Cryptocurrency: The Next Financial Frontier
By Dalton Bradshaw, CPA
In recent years, the unprecedented growth and public adoption of virtual currencies, also known as crypto currencies, have left many investors and professionals with questions and uncertainties as to what these currencies are and how they should be treated for tax purposes.
While the value and function of virtual currencies have continued to grow exponentially over the last decade, guidance from the IRS has been minimal. In recent months, Congress has introduced legislation with the intent to more effectively regulate virtual currencies and their taxation, as we discussed in our August 4, 2021 article titled “An Overview of the Infrastructure Investment and Jobs Act.” But at this point, the legislation has only been proposed and has not been enacted as law. Although guidance has been sparse, we can rely on the current revenue code to guide us in taxation of virtual currency transactions and dispel some of the confusion and uncertainty.
What is Virtual Currency?
The IRS defines virtual currency as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Virtual currencies are created (“mined”) and recorded within a public database known as the blockchain. Owners of virtual currency can store their coins within a crypto currency wallet or within their investment portfolio for a number of brokerages. In certain environments, virtual currencies operate in the same manner as a real currency (i.e., cash and coins); however, it does not have legal tender status in any jurisdiction within the United States. On the other hand, virtual currencies can also act as an investment vehicle, like stocks, and provide a return within an investor’s portfolio. As such, virtual currency can be used for a variety of purposes such as purchasing goods or services, exchanging one crypto for another, or simply holding as an investment.
For those interested in understanding the general provisions regarding virtual currency transactions, we address that immediately below. For those wanting a deeper dive into the technological side of virtual currency, a discussion on blockchain and the creation of virtual currencies follows the tax treatment overview.
IRS Treatment of Virtual Currencies
The first official correspondence from the IRS regarding virtual currencies came in 2014 with the release of Notice 2014-21. This notice provided broad clarification on how general tax principles should be applied to virtual currency transactions, but left questions regarding the treatment of several complex transactions unanswered. In 2019, the IRS supplemented this notice in their release of Rev. Rul. 2019-24, which expands on more complex transactions and provides specific examples for reference.
As previously mentioned, the IRS considers virtual currency to be property, not currency, for federal tax purposes and as such, general tax principles related to property apply to virtual currency transactions. The specific treatment of virtual currency transactions depends on an individual taxpayer’s facts and circumstances. These transactions can be considered business, investment, or personal property and can be regarded as inventory or capital assets depending on each taxpayer’s specific situation.
In the case of mining for coins, the fair market value of the coins rewarded is includible as ordinary income to the taxpayer. If the taxpayer’s mining activity constitutes a trade or business, this income is also subject to self-employment taxes. However, like with any trade or business, deductions, such as depreciation and maintenance expenses, are eligible to offset the income earned from mining activities. Once the virtual currency has been rewarded to the miner and the income has been recognized, the fair market value of the coins upon issuance becomes the taxpayer’s basis in the property.
While virtual currencies can be obtained through the mining process, most individuals obtain their virtual currency holdings by purchasing them through exchanges, as investors do with stocks. In this situation, the taxpayer’s basis in the property is the amount that they paid for the coins. If the taxpayer holds their coins as a capital asset, any gain or loss generated from a sale is subject to taxation at capital gain rates. Coins held as capital assets are still subject to the same holding periods that apply to any other capital assets. Capital assets held for less than one year are considered short-term gains and losses and the gains are subject to ordinary income tax rates. If the capital assets are held for more than one year, they are considered long-term gains and losses and any gains are subject to the preferential long-term capital gain rates. These gains are also typically subject to the 3.8% net investment income tax unless the transaction occurs in the ordinary course of a trade or business, in which case the transaction would be subject to self-employment tax if the activity is not passive in nature. Additionally, since virtual currencies are considered property, rather than stocks or securities, they are not subject to wash sale rules.
As with stocks and securities, gains from virtual currencies can be avoided through charitable contributions. If a taxpayer donates a virtual currency that they have held for more than one year to a charity, they are able to avoid the gain associated with the coin and can claim a charitable deduction for income tax purposes. However, if a taxpayer liquidates their position in the virtual currency and then donates the proceeds from the transaction to a charity, they will have to recognize the associated gain or loss for income tax purposes. Also worth noting, since virtual currencies are treated as property, it is not treated as a currency that could generate a foreign currency exchange gain or loss for income tax purposes.
Since virtual currencies can be used as a means of exchange, but are still considered property rather than currency, it presents a unique situation for income tax purposes. If a taxpayer or business uses their virtual currency to purchase goods or services, any gain or loss that has been generated by the transaction must be recognized for income tax purposes. For example, if a taxpayer is holding one virtual coin with a basis of $100 and they exchange that coin for a good or service whose value is $300, they will have to recognize a gain of $200 for income tax purposes on this transaction. Additionally, investors can use their holdings in one virtual currency to purchase holdings in another virtual currency. Assume the same facts and circumstances of the example above, but instead of purchasing a good or service, the taxpayer is purchasing another virtual currency. The taxpayer would still have to recognize the $200 gain and their basis in the newly purchased virtual currency is $300.
