Tax Aspects of Cryptocurrency

Cryptocurrency – think Bitcoin – is constantly in the news. In addition to Bitcoin, there are over 5,900 other cryptocurrencies (source: www.coinlore.com). Cryptocurrency is also referred to as virtual currency.

The website for the U.S. Federal Trade Commission has an easy to understand description and discussion of cryptocurrency (source www.ftc.gov) – selected excerpts are below:

“Cryptocurrency is a type of digital currency that generally only exists electronically. There is no physical coin or bill unless you use a service that allows you to cash in cryptocurrency for a physical token. You usually exchange cryptocurrency with someone online, with your phone or computer, without using an intermediary like a bank. Bitcoin and Ether are well-known cryptocurrencies, but there are many different cryptocurrency brands, and new ones are continuously being created.

There are important differences between cryptocurrency and traditional currency.

• Cryptocurrency accounts are not backed by a government. Cryptocurrency accounts are not insured by a government like U.S. dollars deposited into a bank account. If you store cryptocurrency with a third-party company, and the company goes out of business or is hacked, the government has no obligation to step in and help get your money back.
• Cryptocurrency values change constantly. The value of a cryptocurrency can vary rapidly, even changing by the hour. It depends on many factors, including supply and demand. An investment that’s worth thousands of dollars today might be worth only hundreds tomorrow. And, if the value goes down, there’s no guarantee it will go up again.”

It is safe to assume that  cryptocurrencies will be around for the foreseeable future. The purpose of this blog isn’t to discuss the pros and cons of cryptocurrency. Our purpose is to cover the tax implications related to becoming involved in the cryptocurrency transactions. In fact, there is now a question on the first page of the Form 1040 asking “…did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

The IRS issued IRS Notice 2014-21 for guidance related to the tax treatment of virtual currencies. Virtual currency is treated as property (such as stocks or bonds) for federal income tax purposes. The potential tax implications could come in the form of ordinary income, short-term capital gains (taxed at the same rate as ordinary income), and preferential rates associated with long-term capital gains. Trading one form of cryptocurrency for another is considered a taxable event. It’s treated as if you sold the original asset, and then purchased the new cryptocurrency with the proceeds. This would trigger either a short or long-term capital gain depending on whether the holding period was less than a year or not.

It is very important to keep records of all transactions in order to properly calculate gains and losses. We have become accustomed to the very detailed reporting of security transactions by brokerage firms and place a great deal of reliance on these for tax return filing purposes. Not all crypto exchanges will issue tax reporting forms. Therefore, it is essential that you have access to all your activity for accurate self-reporting purposes.

Furthermore, keeping detailed records will allow you to use the specific identification method when disposing of units. The IRS states this is an allowed method in Q&A 39 on its FAQ’s page related to virtual currency. This can be an advantageous way of reporting gains and losses in order to reduce your tax bill. You can dispose of your units with the highest cost basis first which can result in the lowest capital gain possible. There are many crypto tax software applications available that can make this process much simpler if you prefer not manually tracking this information yourself.