On March 25th, 2014, the Internal Revenue Service issued a notice regarding cryptocurrency and stated it will be treated as property for the purpose of federal taxation. This statement was issued well before 2017, the year that Bitcoin exploded in value and became a household word. Many became millionaires and even billionaires overnight. However, since only a few hundred people were actually recording their gains from cryptocurrency each year, IRS enforcement is certain to accelerate and become more aggressive in 2018 and onwards.
The IRS sees bitcoin as "virtual currency" in that it operates like legal tender and is accepted as a medium of exchange for goods and services, but it lacks legal tender status in every jurisdiction that it is utilized. If Bitcoin is treated like property, then the owner will realize a gain or loss on the sale or disposition of that property based on the difference between the value or price from when it was obtained and when it was transferred. As a result, there will be federal tax implications on the gain or loss recognized in the transaction.
If a taxpayer is paid in Bitcoin or some other cryptocurrency (even as an employee), then the value that is included in gross income is the fair market value of the property on the date that the payment is made. If the taxpayer "mines" this virtual currency, then the value included in gross income is the fair market value of the property on the day received. If cryptocurrency is paid as wages, then the employer should include the fair market value in the applicable W-2. An independent contractor that is paid for his services in Bitcoin should be given a Form 1099-MISC if the fair market value was over $600.00. Receiving cryptocurrency as payment is always considered ordinary income.
To determine a gain or loss, the taxpayer must first calculate the fair market value of the property on the date that it is received, minus any includible costs in acquiring it. This value is the "adjusted basis". If the money or fair market value of other property received for the cryptocurrency is greater than the adjusted basis, then the taxpayer reports a gain. If the money or fair market value of other property received for the cryptocurrency is less than the adjusted basis, then the taxpayer reports a loss. The type of gain or loss realized depends on the character of the cryptocurrency in the hands of the taxpayer.
- If the taxpayer holds the property as a capital asset (e.g. as investment property), then the taxpayer will generally realize capital gain or loss.
- If the taxpayer holds the property as a non-capital asset (e.g. held for sale to customers in a trade or business), then the taxpayer will generally realize ordinary gain or loss.
- If the property is a capital asset but it is a short-term capital gain (e.g. it was held for one year or less before being sold or exchanged), then the gain is taxed at ordinary tax rates. (Tax brackets are between 10% and 37% in 2018).
- If the property is a capital asset but it is a long-term capital gain (e.g. it was held for longer than one year before being sold or exchanged), then the gain is taxed at capital gains rates. (Tax brackets are between 0% and 20% in 2018).
If cryptocurrency is exchanged for other cryptocurrency, it is a taxable event and the gain or loss is determined by the difference in the adjusted basis of the old cryptocurrency and the fair market value of the new cryptocurrency. The same taxable event must also be determined if the cryptocurrency is exchanged for U.S. dollars.
Given the extreme volatility in the cryptocurrency market, the potential gains from a timely sale are incredible. Unfortunately, many virtual currency exchanges do not submit the appropriate tax information forms to the IRS or its users that would aid in proper reporting. The Internal Revenue Service has taken notice and has started going after the biggest offenders. On November 29th, 2017, the federal government won a court order compelling Coinbase to turn over identifying records for all users who have bought, sold, sent or received more than $20,000.00 through their cryptocurrency accounts in a single year between 2013 and 2015. You can be certain that those taxpayers face an audit if it appears that this income was not reported on the applicable tax returns.
The failure of a virtual currency exchange to file and provide information returns does not relieve the taxpayer of its duty to report all income received to the IRS. In fact, if the Internal Revenue Service determines that income was willfully being hidden from the government, then the taxpayer can be subject to prosecution for tax evasion or gross understatements of income. If you are in a position where you transacted Bitcoin or some other cryptocurrency and failed to report it in a previous tax year, it is highly advisable to file an amended return and pay the tax due rather than wait for the IRS to discover it. If you have questions on the tax consequences of cryptocurrency, do not hesitate to contact the legal and tax professionals at Kershaw, Vititoe & Jedinak PLC.