- IRS Enforcement Campaign
- Virtual Currency
- Character of the Gain or Loss
- Foreign Currency Transactions
- Foreign Bank and Financial Account (FBAR) Reporting
- Payment for Goods and Services
- Acquiring Virtual Currency
- Virtual Currency Mining
- Employee Payments
- Independent Contractor Payments
- 1031 Exchanges
The IRS announced in late July 2019 that it is ramping up its campaign to ensure that taxpayers with cryptocurrency transactions report these transactions on their income tax returns – and report them correctly – by sending “educational” letters to approximately 10,000 taxpayers who either didn’t report their crypto-transactions or may have reported them incorrectly.
The IRS said it used its compliance efforts to identify the taxpayers who may be noncompliant. Because fewer than 900 taxpayers reported virtual currency gains and losses each year on their tax returns from 2013 to 2015, the IRS stepped up enforcement of the rules. As part of that effort, the IRS got court approval in March 2018 for a summons to obtain account and transaction information on more than 14,000 customers from Coinbase, a company that services buyers and sellers of Bitcoin. Although the IRS didn’t say so in its recent announcement, presumably the leads for the 10,000 taxpayers who will receive a letter came from this source.
Taxpayers receiving these letters should not ignore them, as taxpayers who don’t properly report the income-tax consequences of virtual-currency transactions will be liable for not just the tax but also penalties and interest. In some cases, taxpayers could be subject to criminal prosecution. It may be necessary for taxpayers with cryptocurrency transactions to file amended returns to correct their earlier filings or to file a late original return for any year when they filed no return. This holds true not just for the recipients of the IRS’s letters but for others who have a filing requirement related to their cryptocurrency transactions.
So let’s go over the basics of cryptocurrencies and taxes:
As our world has become more “digital,” it was only a matter of time before cryptocurrencies were developed. One of the first of these virtual currencies was Bitcoin, and the Bitcoin network came online in 2009. Since then, additional cryptocurrencies have been developed.
Cryptocurrencies have a comparable value in real currency or take the place of real currency. These virtual currencies can be purchased with or exchanged into U.S. dollars, euros, and other real or virtual currencies.
Valuation – A virtual currency’s value is based upon market value, i.e., what a willing buyer will pay a willing seller – much like trading in stocks. On July 27, 2019, when this article was written and according to Oanda (an online currency converter), a Bitcoin (BTC), one of the more popular virtual currencies, was worth $9,780, while one Bitcoin was worth $12,650 on July 10 and $3,436 six months earlier. So you can see that this is a very volatile market.
It took several years for the IRS to come up with guidance on how to deal to transactions involving virtual currencies. It finally issued Notice 2014-21, determining that virtual currency is to be treated as property and that the general tax principles applicable to property transactions also apply to transactions using virtual currency. Therefore, it is extremely important for taxpayers who engage in cryptocurrency transactions to maintain a record of their cost basis; this can be a daunting but necessary task for those actively buying and selling cryptocurrencies. How the property principles work for cryptocurrency can best be illustrated by example.
- Example A: A taxpayer buys Bitcoins (BTC) to use when making online purchases without the need for a credit card. He buys one BTC for $2,425 and later uses it to buy goods (BTC was trading at $2,500 at the time he made his purchase). He has a $75 ($2,500 − $2,425) reportable capital gain. This is the same result as if he had sold the BTC at the time of the purchase and used U.S. dollars to purchase the goods. This example points to the complicated record-keeping requirement for tracking BTC’s basis. Since this transaction was personal in nature, no loss would be allowed if the value of one BTC had been less than $2,425 at the time when the goods were purchased.
- Example B: Taxpayer buys Bitcoin (BTC) as an investment. The same rules apply as for stock transactions. Gains are taxable in the year realized, and any resulting loss, when combined with the other capital transactions for the year, are limited to $3,000 ($1,500 if a married taxpayer filing separate).
At the same time that the IRS announced it was mailing 10,000 educational letters, it stated that it anticipates issuing additional legal guidance in this area in the near future.
Character of the Gain or Loss – The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the taxpayer’s hands. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency held as a capital asset. For example, stocks, bonds, and other investment property are generally capital assets. A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that he or she does not hold as a capital asset. Inventory and other property held mainly for sale to customers in a trade or business are examples of property that would not be a capital asset.
Foreign Currency Transactions – Under currently applicable law, virtual currency is not treated as currency that could generate foreign currency gain or loss, for U.S. federal tax purposes.
Foreign Bank and Financial Account (FBAR) Reporting – The IRS stated a few years ago that virtual currency transactions need not be reported for purposes of foreign bank and financial account (FBAR) reporting. But the IRS cautioned that its position could change in the future. However, the IRS has not issued any announcements regarding a change in its position on FBAR filings for years through 2018.
Payment for Goods and Services – A taxpayer subject to U.S. taxation who receives virtual currency as payment for goods or services must, in computing his or her gross business income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received.
Acquiring Virtual Currency – One can go to online exchanges and purchase virtual currency. But care should be taken to make sure the exchange is reputable. There are even virtual currency ATMs (kiosks) where cash can be exchanged for Bitcoin or other virtual currency. Once you have the virtual currency in your online wallet, you are free to spend it with anyone who accepts that form of currency.
Virtual Currency Mining – “Mining” is a term used to describe how cryptographic information distributed within a virtual currency network is secured, authorized, and approved. In essence, it is the processing of payments that have taken place once they occur. It takes the place of banks, merchants’ accounts, and clearing houses like Visa, which essentially eliminates all of the third parties’ cuts of income from the transaction. It involves complex mathematical logarithms that need to be solved, and the mining process completes this task autonomously. For individuals who mine virtual currency, it is a trade or business, and they are subject to self-employment tax.
Apparently, virtual currency miners are also subject to Form 1099-K filing requirements if their transactions rise to the reporting threshold. In general, a third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a third-party settlement organization (TPSO). A TPSO is required to report payments made to a merchant on a Form 1099-K, Payment Card and Third-Party Network Transactions. 1099-K filing is required if, for the calendar year, both (1) the number of transactions settled for the merchant exceeded 200 and (2) the gross amount of payments made to the merchant exceeded $20,000.
Employee Payments – If an employee is paid in virtual currency, then the fair market value of the virtual currency paid as wages, measured in U.S. dollars, is subject to federal income tax withholding, Federal Insurance Contributions Act (FICA) tax (Social Security and Medicare A), and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage and Tax Statement. The U.S. government doesn’t accept virtual currency for tax payments.
Independent Contractor Payments – 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 to the independent contractor and is subject to the self-employment tax. These payments are subject to the normal 1099-MISC reporting requirement when the payments for the year measured in U.S. dollars total $600 or more.
Virtual Currency and 1031 Exchanges – Beginning with 2018 returns, Sec. 1031 tax-deferred exchanges will only apply to real property; thus, investors in virtual currency who trade one type of virtual currency for another will be required to report their capital gains/losses and won’t be able to use the 1031 tax-deferral rules.
If you received one of the cryptocurrency education letters from the IRS and need assistance correcting previously filed returns, or if you are investing, trading, or dealing in virtual currency and have any questions about how those activities will affect your tax situation, please give this office a call.