Year-End 2017: Crypto Tax Goes Mainstream. What You Need to Know.
As the New Year rings in, tax season is here once again. For everyone in the crypto world with U.S. tax obligations, it means it’s time to wrap your head around how to deal with the tax man.
However complicated, unclear or contrarian tax and cryptocurrency may seem, there is no way around it in the U.S. There’s death, there’s taxes. And perhaps more than ever the IRS’s recent small victory against Coinbase has made it clear that the IRS intends on getting their hands on some Satoshi.
With 2017 in the rear-view, now is as good a time as ever to reacquaint yourself with what you’re up against. If you jumped into crypto in 2017 and are learning about crypto taxes for the first time, you’ve come to the right place for an introduction.
Let me first start out by stating the obvious: I am not your attorney or CPA, and this is not tax advice. Everyone’s circumstances and situation are completely different. Tax issues are extremely fact intensive, and you must take nothing from this article other than the general tax principles which are presented.
In the U.S., everything we know specifically about cryptocurrency and taxes stems from IRS Notice 2014-21. Accordingly, the following is a review of what IRS Notice 2014-21 says with some basic takeaways for getting you on track to accounting for your crypto taxes.
March 2021 Update: Since this article was written, the IRS has provided additional crypto-tax guidance through its “Frequently Asked Questions on Virtual Currency” page on its website. The additional guidance does not override or negate the original guidance it provided in its 2014-21 Notice (as discussed below), but does provide insight on a number of unaddressed crypto-tax questions. There will be a link to the FAQ page again at the conclusion of the article.
Notice 2014-21: We’re Talking “Virtual Currency” Here
The IRS calls cryptocurrencies “virtual currency.” According to them “virtual currency” is a digital representation of value that functions as a medium of exchange, a unit of account, and/or store of value.
While virtual currencies may operate like real currency, it does not have legal tender status in any jurisdiction (in the U.S. at least)
Virtual currency that has an equivalent value is real currency, or acts a substitute for real currency, is referred to as convertible virtual currency. One such example of convertible virtual currency is Bitcoin.
The Takeaway: First, the IRS has a specific name for cryptocurrencies. They like to call them “virtual currencies.” Virtual reality was all the rave in 2014 so who knows if there’s any connection there. Anyways, Bitcoin is a virtual currency (and a convertible virtual currency). By extension, it also appears that many other cryptocurrencies and altcoins will fall under the definition of a “virtual currency.” Cryptocurrency aka virtual currency, got it.
Notice 2014-21: Tax Principles for Virtual Currency
The sale or exchange of convertible virtual currency to pay for goods or services has tax consequences that may result in a tax liability.
For federal tax purposes, virtual currency is treated as property, and general tax principals that apply to property transactions apply to transactions using virtual currency.
The Takeaway: Virtual currency is property. For tax purposes, despite calling it a “currency,” virtual currency is not a foreign currency, it is not a domestic currency. It is property, like stocks and bonds. And so, essentially, whatever general tax principals apply to property transactions, including payments for goods or services in property, will also apply here to virtual currencies.
Notice 2014-21: Exchange of Virtual Currency for Other Property
A taxpayer who receives virtual currency as payment for goods or services must include the fair market value of the virtual currency received, as of the date they receive it in U.S. dollars, in their gross income.
A taxpayer’s basis in their virtual currency is the fair market value of the virtual currency in U.S. dollars as of the date or receipt or purchase (the former if received for payment of goods or services).
To the extent the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. The taxpayer has a loss if the fair market value of property received is less that the adjusted basis for the virtual currency.
The character of the gain or loss depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
The Takeaway: For example, let’s say you receive 100 shares of Google stock for painting someone’s house. Upon receipt of the stock for painting the house, you are supposed to report the value of the stock on the day you received it, as income. So if the 100 shares of Google stock were worth $10,000 on the day you received it, you are supposed to claim $10,000 of income. The same principles apply to the receipt of cryptocurrencies when it’s received as payment for goods or services. If you receive 1 BTC for painting someone’s house, you are supposed to report, as income, the value of that 1 BTC on the date you received it. If it was worth $10,000 on the date received, then that’s the income to report.
