Tax Treatment of Virtual Currency Transactions

Cryptocurrencies made their way into history as one of the few investment instruments gaining worldwide recognition. People from all walks of life, doctors, engineers, real estate professionals, and investment managers bought into the Bitcoin wave receiving impressive returns on their investments. If you’re a part of this investment group and want to reap the gains, it is critical to understand the tax treatment of virtual currency transactions before selling your crypto assets.

Background

Unlike other financial instruments, the IRS didn’t have a formal regulatory structure for cryptocurrencies until 2014, leaving people in the dark about the tax handling of virtual currency transactions. Most of the early investors had to cough up money for a hefty tax bill, whereas others simply failed to report these transactions because of the lack of awareness or complicated reporting structure of virtual currency transactions.

The IRS started addressing the tax noncompliance associated with virtual currencies in 2018, through its Virtual Currency Compliance campaign. The regulatory authority started sending letters to individuals, owning virtual currencies, or having a history of virtual currency transactions, who had failed to:

• report virtual currency transactions, the associated income with these dealings, and pay the due taxes on their gains; or
• accurately report virtual currency transactions with the IRS.

The IRS ran multiple compliance campaigns for obtaining and sendings letters to over 10,000 taxpayers falling under this category. These letters can be classified into three types, namely Letter 6173, Letter 6174, plus Letter 6174-A. Each of these versions aims to educate taxpayers about the tax filing obligations and the correct way of reporting virtual currency transactions.

The taxation of cryptocurrencies relies on multiple factors. The first critical factor is the sum you spent on purchasing a specific virtual currency, the cost basis, and the second is the capital gains you received post its purchase, the gain.

The current tax regulations make it difficult to track both the gains or losses one might incur in a cryptocurrency transaction. The IRS allows a deduction only against losses that a taxpayer might sustain during a transaction, business, or trade carried out for profit. In the case of cryptocurrencies like Bitcoin, the IRS allows a tax deduction for an investment loss only if the crypto asset is secured for investment purposes and later used to purchase business merchandise, structured as a business expense. The loss on a cryptocurrency transaction fails to qualify as a deductible capital loss if the virtual currency owner uses it for a personal purchase or a regular financial transaction.

To offer more clarity about the reporting and tax treatment of cryptocurrency transactions, the IRS issued new guidance in October 2019, namely, Rev. Rul. 2019-24, along with a FAQ segment. These new rules include:

• Rev. Rul. 2019-24 provides explicit answers concerning the tax regulations for hard forks
• Addresses common queries of taxpayers about the taxation of cryptocurrency hard forks
• Detailed frequently asked questions surrounding cryptocurrency transactions for individuals holding cryptocurrencies as capital holdings.

According to the Rev. Rul. 2019-24, the tax obligations for a new crypto asset received after the hard fork of a cryptocurrency depends on whether the crypto asset owner receives immediate control of the new cryptocurrency. In the event of the taxpayer receiving instant control over the new crypto asset, he or she must include the gross income (as ordinary income) based on the fair market price of the newly received crypto asset.

Definitions

Airdrop: An airdrop is the distribution of a new crypto asset to a large number of wallet addresses with the primary intent of gaining attention within the crypto community. Airdrops allow new cryptocurrencies to build followers, create a user-base, and, thereby, gaining wider adoption.

Virtual Currency: A virtual currency is a digital representation of the value of a digital asset, different from the U.S. dollar or any foreign currencies (“real currency”), that functions as a medium of value exchange and represents a unit of the digital asset.

Cryptocurrency - Cryptocurrency is a kind of virtual currency that utilizes cryptography for encryption purposes, and has digital records of all of its transactions over a distributed database (ledger), such as a blockchain. 

Hard Fork - A hard fork is an event/occurrence in the history of a cryptocurrency that splits it into two separate currencies. In the case of a hard fork, the legacy cryptocurrency keeps functioning on its existing distributed ledger, whereas the new crypto asset operates on a new distributed ledger, such as a blockchain.

Virtual Currency Taxed as Property

The tax treatment of cryptocurrencies as property causes complications for taxpayers using these virtual currencies for daily purchases. Whenever a cryptocurrency is used for the purchase of a good or service, the IRS considers it as a taxable event. If an individual was to use cryptocurrencies for grocery shopping, he would have to identify the cost basis of the desired cryptocurrency, such as Bitcoin, from the time of its purchase, and then subtract that amount from the net spending on the groceries to identify whether the transaction resulted into a gain or loss on the capital investment.

