Many view the world of virtual currency (or “cryptocurrency”) as an unregulated landscape. While it is true that this new area of technology is constantly advancing, and lacks many of the regulations in place for traditional forms of commerce, the profits involved in investing, selling and mining cryptocurrencies are real, and create tax obligations. The IRS has issued some, but not much, guidance on how cryptocurrency should be treated for tax purposes. Key concepts that investors should keep in mind are outlined below.
- Cryptocurrency is treated as property, not currency.
For tax purposes, the IRS treats cryptocurrency as property not currency. Therefore, existing tax rules that apply to property transactions should be applied when possible. For instance, if you receive cryptocurrency as a form of payment, you have taxable income in the amount of its fair market value in US dollars at the time received. You also pay taxes on gains from the sale of cryptocurrency. This may require some vigilance by recipients of cryptocurrency due to the volatile nature of cryptocurrency exchange rates. You should keep records of any payments or receipts of cryptocurrency in order to accurately report the amount of income received.
When cryptocurrency is sold or exchanged, the seller will realize a gain or loss. Whether that gain or loss is of a capital or ordinary nature depends on how you are holding the asset. Many people hold cryptocurrencies as forms of investment, meaning that the majority of people will see capital gains and losses. This produces some incentives to hold currencies for over one year in order to take advance of long-term capital gains rates. However, some individuals may have cryptocurrencies for use in a trade or business or as inventory, which are not considered capital assets.
- If you mine cryptocurrency, the resulting payment is considered income when received in the amount of its fair value in US dollars.
Miners (people who use their computer’s processing capacity to participate in validating and recording cryptocurrency transactions in the public ledger, and are in turn rewarded with a small amount of the currency) should be especially careful to keep track of the value of currency received and report all of it as income. Miners must pay taxes on this income even if they leave the asset untouched in the form received and don’t exchange it for US dollars. As discussed above, your income is the fair value of the currency in US dollars at the time it is received.
- Miners may be considered “self-employed” and subject to self-employment tax.
Another consideration for miners is that if your mining activity is substantial enough, you may be considered “self-employed” by the IRS and subject to self-employment tax. Self-employment tax is a tax consisting of Social Security and Medicare taxes imposed on those who work for themselves. These taxes are normally withheld from the pay of regularly employed individuals. The IRS considers someone “self-employed” if they are carrying out a trade or business, aka an activity carried on for a livelihood or in good faith to make a profit. Those with significant income from mining are likely obligated to pay self-employment taxes, and should consult their accountant on this issue.
- Previously used, but questionable, like-kind exchange loophole is now closed.
In the past, some currency traders have elected to claim exchanges from one type of cryptocurrency to another as “like-kind exchanges” under section 1031 of the Internal Revenue Code. Like-kind exchanges defer capital gains on an asset when it is exchanged for another asset of the same nature or character. The use of this exemption for cryptocurrency exchanges was never clearly valid, because this type of property was not contemplated by the statute, and the IRS never issued a ruling or guidance on the subject. Stocks and bonds, on the other hand, have been expressly excluded, which casts doubt on whether those holding cryptocurrencies should be using this exemption, since these individuals are likely holding the cryptocurrency for a similar investment purpose. However, the new tax bill effective in 2018 now limits like-kind exchanges to real property only, eliminating any question as to whether an exchange of one cryptocurrency for another cryptocurrency can be claimed as a like-kind exchange on returns after the 2017 tax season.
- Currency Forks
Currency forks occur when a new cryptocurrency is created that branches off from an existing cryptocurrency. When this happens, owners of the original cryptocurrency usually receive units of the new one for free. Because you are receiving something of value, if you receive cryptocurrency from a fork, that currency will most likely be considered income to you by the IRS, and you will owe income tax on the value of the new cryptocurrency. This sounds easy enough, but it may be extremely difficult to value a newly created currency, and you may not have access to the currency right away. This is just one of the many issues surrounding cryptocurrency that creates unique and interesting challenges for tax law. However, as it stands now, you should use your best efforts to report the value of the income you receive from a fork.
Key takeaways: You cannot avoid paying income taxes just because you are receiving income in the form of cryptocurrency or investment gains in cryptocurrency. You should disclose all income from cryptocurrency sources when filing your taxes. Because this is such a new and unregulated area, new IRS or legal interpretations will likely affect this analysis in the future. If you invest or mine cryptocurrency, we recommend seeking the advice of an accountant who is experienced with these types of assets.
Revenue Notice 2014-21
The law is continually evolving and Dudley and Smith, P.A.’s blog posts should not be relied upon as legal advice, nor construed as a form of attorney-client relationship. Postings are for informational purposes and are not solicitations, legal advice, or tax advice. A viewer of Dudley and Smith, P.A.’s blog should not rely upon any information in the blog without seeking legal counsel.