Additionally, once you have paid tax on that $10,000 of income, that $10,000 also becomes your tax basis in the 1 BTC moving forward. Unless you are considered a dealer holding the cryptocurrency as inventory (an exchange for example might be holding crypto as inventory), then the cryptocurrency is likely a capital asset in your hands. Your tax basis (the $10,000) is then used to determine whether you have a gain or loss upon the exchange of that capital asset (read: the 1 BTC). If you sell, trade, or otherwise dispose of the 1 BTC for an amount greater than your cost basis (say $12,000), you have a capital gain of $2,000. On the other hand, if you dispose of it for less than your cost basis (say $8,000), you have a capital loss of $2,000.
After the cryptocurrency is in your hands, the gains and losses from selling, trading, or exchanging them are no longer considered income to you (there may be exceptions for certain traders who make certain elections), rather, they are considered capital gains or losses. It’s the same concepts for stocks. If you get paid in stocks, you have income at the FMV of the stocks. Moving forward however, most people have a capital asset and the gains and losses from disposition of that asset are now capital in nature.
Notice 2014-21: Mining Virtual Currency
A taxpayer realizes gross income from the receipt of virtual currency from mining activities. The amount includable in gross income is the fair market value of the virtual currency as of the date of receipt.
The Takeaway: Mined cryptocurrency is includable in your gross income, and the value of the mined cryptocurrency depends on the fair market value of the cryptocurrency on the date it was received. For example, let’s say you mined 1 BTC Friday, it was deposited in your wallet immediately, and the value of 1 BTC (on Friday) was $8,000. In that scenario, you have $8,000 includable in gross income from mining that 1 BTC on Friday. Next Wednesday, you mined another 1 BTC, and it was deposited in your wallet the same day. The value of 1 BTC on Wednesday however was $10,000. As a result, you have $10,000 includable in gross income from mining Wednesday’s 1 BTC.
If you mine, you have income. The amount of income from that mining activity is determined by the fair market value of the asset on the day it was received. Moving forward, if the cryptocurrency is a capital asset in your hands, then gains and losses from the disposition of it would be capital in nature (i.e. capital gains or losses).
Notice 2014-21: Reporting Information
Payments using virtual currency are subject to information reporting to the same extent as any other payment made in property. Meaning, payments of virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a taxable year is a reportable transaction and should be reported to the IRS and the payee.
The Takeaway: Taxpayer reporting obligations are still in effect for those making payments to others in cryptocurrency. Those reporting obligations generally kick in when making payments of $600 or more. So sending someone cryptocurrency does not excuse you from compliance with IRS reporting obligations. For example, if you would normally (are supposed to) issue your employees and contractors W-2s or 1099s, nothing changes just because you paid them in crypto. You are still supposed to report those payments to the IRS, and should still issue them W-2s and 1099s. Same goes for payroll and the like. Of course however, you are not expected to report numbers in cryptocurrency denominations. The IRS (for now at least) only deals in USD, so you must convert the value of those payments based on the fair market value of the currency paid, on the date the payment was made.
What Did IRS Notice 2014-21 Say About §1031 Like-Kind Exchanges?
The IRS did not say anything about the application of §1031 like-kind exchanges to crypto-to-crypto trades. Again, they said nothing.
Over the past few years many non-legal scholars (and perhaps some tax professionals I’m guessing) in online forums and the reddit space have posited the argument that the exchange of one cryptocurrency for another cryptocurrency is not a taxable transaction. Instead, the argument goes, the trade is a tax-deferred “like kind” exchange under Internal Revenue Code (“IRC”) §1031. Unfortunately, there is currently no legal precedent to apply IRC §1031 to cryptocurrency trades. There are only untested arguments.
