Taxpayers who mine, sell or exchange cryptocurrency likely owe federal income tax because of those activities. But have they reported that income or gain? After dramatic changes in value due to volatile digital currency markets in 2018, they may even have losses.
Currently, the IRS has a campaign, actively auditing for failures to report income and gains related to cryptocurrency transactions. The campaign focuses on transactions where “virtual currency” is used as payment.
Charles Rettig, the new IRS commissioner, has been reported as saying that the IRS will take a hard line on tax crimes involving cryptocurrency. Taxpayers who have mined cryptocurrency, made a purchase with cryptocurrency, or accept cryptocurrency as payment may find themselves under IRS scrutiny.
Treating Cryptocurrency as Property for Federal Taxes
It should be well known that the IRS does not consider cryptocurrency to be the equivalent of legal tender. Since cryptocurrency is property, according to the IRS, taxpayers reporting on cryptocurrency transactions will have to know or have documented:
- the dates they received cryptocurrency, whether through mining or as payment;
- the fair market value of the cryptocurrency on those dates;
- the dates they sold or exchanged cryptocurrency; and
- the fair market value of the currency on those dates.
With this information, taxpayers will calculate their:
- basis in the cryptocurrency, and
- gains or losses they realized from selling or exchanging that cryptocurrency.
Fair Market Value
Fair market value is the exchange rate of the cryptocurrency on the date it is received sold or exchanged if the cryptocurrency is listed on a market exchange.
The IRS does not have guidance on valuing cryptocurrency that isn’t traded on an exchange. Nevertheless, a fair market value must be assigned. Taxpayers should aim to have a documented, reasonably-determined fair market value.
Mining Cryptocurrency Results in Income
Taxpayers who mine cryptocurrency realize income from the cryptocurrency they acquire through mining. The income is the fair market value of the cryptocurrency on the date the taxpayer received it. That income must be reported on their tax return and may be subject to income tax.
People in the business of mining cryptocurrency will have income subject to self-employment tax.
Selling or Exchanging Cryptocurrency, Basis First
To calculate gain and loss, taxpayers need to know the basis of their cryptocurrency. IRS guidance only addresses the basis of cryptocurrency received as payment for goods and services. It leaves taxpayers to look to the Internal Revenue Code and Treasury regulations to determine the basis in their cryptocurrency.
Generally, basis is the cost of the property. If cryptocurrency was purchased for cash, the amount of cash paid by the purchaser will be the basis in the cryptocurrency. In the case of mined cryptocurrency, the basis would likely be equal to the amount of income realized from mining it. Where cryptocurrency was received in an exchange, the basis will be the fair market value of the cryptocurrency on the date the taxpayer received it.
Each Unit Has its Own Basis
Each unit of cryptocurrency has its own basis. For each unit of cryptocurrency held by a taxpayer, the taxpayer has a private key. That key, along with the public key on the blockchain, is required to transfer the cryptocurrency. Taxpayers can keep track of the basis of each unit of cryptocurrency based on the private keys.
Calculating Gain or Loss
When basis is established, taxpayers can calculate gains or losses. As with any type of property, a taxpayer will realize a gain on the sale of cryptocurrency if the sale price exceeds the taxpayer’s basis in the cryptocurrency. If the basis is greater than the purchase price, the taxpayer will incur a loss.
In an exchange of cryptocurrency for other property, including another type of digital currency, the purchase price will be the fair market value of the other property or digital currency.
Is Cryptocurrency a Capital Asset?
After determining gains or losses, the next question is whether the cryptocurrency was a capital asset.
While the IRS views cryptocurrency as property, it has not stated that cryptocurrency is a capital asset. It refers taxpayers to other tax guidance to figure out whether their cryptocurrency is a capital asset. Under federal tax law, capital assets include all property except the inventory of a trade or business.
If cryptocurrency is not held as stock or inventory in a trade or business, it is probably a capital asset. This would include cryptocurrency acquired through mining.
However, taxpayers in the business of mining may have both capital and ordinary holdings. If they do, they should document their capital cryptocurrency holdings separately from their business cryptocurrency. Ordinary losses are not deductible.
Can Cryptocurrency Gain be Deferred?
As of 2018, taxpayers can defer gain in a IRC Sec. 1031 exchange only when the exchange involves real property. There is no guidance on whether IRC Sec. 1031 would apply to exchanges of one cryptocurrency for another before 2018. Trading cryptocurrency on exchanges likely would not meet the requirements of IRC Sec. 1031 because:
- trading on an exchange is not a direct exchange between two parties; and
- a market exchange is not a qualified intermediary.
However, if a transaction involving digital currency results in a capital gain or loss, different tax rates apply depending on how long the taxpayer held the cryptocurrency before selling or exchanging it and other factors.
Reporting Income, Gain, or Loss from Cryptocurrency
IRS guidance on how to treat transactions involving cryptocurrency is sparse and incomplete. Taxpayers are left to apply existing tax rules and hope their positions will be considered correct or reasonable should the IRS look at them.
Due to the significant drop in Bitcoin’s market value in 2018, many taxpayers may find themselves selling or exchanging Bitcoin at a loss. While those losses might be deductible capital losses, taxpayers will want to be sure they have reported all income and gains from past cryptocurrency transactions before reporting losses for 2018.
Failure to report can result in penalties and interest, and, if tax evasion is involved, even more severe consequences.
By Lisa Lopata, JD