No matter what your attitude or comfort level is about cryptocurrency, it has become mainstream in a relatively short time.
What has gained the keen interest of the IRS is the meteoric rise of bitcoin’s price (before its recent descent) and the increased acceptance of bitcoin and other cryptocurrencies as forms of payment. Bitcoin can now be used to buy much more than you might think.
Let’s get down to brass tax about cryptocurrency.
So, you need to know that the IRS is looking into crypto’s comings and goings — from one account to another. Those playing hot potato with cryptocurrencies need to be aware of the federal income tax implications.
What Is Cryptocurrency? It is digital property usually issued and controlled by software developers and accepted as payment by willing parties.
Also known as virtual currencies, cryptocurrencies can be transferred, stored for future use, held for investment (if you consider making bets to be investing), or traded electronically.
Unlike conventional currencies such as the U.S. dollar or the euro, cryptocurrencies are essentially unregulated. So, buyer beware!
Some businesses happily accept payment in cryptocurrencies to avoid the transaction fees charged by credit card companies and online payment
processing services such as PayPal.
Though cryptocurrencies are basically unregulated, every cryptocurrency transaction is digitally recorded in a distributed public ledger, such as a blockchain. Anyone can download a copy of the blockchain to trace the path of cryptocurrency transactions.
Distributed ledger technology uses independent digital systems to record, share, and synchronize transactions, the details of which are recorded in
multiple places at the same time with no central data store or administrative functionality.
WANTED: The IRS wants to know about your cryptocurrency transactions
The term “cryptocurrency” is also referred to “virtual currency” — and you’ll find the latter being used on the 2020 version of IRS Form 1040.
This form 1040 asks if you received, sold, sent, exchanged, or otherwise acquired a financial interest in any virtual currency at any time during the year. If you did, you should check the “Yes” box.
Since this question appears on page 1, it’s evident that the IRS is very serious about enforcing compliance with the applicable tax rules.
The 2020 Form 1040 instructions clarify that virtual currency transactions for which you should check the “Yes” box include but are not limited to:
- the receipt or transfer of virtual currency for free (i.e., without having to pay),
- the exchange of virtual currency for goods or services,
- the sale of virtual currency,
- the exchange of virtual currency for other property, and
- the disposition of a financial interest in virtual currency.
Cryptocurrency Transaction Tax Basics
The IRS position is that cryptocurrency is “property” for federal income tax purposes. Because it is property, you recognize and report taxable
gain or loss when you exchange cryptocurrency for goods or services, U.S. dollars, euros, different cryptocurrency, etc.
Should you get audited and you failed to report cryptocurrency transactions on your Form 1040, you risk interest and penalties, and even criminal prosecution in extreme cases.
To determine the federal income tax results of a cryptocurrency transaction, calculate the fair market value (FMV), measured in U.S. dollars, of the cryptocurrency on the date you receive it and on the date you use it to pay something.
The current values of the most popular cryptocurrencies are listed on exchanges such as the Coinbase exchange. At the time we began this article, one bitcoin translated to $57,182 according to the Coinbase exchange. So, if you bought one bitcoin with U.S. dollars at that price, your basis in the bitcoin for federal income tax purposes would be $57,182.
When you exchange cryptocurrency for other property, including U.S. dollars, a different cryptocurrency, services, etc., you must recognize taxable gain or loss just as you do when you make a stock sale in your taxable brokerage account.
- You’ll have a taxable gain if the FMV of what you receive exceeds your basis in the cryptocurrency that you exchanged.
- You’ll have a taxable loss if the FMV of what you receive is less than your basis in the cryptocurrency.
Tax Treatment: Cryptocurrency Payments to Employees and Independent Contractors
If you use cryptocurrency to pay employee wages, the FMV of the currency counts as wages subject to federal income tax withholding, FICA tax, and
FUTA tax. As with any other wages paid to employees, you must report the wages to the employee and to the IRS on Form W-2.
If you use cryptocurrency to pay an independent contractor for performing services for your business, the FMV of the currency is subject to self-employment tax for the contractor. You’re required to report the payment on Form 1099-NEC if payments to that contractor during the year amount to $600 or more.
Note that you may also have a tax gain or loss due to appreciation or decline in the value of the cryptocurrency during the time you held it before paying it out as wages or for services from an independent contractor. Because you’re not in the business of buying and selling cryptocurrencies, the gain and loss will be a capital gain or capital loss (and will be short term or long term, depending on how long you held the cryptocurrency).
Tax Treatment of Cryptocurrency Receipts
If you accept cryptocurrency for goods or services, you must determine the FMV of the currency on the transaction date to convert the deal into U.S. dollars. Then calculate your taxable income or gain.
Here’s an example. You sell a valuable painting that you restored for two bitcoins. On the date of sale, bitcoins are worth $55,000 each. Your tax basis in the painting is $47,000.
To report this transaction on your Form 1040, convert the two bitcoins into U.S. dollars ($55,000 x 2) = $110,000. The taxable gain on the sale of the painting is $63,000 ($110,000 – $47,000). Report the $63,000 as income or gain on your Form 1040.
You also have to figure and report your gain or loss on the two bitcoins.
This illustrates the situation. You are a self-employed professional. You operate your business as a single-member LLC that’s treated as a sole proprietorship for tax purposes. You accept one bitcoin as payment from a major client.
On the date of receipt, bitcoins are worth $55,000 each according to the Coinbase exchange. You must recognize $55,000 of taxable income for services rendered.
Because you are a self-employed independent contractor, the $55,000 is also subject to the dreaded self-employment tax.
Ignorance of cryptocurrency rules is not an excuse for failure to comply with the federal tax rules.
Detailed records are essential for compliance. Your records should include:
- the date when you received the cryptocurrency,
- its FMV on the date of receipt,
- the FMV on the date you exchanged it (for U.S. dollars, etc.),
- the cryptocurrency trading exchange that you used to determine FMV, and
- your purpose for holding the currency (business, investment, or personal use).
With this information, you and/or your tax professional can determine the federal income tax consequences of your cryptocurrency transactions. Be aware that there may be state income tax consequences as well!
Please contact our office if you need more information on the taxation of cryptocurrencies. More articles about cryptocurrencies.