The opposite side of the aforementioned transaction also presents its own set of income tax implications. If an individual that is considered an independent contractor receives virtual currency as payment for goods or services, this income must be recognized as ordinary in nature and is subject to self-employment taxes, just like payments made in actual currency would be treated. Additionally, virtual currency payments whose value exceeds $600 must be reported on Form 1099-MISC by the payer.
While uncommon, employers can pay their employees’ wages with virtual currencies. In this situation, the fair market value of the virtual currency paid is considered wages and is subject to federal income tax withholdings. The business must recognize a gain or loss on the virtual currency that is paid as wages and the fair market value of the virtual currency on the date of payment becomes the basis in the currency for the employee. These wages, along with the related withholdings, must be reported by the employer on Form W-2.
In 2020, the IRS specifically addressed virtual currency transactions on its income tax forms for the first time. On page 1 of the 2020 Form 1040, the IRS has included the following question for taxpayers: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” The intent of including this question on Form 1040 is to identify whether a taxpayer has any taxable transactions related to virtual currencies, not necessarily whether they simply hold positions in virtual currencies or not. The specific wording of this question has caused some confusion amongst taxpayers, which the IRS has attempted to clarify through a series of FAQs. In these FAQs, the IRS has specifically stated that taxpayers should not answer “Yes” to this question if their only transactions were purchasing virtual currency with real currency, as this is not a taxable transaction.
What is the Blockchain?
Simply put, the blockchain is a massive public database, or distributed ledger, that stores information on every single transaction of a specific virtual currency since its inception. Generally, the information contained within a blockchain is decentralized and comprised of computers, known as nodes, all over the world. However, while rare, private, centralized blockchains do exist.
The information within these massive ledgers is stored within “blocks.” Each individual block contains pertinent data on every transaction within the ledger and is comprised of the following components:
- Data: Includes information on the sender, receiver, and amount of coins transferred
- Hash: A unique identifier generated for the respective block; similar to a human’s fingerprint
- Hash of Previous Block: To establish and secure the chain
- Genesis Block: The very first block within a blockchain; will not contain the hash of a previous block
Due to the nature and structure of the blockchain, once a block has been recorded its contents cannot be changed. If a block were to be altered, its hash would be regenerated and thus invalidate every subsequent block on the chain. Although computing power today could regenerate hashes of all subsequent blocks in a matter of seconds, safeguards are in place to prevent this through a mechanism called “proof-of-work.”
The proof-of-work mechanism slows the creation of new blocks so that a multitude of blocks cannot be tampered with at once. The Bitcoin blockchain, for example, only allows a user to create a new block every 10 minutes. Additionally, when a new block is added to the chain it is sent to everyone on the network to verify that it is valid and has not been tampered with. Each block must reach a consensus from all the other users on the chain to be validated. If a block has been tampered with, it will not agree with each nodes distributed ledger and will be rejected. Since the contents of the blockchain are irreversible, the ledger remains transparent and provides a historical account of every transaction for each virtual currency.
How are Virtual Currencies Created?
Virtual currencies are created, or minted, through a process referred to as “mining.” Mining is the process of verifying transactions by solving an extremely complicated mathematical equation. This process is facilitated by thousands of nodes on the blockchain’s network that compete to solve the equation first. The first node to solve the equation is rewarded with newly minted virtual currency and their verified transaction becomes the official record on the blockchain. The value of the newly minted coins rewarded to the miner is based on the fair market value of the relative virtual currency at the time it is issued. Once a block has been verified and added to the blockchain, the process starts over, and a new equation is released for verification.
Due to the explosion in the value of virtual currencies in recent years, mining has become an incredibly competitive, but lucrative, endeavor. Businesses and individuals across the globe have invested massive resources to create “mining farms.” Mining farms are physical locations that house hundreds to thousands of computers whose sole purpose is to solve these mathematical equations in pursuit of being rewarded with virtual currencies. While this is an incredibly enticing opportunity to turn a profit, it also presents a number of income tax considerations.
In summary, virtual currencies are here to stay and present an extremely alluring investment opportunity for individuals and businesses worldwide. While an incredibly exciting and enticing opportunity, it comes with no shortage of income tax implications for U.S. taxpayers. If you are considering investing in any sort of virtual currency, it is wise to be educated on how these assets work and what the tax implications of these transactions are to your specific situation.
We will continue to monitor developments on virtual currencies and provide updates as they occur. If you would like to discuss how virtual currency transactions affect your specific situation, please contact your BMSS professional.