The reporting and taxability of cryptocurrencies

Bitcoin was developed in 2009 as a decentralised, peer-to-peer electronic cash system powered by its users. Transactions take place between users directly through the use of cryptography. Since the inception of Bitcoin, additional virtual currencies have been created, such as Litecoin, Ethereum and Zcash, all of which are similar to Bitcoin.

To obtain virtual currency, people generally use traditional currency to buy it from someone who already has the virtual currency. This tends to be handled through virtual currency exchangers such as Btc.sx, BTCChina, Coincheck, Coinbase and LocalBitcoins.

The US Internal Revenue Service (IRS) has issued basic guidance stating that it considers virtual currencies to be property. IRS Notice 2014-21, 2014-16 IRB 938, 03/25/2014, IRC Sec(s). 1001 was created to address the sale or exchange of convertible virtual currency and its use in real-world economic transactions. The currency could be used as payment for goods or services and must be included in computing the gross income of each transaction. The amount of such income is the fair market value (FMV) of the virtual currency, measured in US dollars, as of the date that the virtual currency was received.

Gain or loss can be computed based on when the property was purchased by a taxpayer and its FMV at that time, over the basis of the property and its FMV at the time of the exchange for other property or services by that same taxpayer. The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realises capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer—similar to stocks, bonds, and other investment property. A taxpayer can realise ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer. Inventory and other property held mainly for the sale to customers in a trade or business are examples of property that is not a capital asset. In that sense, cryptocurrency miners would be treated as recognising ordinary income on the dates of mining and receiving the coins, and capital gains to those merely investing and trading for profit. 

The main problem with identifying taxpayers with income from these transactions is that they are supposed to be anonymous. Public exchanges do have a record of their users and their wallets, but no Form 1099s are being distributed. The IRS has said that anyone who uses virtual currency as a form of payment must issue a 1099 when the gross amount exceeds the reporting thresholds. 

Recently, the IRS has been increasing investigations into individual tax returns for potential unreported gains from virtual currencies. A recent California case shed light on the need to identify individual account holders who conducted transactions of the various virtual currencies for purposes of unreported tax gains. The IRS won a court battle when it issued a John Doe summons for all account holders’ information with transactions over $20,000 on Coinbase from 2013 to 2015. This same type of John Doe summons is how the IRS obtained the names of Swiss bank account holders from UBS – effectively changing the face of offshore banking.

The IRS claims that only 802 people declared a capital gain or loss related to Bitcoin in 2015, in the face of millions of transactions. Recently, in the Tax Cuts and Jobs Act, the IRS addressed like-kind exchanges limiting the exchange only to real property that is not held primarily for sale. Under the Act, cryptocurrencies can no longer be exchanged for other like-kind property. So if you were thinking about trading Bitcoin for Ethereum or vice versa, it will no longer be a tax-free exchange post December 31, 2017.

Cryptocurrencies that register as a money transmitter are required to develop, implement and maintain an effective anti-money laundering program that includes a process for verifying customer identification. The IRS hopes to identify records that will reveal the identity and transaction activity of cryptocurrency users who are US persons. This information may be relevant to identify and correct federal income tax liability of those who conducted convertible virtual currency transactions as that term is defined per IRS Notice 2014-21.

If you hold virtual currencies in a foreign exchange marketplace, you may have an “other foreign asset” reportable on IRS Form 8938. The treasury has yet to issue guidance about these exchanges being considered a “financial institution” or a wallet to be considered a “financial account,” which requires reporting on the Foreign Bank and Financial Account Report (FBAR) and Form 8938. If you are unsure if the exchange is foreign, consider reporting the asset vs. not reporting it at all. There is no actual tax computed on the value of your foreign holdings, and this is strictly for informational purposes. The IRS has harsh penalties for failing to report such kinds of information, so to avoid a $10,000 IRS penalty for non-filing, US taxpayers should disclose all holdings.

This article was prepared by Matthew Halpern, senior tax accountant at EisnerAmper