Bitcoin and Taxes: Does the IRS Care?

The short answer would be “Yes. OF COURSE.”

The longer answer would be “it depends on how you acquired the cryptocurrency and what did you do with them”.

It seems like everywhere I look these days, it’s all about cryptocurrency. Bitcoin keeps reaching record highs on a daily basis, ICOs are hot and cold, and people are signing up on exchanges at a rapid rate looking to get in on the action. While the blockchain technology is fascinating (and a struggle to wrap my head around sometimes), any time I think of monetary transactions, I still think of the tax impact. This got me to thinking— how does the IRS tax transactions for a currency that clearly has value but is intangible? I remember a few years ago working on some taxation issues related to the taxability of “virtual sheep” — should sales tax be assessed on the intangible items (virtual cars, avatars, guns, coins, etc) purchased through gaming apps such as Zynga? Someone paid $1 for an item; are the virtual goods subject to sales tax? Are virtual goods considered tangible personal property? I think we’re now in similar stages of questions and answers when it comes to taxation of cryptocurrency.

Cryptocurrency has become mainstream enough for the IRS to start paying attention to it (after all, they love having visibility on all of your personal transactions, income, gains and losses) but still new enough for the IRS to not have very much guidance on it. To date, there’s only been a single piece of official guidance from the IRS relating to taxation of cryptocurrencies: Notice 2014–21. It is a short, 16-question FAQ that explains their interpretation of cryptocurrency, federal tax treatment, and when to recognize income or gains/losses in a few scenarios.

I’ll walk through the notice first and follow up with a few thoughts and unanswered questions. This post should not be taken to be actual tax advice.

Notice 2014–21

How does the IRS define cryptocurrencies?

• Cryptocurrency is considered Virtual Currency.
• Virtual Currency is defined as a “digital representation of value that functions as a medium of exchange, unit of account, or store of value that may behave similar to fiat currency, but does not have any legal tender in any jurisdiction”.
• Convertible Virtual Currency is a type of virtual currency that has an equivalent value in real currency and can behave as a substitute for real currency. Bitcoin would be the prime example of a CVC.

How does the IRS treat Virtual Currency?

• Since virtual currency is not recognized by the US as a currency, it cannot be treated as such.
• Virtual currencies are treated as property. All general rules that apply to property transactions will apply to virtual currency transactions, including basis determination and gain/loss characterization.
• For most individuals, virtual currencies are capital assets. Companies who hold currency as inventory for sale will recognize any gain/loss as ordinary income.
• Currencies held and sold within less than 1 year of purchase will trigger a short term capital gain/loss taxed at the ordinary rates.
• Currencies held and sold after 1 year of purchase will trigger a long term capital gain/loss taxed at the more beneficial long term capital gains rates.

Virtual Currency as Income

• Virtual currency received for payment of goods or services constitutes income, and recipients must report the fair market value of the currency on the date of receipt in gross income. The currency’s FMV (calculated by converting the virtual currency into USD using current date rates of exchange) becomes the currency’s basis.
• All individuals who receive virtual currency as income, whether as an employee or an independent contractor, must recognize in their gross income the FMV of that currency on the date of receipt.
• Employee virtual currency income is subject to Federal employment taxes such as FICA and FUTA as well as income tax withholding.
• Independent contractor virtual currency income is subject to self-employment tax.

Sale or Exchange of Virtual Currency for other property

• Individuals must recognize gain or loss on the date of sale or exchange. Gain/loss characterization follows property rules. Gain/loss calculated by taking the difference between basis (date of receipt or purchase) and FMV (date of sale or exchange).

Virtual Currency Received through Mining

• Miners need to recognize the FMV of the currency on date of successful mining as part of gross income.
• Miners who mine as a trade or business are subject to self-employment tax on the income generated from mining activities. However, miners can also deduct allowable business expenses (electricity, hardware, etc) against gross income.

Virtual Currency Transaction Reporting

• Any individual or entity who makes a payment to someone in excess of $600 per year is subject to informational reporting to the IRS. These rules are similar to other payments made in property.

Penalties

• The notice‘s exact wording of the question was “Will taxpayers be subject to penalties for having treated a virtual currency transaction in a manner that is inconsistent with this notice prior to March 25, 2014?”
• Taxpayers may be subject to penalties for reporting and payment failures related to virtual currency transactions, such as accuracy-related penalties (section 6662) and timely information-reporting penalties (section 6721 and 6722).
• Penalty relief can be available if taxpayers can prove that the reporting and payment failures were due to reasonable cause.

