While cryptocurrencies have become a popular investment vehicle, there is still much ambiguity regarding how to treat the emerging asset class for tax purposes. Taxation of cryptocurrencies is complicated at any level, be it partnership, corporation or other. However, it's also important to understand how they should be handled at the most personal level — on your individual tax return.
To determine how cryptocurrencies are taxed, it’s necessary to have a basic understanding of the asset class itself. Broadly speaking, while traditional currencies take a physical form and are backed by a centralized government — the U.S. dollar for example — cryptocurrencies are different.
Instead, cryptocurrencies are electronic in nature and commonly operate via a decentralized network. Each time a cryptocurrency transaction takes place, that transaction is verified and approved using blockchain. In its simplest form, blockchain is a digital ledger that validates and records thousands of transactions. Each transaction is recorded on a block and one transaction builds on the next, hence the name blockchain. Blockchain is built on the concept of a decentralized network, which works on a peer-to-peer basis. So when someone enters into a transaction using a cryptocurrency, that transaction must be approved by the decentralized network, which verifies the transaction by performing sophisticated math called cryptography.
For more background on cryptocurrencies and blockchain in general, read Understanding Cryptocurrencies and Their Place in Our World.
There are different types of cryptocurrencies, with various uses, that generally fall under the categories of utility tokens, equity tokens or asset-backed tokens:
It’s important to mention that investors also may invest in cryptocurrencies before they are readily available to the public through offerings such as ICOs (Initial Coin Offerings) or SAFTs (Simple Agreement for Future Tokens).
There are a couple of different ways to determine the current “spot” value of your cryptocurrencies, or what it’s worth at the moment. The most common method is to look up the spot rate of the cryptocurrency on a market data site such as coinmarketcap.com. The free site provides historical open, close, high and low values of most cryptocurrencies dating as far back as when the coin became marketable and began trading. There is no single recommendation on how to value the coin, whether it’s based on the close or some average for the day, but the key is to remain consistent. Another method to value cryptocurrencies is to use the actual current USD value being traded on an exchange, such as Coinbase.
As of the date of this blog post, the IRS has provided very little guidance on the treatment and taxation of cryptocurrencies. In fact, the only guidance they’ve provided to date is IRS Notice 2014-21, issued in 2014. As you can imagine, the increased interest and prominence of cryptocurrencies has raised numerous questions and scenarios, for which tax treatment needs to be interpreted based on guidance that is no longer aligned with the current market.
What Notice 2014-21 does tell us, though, is that cryptocurrencies are considered property for tax purposes. This guidance provides that the general rules governing property transactions apply; thus gain (or loss) may be ordinary or capital. Additionally, cryptocurrencies received in exchange for goods are considered income and cryptocurrencies received as payment for services constitute wages for employees and self-employment income for independent contractors, and is subject to applicable withholding and information reporting requirements. The cryptocurrencies received should be valued on the date received and reported accordingly for tax purposes.
Since cryptocurrencies are considered property for tax purposes, anytime they are disposed of, in any manner, a gain or loss must be recognized based on the difference in value from the date disposed to the date acquired.
The most common taxable transaction is selling cryptocurrencies for “fiat,” or government-backed paper money such as the U.S. dollar. Cryptocurrencies can also be exchanged for other cryptocurrencies on a decentralized exchange. For example, you could exchange Bitcoin for another cryptocurrency coin or vice versa. While cryptocurrencies could be lumped together in their own asset class, each cryptocurrency is its own separate property, so exchanging one for another triggers a taxable event and IRC Section 1031, Like-Kind Exchanges, is not applicable.
Another type of taxable transaction is exchanging cryptocurrencies for goods or services. This is technically a disposition of the cryptocurrency and gain on the transaction must be recognized. Losses, in this case, are disallowed and may not be taken. The AICPA has proposed a de minimis rule and there is currently pending legislation that would allow for an exemption of gains related to non-investment transactions. This could provide a strategy for those who plan to spend their cryptocurrencies to only use appreciated holdings to maximize the potential de minimis rule to the fullest extent possible. This is one of the many strategies that can be used to minimize your tax burden related to cryptocurrency gains.
Not all cryptocurrency transactions are taxable. Transfers of cryptocurrencies are not reportable transactions and are therefore not taxable. This would include moving cryptocurrencies to or from exchanges, digital wallets, etc. As long as the cryptocurrencies do not change ownership, the transaction is not reportable.
The world of cryptocurrencies, and particularly how the U.S. government will tax this asset class, is complex and rapidly evolving.
Contact Matt Rager or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.