A virtual currency works in the same way as the conventional currency of a country. The IRS considers virtual currencies as property for taxation purposes, so cryptocurrency transactions are subject to the same taxation principles as applicable to property transactions. Here are some examples:

• A virtual currency payment is subject to the same reporting practices as that of a payment made in the property.
• Any payments released to independent contractors or service providers through virtual currencies are taxable, with the self-employment tax rules applicable to the amount. The payers are required to issue Form 1099-MISC.
• If an employee received wages in virtual currency, the entire amount is subject to taxation for the employee. The employer must report these wages on a Form W-2 and apply the same income tax withholding or payroll taxes to this income.
• In the case of merchants accepting virtual currency from clients, the third parties responsible for the settlement of these payments must report these payments to the merchants on Form 1099-K, also known as Payment Card and Third-Party Network Transactions.
• In the event of the sale or exchange of digital currency, virtual currency, the nature of gain or loss relies on the fact that whether the taxpayer holds the virtual currency as a capital asset.
• The taxpayer must report gains and losses on Form 8949 and 1040 Schedule D (the form used for reporting profits or losses on properties, such as cars, stocks, bonds, collectibles, etc.)

There are separate tax regulations for investing and mining cryptocurrencies. The IRS treats cryptocurrency investments like other investments, whereas mining comes under a business activity or trade, thereby receiving a different tax treatment. In case of a cryptocurrency mining operation considered as a business, where the taxpayer isn’t classified as a worker in the entire operation, any gains reported in the business after subtracting qualified deductions will come under the same tax regulations as self-employment income.

In the event of the sale of a cryptocurrency held as a capital asset for cash, one must report any gains on Form 8949. If the holding period of the virtual currency were less than one year, these capital gains would be subject to short-term capital gain, taxed at regular tax rates. On the contrary, if the holding period is over one year or longer, long-term capital gains taxes are applicable on the booked gains, taxed in accordance with classified thresholds for taxable income, as per the designated tax rates, 0%, 15%, or 20%. In case of capital losses on cryptocurrency investments, the IRS has set a limit of $3,000, or $1,500 for married couples filing separately, similar to the losses incurred in stock trades, for an individual tax return. Any losses above these limits are carried forward to the next taxation period.

What could happen in the case of Noncompliance

The taxpayers should understand that the IRS doesn’t hold a favorable view against individuals who forget to report income from cryptocurrency transactions or cite ignorance or lack of awareness for their mistake. The IRS has the right to audit taxpayers who fail to accurately report virtual currency transactions or the gains associated with it, subject to late fees or other penalties.

The IRS obtained information of over 14,000 virtual currency owners from Coinbase Inc. in 2017. With the help of data analytics, the IRS can easily connect and relate the information of U.S. taxpayers with virtual currency holders. For individuals mistaking their cryptocurrency transactions to be untrackable, it may come as a surprise that their virtual currency accounts, as well as transactions, aren’t as secret as they assumed them to be.

Taxpayers must note that if they didn’t report virtual currency transactions or failed to file their returns properly, they’re are liable to penalties, tax, and interest payments on withheld taxes. In fact, criminal prosecution is also on the cards for taxpayers failing to report their income correctly from virtual currency trading, depending on the circumstances. The IRS can file different criminal charges, including falsifying tax returns or even tax evasion. One must understand that anyone found guilty of tax evasion is subject to a five years prison term or a $250,000 fine. In the event of filing a false return, one may end up spending up to three years in prison or paying a fine of up to $250,000..

The Right Course of Action if You Failed to Report Transactions

If you’re guilty of not reporting your income from virtual currency trading, there is still time to make amends. The IRS allows taxpayers to report this income through Form 1040X, Amended U.S. Individual Income Tax Return, within 3 years of the original return filing date, or within 2 years of paying the taxes, whichever is later.

In a new draft version of Form 1040 (Schedule 1), released in October 2019, the IRS added a question about the involvement of a taxpayer in the sale, exchange, purchase, or any form of virtual currency transaction.

The IRS is strict about the proper reporting of cryptocurrency transactions and levies strict actions if one fails to do so. If you didn’t report your crypto transactions properly in the past, take this chance to correct any filing errors and avoid any harm from regulatory actions in the process. If you're ready to learn more about what strategies you can use to reduce your tax bill next year please schedule your complimentary tax assessment with our team HERE.