Author: Matthew Cochrane | April 04, 2018
A lurking certainty
Benjamin Franklin famously declared that paying taxes was one of the two certainties in life. