRS has opted to treat the sale of a virtual currency as the sale of property, which may be a capital transaction if the virtual currency was held as a capital asset. Such virtual currency that is held for less than a year will be treated as a short-term capital gain for tax purposes, which is subject to ordinary income tax rates. If the cryptocurrency is held for more than 12 months, it may be taxed at 15% or 20%, depending upon the applicable long-term capital gains rate.[5]Thus, gains and losses are calculated in the same manner as buying and selling stock, including basis, holding period, and triggering event.[6]
Summary
Cryptocurrency may pose some significant questions in the realm of federal taxation. Unfortunately, many of these questions have not been fully addressed by the IRS. Nonetheless, failing to properly report cryptocurrency transactions could give rise to severe penalties or, in some cases, even criminal exposure. Taxpayers with cryptocurrency transactions should seek professional assistance. As we have detailed in prior posts, Virtual Currency and Taxes: The IRS’s Ongoing Battle to Summons Virtual Currency Records and Coinbase: The Government Strikes Back, Again, the IRS is actively seeking to identify unreported cryptocurrency transactions.
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[1] I.R.S. Notice 2014-21, Internal Revenue Service (March 25, 2014).
[2] Id.
[3] Id. See Sarah-Jane Morin, Cryptocurrency and taxes – it’s complicated, Virtual Beat (April 7, 2018). (“The 2014 Notice gives some very high-level background on how existing tax code applies to cryptocurrency and how the IRS views it as property”).
[4] Id. Taxpayers must determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied. Id.
[5] See Scott Peterson and Jessica Campbell, Understanding the Tax Implications of Cryptocurrency, Moss Adams (November 2017). A capital gain or loss is calculated by determining the change in the cost basis from the time the asset was acquired until there’s a taxable event. Richard Loth, How do I calculate my gains and/or losses when I sell a stock? Investopedia (November 30, 2021).
[6] Kelly Phillips Erb, What You Need To Know About Taxes & Cryptocurrency, Forbes (January 9, 2018).