Traditionally IRC §1031 like-kind exchanges are used in real estate transactions. In fact, the new Tax Bill goes as far as eliminating IRC §1031 exchanges for anything other than real estate exchanges after December 31, 2017.
Ok, so if they are eliminating 1031s for everything other than real estate after December 31, 2017, then aren’t they implicitly saying that for everything before January 1, 2018, we can claim §1031 treatment? No, not necessarily.
Here are a few reasons why. First, if we are to look at the treatment of property that most closely resembles cryptocurrency, we can look no further than stocks. We already know that even before the new tax bill, stocks have been specifically excluded from IRC §1031 tax deferred treatment. So stocks, another form of property, do not get §1031 treatment. Accordingly, it would be an easy extension for the IRS to take on the position that the exclusion for stock also applies to cryptocurrency exchanges for all trades before 2018. After all, when Congress excluded stocks, cryptocurrencies had not yet come into existence. And certainly, the new tax bill makes clear it cannot be done after 2017. So, why would we say your §1031 for crypto, which closely resembles stocks, is good between 2009 and 2017? While possible to argue, it’s a tough sell.
Perhaps more importantly for those still wanting to grasp at the straws, IRC §1031 has specific requirements that must be met in order to qualify for “like-kind” tax-deferred treatment. Not only does a qualified intermediary need to get involved (among other requirements too complex for our purposes here), one would also need to report the election by filing the appropriate forms with their tax return. Without reporting the §1031 election on your return, your already flimsy tax position might be as good as not having one at all.
Bottom line, the §1031 route is a risky tax position to take for pre-2018 tax years. For 2018 and beyond, it’s explicitly prohibited. Until the IRS releases further guidance on how it will treat like-kind exchanges for tax-years leading up to 2018, making the election on your return or amended returns can certainly make you a target for the IRS. In all cases, proceed with caution and always get professional tax advice from an attorney or CPA before assuming any of your crypto-exchanges are tax deferred.
In Conclusion, You Should Report Your Crypto Transactions
You already know this, but it’s worth repeating. You are supposed to report everything on your tax return, accurately. If you were involved in receiving crypto for goods or services, if you mined crypto, or if you made some crypto trades, the IRS expects you to report that. IRS Notice 2014-21 makes that clear.
Failure to report your crypto transactions, like almost anything else that’s supposed to be reported on your tax return, could result in penalties, interest, and possible criminal liability depending on your circumstances. Failure to report income could also mean you are submitting a fraudulent tax return, which might follow you indefinitely.
But my CPA still files paper returns and doesn’t know a thing about crypto. If your CPA still files paper returns or is uncomfortable communicating over email, he or she is probably not the one you want helping you with crypto transactions. Moreover, even for the tech competent, your tax preparer still might not fully grasp crypto issues or want to take the time to learn about them.
Casual investors who made a handful of trades, or people who received payment in crypto for a one-off job they did might not have a hard time explaining to their tax-preparer what’s going on. But for more complicated traders who moved coins in and out of different exchanges, between hot and cold wallets, with hard fork air drops, and possible mining income, you might be better suited contacting an attorney or CPA who is relatively more versed in the crypto world. Right now, these might be few and far between, and will probably tend to be younger professionals.
At the end of the day, taxes are your responsibility. They are too important to be ignored altogether. Even Coinbase, who just fought the IRS about turning over consumer records is telling its users to pay taxes by pinning a reminder on their dashboards. It would behoove you to pay careful consideration to these tax issues. Gathering your crypto transaction records and getting in touch with your tax-preparer, CPA, or tax attorney well before upcoming April filing deadlines is a good start.
March 2021 Update: Since this article was written, the IRS has provided additional crypto-tax guidance through its “Frequently Asked Questions on Virtual Currency” page on its website. The additional guidance does not override or negate the original guidance it provided in its 2014-21 Notice (as discussed below), but does provide insight on a number of unaddressed crypto-tax questions.