The diversity of transactions that occur in the crypto ecosystem touch almost all parts of the U.S Internal Revenue Code. However, the Tax Code contains no reference to “virtual currency” or “crypto currency.” Instead, you will find myriad technical rules that can be hard to understand, or lead to the wrong answer when viewed in isolation or when applied generically. To better understand how the U.S. tax rules apply to virtual currency, one can view the many technical issues that arise as answering one of four questions.
1. When am I taxable on income I receive?
To answer this, one has to consider what income is, whether it was received, and whether an exception applies that does not require the taxpayer to include the item in the taxable income calculation.
What income is: Most people think of income as anything that increases wealth. However, not all accessions to wealth are considered income. For example, a miner who discovers gold has an accession to wealth but is not taxed at that time. With regard to crypto, the notion of an accession to wealth comes up in the context of mining and certain other transactions. However, the IRS has not agreed that income that arises on the grant of rewards is an appropriate departure from the gold-mining paradigm that does not tax the miner upon the discovery of gold.
Whether income was received: The term ‘receipt’ contains nuances in the crypto context. The traditional definition states that receipt arises when a taxpayer has dominion or control over the property that creates the income event. However, an airdropped crypto asset that would meet the traditional definition brings up additional considerations such as whether there are restrictions on the taxpayer’s ability to access or monetize the asset (e.g. due to an exchange not supporting the asset).
Exceptions to recognizing taxable income: All income that is “realized” is potentially subject to tax unless an exception allows for taxation to be deferred. Whether the deferral of taxation is permitted can depend on the nature of the virtual currency at issue, whether the virtual currency is transferred to a partnership or corporation, whether the interest in the virtual currency is a spot contract or derivative, and a number of other factors.
2. What is the amount of income I have to recognize?
The amount of gross income that has to be recognized is based on the proceeds from sale or exchange of an asset, reduced by the taxpayer’s tax basis in the asset and fees incurred on the sale. Valuation for virtual currencies sold between unrelated parties for cash (fiat currency) is relatively straightforward. However, complexity arises when an asset like bitcoin is purchased using another capital asset such as Ethereum, and a fee is paid in a third capital asset such as Ripple’s XRP. In such instances, there may not be a fiat value for one or either of the crypto pairs on the exchange, and the fiat value of each part of the pair may vary among exchanges. Further, the choice of accounting method — first-in, first-out (FIFO); last-in, first-out (LIFO); highest-in, first-out (HIFO); or specific identification — that a taxpayer selects determines the amount of income that is subject to tax (or which losses can be denied or deferred).
3. At what rate is the income taxed?
Tax rates are outlined by statute, but vary based on whether the income at issue is (a) long-term capital gain, (b) ordinary income or short-term capital gain. Classifying income in one of these buckets can mean the difference between a 37 percent tax rate and a 20 percent tax rate.
While there is little question that virtual currency is property, it does not always mean that a taxpayer receives capital gain whenever transacting in virtual currency. For example, receiving virtual currency for performing a service or as a staking reward does not result in capital gain. Likewise, deferring income recognition of a staking or mining reward with the hope of generating capital gain on disposition of virtual currency may be challenged by the IRS.
There are certain statutory rules around tax character that can replace the normal character rules relating to capital vs. ordinary. These rules often pair with timing rules and can depend on a taxpayer’s status. For example, persons who trade in bitcoin futures (and potentially options) may have a portion of their gains taxed as long-term gains even though they have a short-term holding period. Such favorable treatment may be dependent on the virtual currency position at issue and the exchange where it is traded. There are separate character (i.e., ordinary) and timing elections (i.e., mark-to-market) for dealers and traders in actively traded virtual currencies.
4. When can I take a tax deduction for a loss or expense I incurred?
Taxpayers who are on the cash-basis method of accounting can take a deduction when they pay an expense, and taxpayers who are on the accrual method of accounting can take a deduction when all events have occurred that establish their obligation to pay and economic performance has occurred.
There are special rules, however, that can apply to deny or defer a deduction on sales or other dispositions of property. One needs to consider when and how these rules apply to virtual currencies. Where tax rules are indifferent as to the type of property at issue, the rules generally apply to virtual currency. However, where the application of rules differs based on the asset class at issue or particular characteristics of the asset (e.g., actively traded), greater scrutiny must be given to the relevant asset (such as cryptocurrency) to determine whether the particular rule applies to virtual currency.
The lack of detailed crypto tax rules complicates the tax treatment for transactions in the crypto ecosystem. However, this absence does not mean there are no rules. but rather that the existing rules have to be applied with a proper understanding of the transaction at issue and the technological and commercial characteristics that inform the tax treatment. Approaching transactions from the framework outlined in this article can be a helpful starting point.
