Virtual currency transactions are taxable by law just like transactions in any other property. The IRS is aware that some taxpayers with virtual currency transactions may have incorrectly reported or failed to report income and pay the related tax. Therefore, it is actively addressing potential non-compliance in this area. Millions of taxpayers may find themselves the target of a new IRS initiative called Operation Hidden Treasure. Additionally, in 2019 the IRS added a question to individual tax returns on virtual currency transactions that requires a yes or no response to determine if further reporting is needed.
Virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange. Some virtual currencies are convertible, which means that they have an equivalent value in real currency or act as a substitute for real currency. The IRS uses the term “virtual currency” to describe the various types of convertible virtual currency that are used as a medium of exchange, such as digital currency and cryptocurrency.
Cryptocurrency. Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. 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 administration functionality. A transaction involving cryptocurrency that is recorded on a distributed ledger is referred to as an “on-chain” transaction; a transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction.
Regardless of the label applied, if a particular asset has the characteristics of virtual currency, it is virtual currency for Federal income tax purposes. In general, virtual currency is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency.
Form 1040 Reporting: Virtual Currency Question
The IRS added the question on individual tax returns that requires a yes or no response to: “At any time during 20xx, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” Taxpayers that merely owned virtual currency at any time during the year can check the “No” box when they have not engaged in any transactions involving virtual currency during the year, or their activities were limited to:
- holding virtual currency in their own wallet or account,
- transferring virtual currency between their own wallets or accounts,
- purchasing virtual currency using real currency, including purchases using real currency electronic platforms such as PayPal and Venmo, or
- engaging in a combination of holding, transferring, or purchasing virtual currency as described above.
If taxpayers are involved in any exchange, receipt, sale, or disposition of virtual currency, then additional reporting is required for the transaction in addition to answering “Yes” to the required question.
Sale or Exchange of Virtual Currency
When a person sells virtual currency, they must recognize any gain or loss on the sale, subject to any limitations on the deductibility of losses. The gain or loss is the difference between adjusted basis in the virtual currency and the amount received in exchange for the virtual currency, which should be reported on the Federal income tax return in U.S. dollars. The basis is the amount spent to acquire the virtual currency, including fees, commissions, and other acquisition costs in U.S. dollars. The adjusted basis is basis increased by certain expenditures and decreased by certain deductions or credits in U.S. dollars.
Transfer of property. If virtual currency is exchanged for property, the gain or loss is the difference between the fair market value of the property received and adjusted basis in the virtual currency exchanged. If a taxpayer transfers property held as a capital asset in exchange for virtual currency, they will recognize a capital gain or loss. If they transfer property that is not a capital asset in exchange for virtual currency, they will recognize an ordinary gain or loss.
Transfer of services. Generally, self-employment income includes all gross income derived by an individual from any trade or business carried on by the individual as other than an employee. Consequently, the fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to the self-employment tax.
In addition, the medium of remuneration for services is immaterial to the determination of whether the remuneration constitutes wages for employment tax purposes. Consequently, the fair market value of virtual currency paid as wages, measured in U.S. dollars at the date of receipt, is subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage and Tax Statement.
The amount of income a taxpayer must recognize is the fair market value of the virtual currency, in U.S. dollars, when received. In an on-chain transaction, the taxpayer receives the virtual currency on the date and at the time the transaction is recorded on the distributed ledger.
If a taxpayer pays for a service using virtual currency that they hold as a capital asset, then they have exchanged a capital asset for that service and will have a capital gain or loss. The gain or loss is the difference between the fair market value of the services received and the adjusted basis in the virtual currency exchanged.
Cryptocurrency Transactions and Hard Forks
A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger. This may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. If the cryptocurrency went through a hard fork, but the taxpayer did not receive any new cryptocurrency, whether through an airdrop (a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses) or some other kind of transfer, the taxpayer doesn’t have taxable income. If a hard fork is followed by an airdrop and the taxpayer receives new cryptocurrency, they have taxable income in the tax year they receive that cryptocurrency.
This letter covers some highlights of the complex tax rules for virtual currency transactions. We encourage you to maintain records that document receipt, purchase date, cost basis, fair value at the time of sale, exchange or other dispositions of virtual currency. Please contact our office if you would like additional guidance on when and how to report and treat transactions related to virtual currency and cryptocurrency.
Jerry E. Bartram, CPA