It has been a hot year for cryptocurrencies, even in the midst of a global pandemic. Bitcoin, the largest cryptocurrency by market value, skyrocketed and fluctuated wildly in price between 2020 and 2021. Additionally, other cryptocurrencies such as Ethereum, XRP, and Tether have gained popularity as the public’s comfort level with cryptocurrency increases. Then there is the category of meme coins, such as the iconic Dogecoin. Starting as a facetious joke between crypto investors, Dogecoin has grown to become the fifth largest cryptocurrency by market capitalization.
A cryptocurrency is a form of digital currency that can be exchanged online for goods and services. Many cryptocurrencies are based on a decentralized network of blockchain technology to ensure the integrity of the transactional data. They are appealing and novel to many because they offer secure transactions with less influence from central authorities.
Increasingly, companies like Square and Tesla have invested in Bitcoin, and institutional investors and retail traders alike have jumped into the market. In fact, American investors made an estimated $4.1 billion in realized bitcoin gains in 2020. With the growing acceptance of Bitcoin and other coins as payment, an increasing number of people are keeping an eye on cryptocurrency, including the IRS. Whether you’ve already hopped on the trend or you’re considering investing in cryptocurrencies in the future, there are some tax implications that you should be aware of.
Per IRS Notice 2014-21, cryptocurrencies are taxed like capital assets (similar to stocks and bonds) vs. a currency. As such, cryptocurrencies can be classified as business property (in the case of mining), investment property, or personal property. This means that you will be taxed only if you sell your assets for a profit. Jeff Hoopes, the research director of the University of North Carolina Tax Center, offered his opinion on this ruling, saying, “I assume [the IRS] decided this because most people hold crypto as an investment, and we tax the appreciation on the capital assets held as an investment.” For the IRS, that means there is significant tax revenue to be collected, especially when cryptocurrencies began having trading volumes in the tens of millions of dollars on a daily basis.
Tax Considerations as a Cryptocurrency Investor
The 2020 version of IRS Form 1040, the form used to file an annual income tax return, asks whether you received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency. The form’s instructions clarify that virtual currency transactions for which you should answer “Yes” include, but are not limited to:
- the receipt or transfer of virtual currency for free (i.e., without having to pay);
- the exchange of virtual currency for goods or services;
- the sale of virtual currency;
- the exchange of virtual currency for other property; and
- the disposition of a financial interest in virtual currency.
However, you are not required to answer “yes” if the only transactions you made were to purchase cryptocurrency with real money. Generally, the IRS is looking for sales of cryptocurrency that result in capital gains and losses, as well as receipt of cryptocurrency as payment for services, gifts and airdrops.
Taxes Owed on Cryptocurrency Transactions
How much you owe on your cryptocurrency transactions depends on the fair market value (FMV), measured in USD, of the cryptocurrency on the day you received it and on the day you used it to pay for something.
Similar to a stock sale in your brokerage account, you will incur short-term or long-term capital gains taxes, and those gains will be taxed accordingly. If the FMV of what you receive exceeds your basis in the cryptocurrency that you exchanged, you’ll have a taxable gain. If the FMV of what you receive is less than your basis in the cryptocurrency, then you’ll have a taxable loss.
For example, suppose you use one bitcoin to buy tax-deductible supplies for your sole proprietorship business. Bitcoins are worth $55,000 each on the date of purchase, resulting in a business deduction of $55,000 for you.
However, you also must take into consideration the tax gain or loss from holding and spending the bitcoin. If you bought the bitcoin in January of this year for only $31,000 (what a steal!), you have a $24,000 taxable gain from appreciation in the value of the bitcoin ($55,000 – $31,000). This $24,000 gain is a short-term capital gain because you did not hold the bitcoin for more than one year, and therefore you will be taxed accordingly.
In order to be well prepared for filing taxes, it is important to keep detailed records of your transactions. Your records should include:
- the date when you received the cryptocurrency;
- its FMV on the date of receipt;
- the FMV on the date you exchanged it (for U.S. dollars or whatever);
- the cryptocurrency trading exchange that you used to determine FMV; and
- your purpose for holding the currency (business, investment, or personal use).
Ambiguity around Cryptocurrency Transactions
It is important to note that cryptocurrency is a relatively new development and we are still awaiting additional guidance from the IRS as they develop more specific rules and regulations. There are a few areas of ambiguity surrounding taxes on cryptocurrency that have yet to be addressed.
Cryptocurrency as Property
As mentioned previously, cryptocurrency is considered property by the IRS. According to the IRS, activities like trading one cryptocurrency for another is a taxable event as well, so taxpayers must recognize capital gains and losses for coin-to-coin trades. For example, suppose you purchased 4 Litecoin for $240, then decided to trade your Litecoin for 0.1 Ethereum a few months later. At the time of the trade, the Litecoin is worth $500. The trade is considered a disposal and you would incur a $160 capital gain for tax purposes.
Hard Forks and Airdrops
There are also ambiguous tax implications for hard forks and airdrops. A hard fork occurs when the developers of digital currency create a permanent split in a blockchain, turning a single cryptocurrency into two. An airdrop is a means of distributing units of cryptocurrency to certain investors on their distributed ledger addresses, and it is often used to do so after a hard fork. However, a hard fork is not always followed by an airdrop. Current IRS guidance says that you must pay ordinary income tax when you receive airdropped cryptocurrency, and these airdrops become taxable once you officially receive the currency. For tax purposes, you receive the cryptocurrency the moment you acquire the ability to transfer, sell or exchange it. If your cryptocurrency went through a hard fork but you did not receive any new currency, then there is no tax effect. Soft forks, or changes in the software that only render previously valid blocks and transactions invalid, are not a taxable event.
The IRS has confirmed that airdrops following a hard fork are taxable, but there is currently no guidance on whether promotional airdrops or other airdrops that do not follow a hard fork are taxable.
United States persons are required to file Form 114, Report of Foreign Bank and Financial Accounts (FBAR) if they hold a financial interest in or signature authority over at least one financial account located outside of the United States and the aggregate value of all accounts exceeds $10,000 at any point during the calendar year. In 2014, the IRS did not consider cryptocurrency assets as something included under FBAR. However, on December 30, 2020, the Financial Crimes Enforcement Network (FinCEN), which is responsible for issuing regulatory guidance for FBARs, announced through FinCEN Notice 2020-2 that there were plans to include virtual currency under FBAR reporting requirements. As of right now, there has been no further specific guidance.
Timing of Sale
Taxpayers have the option to choose which unit of cryptocurrency to sell, exchange or dispose of when it comes to calculating capital gains and losses. You can specifically identify a unit of cryptocurrency if you know the date and time of acquisition and sale or disposal, the basis and the fair market value at the time of acquisition, and the fair market value at the time of sale or disposal. This gives you a few different options when it comes to investing in cryptocurrency: first in first out (FIFO), last in first out (LIFO), and highest in first out (HIFO). These can all lead to different capital gains or losses, providing investors with important considerations when it comes to taxes. The IRS does not provide guidance on a particular method or way of identification.
For more on the tax implications of cryptocurrency transactions, read GRF’s article, How Virtual Currency Transactions Affect Your Tax Situation. You may also receive answers to other commonly asked questions by reading the IRS FAQ on Virtual Currency Transactions. Contact your CPA for help with cryptocurrency transactions or submit a question to GRF CPAs & Advisors’ tax team.
Jennifer Galstad-Lee, CPA, JD
GRF CPAs & Advisors