Cryptocurrencies and taxes: A primer

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Are you talking to clients about cryptocurrencies (a.k.a., virtual currencies, or digital currencies)? Even though most taxpayers are not miners, traders, or even users of cryptocurrency, they likely have questions about it -- and some may have engaged in some form of taxable transaction involving cryptocurrency without realizing they have a tax liability.

A cryptocurrency is a digital asset, or currency, that is traded and secured using cryptography, according to Chuck McCabe, president and founder of Peoples Income Tax and The Income Tax School. “You don’t need a bank to trade this currency,” he explained. “You can trade it peer to peer on a decentralized control called blockchain, which is basically a public transaction database that functions as a distributed ledger.”

Anyone can purchase cryptocurrency using a debit or credit card, McCabe noted. “You set up an account, verify your identity, usually with a driver’s license, and you’re good to go,” he said. “Currently, the cryptocurrency market is experiencing a gold rush because many of the available currencies have been increasing in value rather rapidly. It is quite likely that one or more of a preparer’s clients have invested in cryptocurrency, which is why preparers should ask about it during tax season appointments this year.”

While it has “currency” in its name, the IRS actually views cryptocurrency as property, which means there could be capital gains implications, according to McCabe.

While the IRS provided guidance in Notice 2014-21 nearly four years ago, it hasn’t revisited the topic since. “And as tax pros, we know that it is better to just disclose than to end up with criminal charges,” McCabe said.

“So, if you have clients selling, spending or even exchanging cryptocurrency for other tokens, they will likely have capital gains implications, and, if they were paid in cryptocurrency, they will have to report that as income.”

The following are taxable actions with regard to cryptocurrency, according to McCabe:

  • Trading cryptocurrency produces capital gains and losses.
  • An exchange of cryptocurrency is treated as a sale and is subject to capital gains. Under the Tax Cuts and Jobs Act, like-kind exchanges are limited to real property.
  • Receiving payment in cryptocurrency for goods and services is income and must be reported.
  • Spending cryptocurrency is a taxable event and is treated as a capital gain or loss.
  • Converting a cryptocurrency to a U.S. dollar can generate a capital gain or loss.
  • Mining coins is considered income equal to the fair market value of the coin. (This is so despite the treatment of mining other forms of property, such as gold or diamonds, which don’t produce income until they are sold.)

Major impacts

Since Bitcoin’s launch in 2009, 3 million people have sent $166 billion in virtual currency payments via the internet for goods or services, or have held the funds for investment, according to Selva Ozelli, CPA, Esq. “Although there are over 800 active virtual currencies listed, Bitcoin is by far the most popular, comprising nearly 80 percent of the entire virtual currency market,” she said. “Bitcoins originally were used in the online gaming industry, but the increasing popularity of virtual currencies allows users to pay for everything, even real estate in a high-end Dubai real estate project, in the same way as fiat currencies. More than 100,000 merchants worldwide now accept them as legal tender.”

The blockchain technology behind cryptocurrency has the potential to change the accounting industry all together, according to McCabe.

“Cryptocurrency is just one application of blockchain technology,” he observed. “Blockchain is a chain of blocks that exist in a database. Each block contains a digital ledger of transactions, with time stamps, that have been hashed and encoded, and a cryptographic hash of the block that came before it. All of these blocks are linked to each other because they contain an encryption from the prior block. This creates a layer of security that prevents people from altering details about the transaction after it has occurred.”

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Cryptocurrencies Bitcoin Tax liabilities Tax planning Blockchain