Beyond the IRS Guidance

The IRS is primarily concerned with transactions that involve cryptocurrency as income, payment for goods or services, and sales or exchanges, which is in line with how those transactions are treated with real currencies and property. After I read through the notice several times, a few questions immediately jumped out at me. The following are simply personal thoughts, and should not be taken as actual tax advice.

Q: How does the IRS actually know if I’ve mined/purchased/sold Bitcoin?

A: As a general guide to information reporting, it’s best to take a conservative approach and provide as much information as possible. Bitcoin is only pseudonymous, and the amount of of personal information that you provide to an exchange is enough to track your Bitcoin movements. The IRS is investigating into those who transacted with Bitcoin from 2013–2015, and although Coinbase secured a minor win by reducing the scope of information that it was asked to provide, the new summons still requires the exchange to turn over information such as:

NOW LIMITED TO: name, address, tax identification number, date of birth, account opening records, copies of passport or driver’s license, all wallet addresses, and all public keys for all accounts/wallets/vaults.

… which is still A LOT of information and enough to trace the transactions to individual users. The investigation only covers the period when Bitcoin prices rose from $13 to $1,100 and since then the prices have soared even higher, so I wouldn’t be surprised if the IRS started to pay more and more attention to cracking down misinformation reporting in this space.

Plus, the whole purpose of the blockchain’s public ledger is that it’s public. Once the IRS has matched your personally identifying information to your public key, they can easily see what you’ve been up to. This can open people up to audit risk, fines, and penalties.

Q: What kinds of records do I need to keep if I am an active trader of cryptocurrency?

A: I think the compliance burden is going to be extremely heavy on the individual. Usually traders who invest in properties such as stock through a broker are given a 1099-B at the end of the tax year that neatly summarizes all of the transactions (description of property, purchase date and price, sell date and price, and profits). It appears that Coinbase offers a beta reporting tool that summarizes all of your transactions on their exchange, but it wouldn’t work for those who trade across multiple exchanges with multiple currencies. In the latter scenario, I would most likely create an Excel spreadsheet with columns for the following information:

• Property description (currency name)
• Purchase date
• Purchase price
• Sell Date
• Sell price
• Gain/Loss (Purchase price — Sell Price)

Update the sheet any time you do any trading activity.

Q: Can I use Section 1031 Like Kind Exchange to defer gains?

A: It’s not recommended to do this. This recent article goes into detail on how traders have been trying to defer any gains when trading Bitcoin for Ethereum or Bitcoin for any other kind of coin by claiming that since both are coins, they qualify for “like-kind” property. Section 1031 has very stringent rules on what qualifies for like-kind, and tax rulings have gone so far as to even compare the composition of coins (gold vs silver = not like kind) to determine qualification. The IRS has not issued any type of guidance on whether or not all virtual currencies are the same (even from a tech standpoint, it can be argued that Bitcoin and Ethereum are quite different), so until they explicitly determine this, I would avoid using Section 1031 as a tax position.

Q: What exchange rate should be used to calculate fair market value?

A: The guidance says to use the exchange rate on date of receipt/sale/exchange. But exchange rates for coins can fluctuate wildly in the span of minutes; what rate should be used? Again, there’s no concrete instruction; some options would be to use the rate at the exact timestamp that the coin arrived/left your account or to use an average rate of the day.

Q: Do capital gains/losses need to be reported for all of my transactions, even if I used crypto to pay for a t-shirt?

A: There’s a very new bill out for vote that proposes to create a de minimis threshold for cryptocurrency spending in an attempt to alleviate the reporting burden on casual crypto users. Cryptocurrency transactions that are $600 or less will not trigger a capital gains/loss filing requirement. Interestingly, the body of the bill also puts forth an Aggregation Rule related to the de minimis threshold: “all sales or exchanges which are part of the same transaction (or a series of related transactions) shall be treated as one sale or exchange”. Curious to see how this would apply to chain transactions, especially those involving currencies that are not purchasable with USD.

If you’re still reading at the point, hopefully it’s clear that remains a lot of grey in terms of how complex cryptocurrency transactions will be reviewed and analyzed. My takeaway from reading the notice and seeing all the developments related to the Coinbase investigation is that 1) the IRS regulations can only get more stringent with possibly a wider range of investigations, and 2) individuals who transact with cryptocurrency have a heavy burden for record-keeping and compliance reporting.

Leave a comment below if you have any questions!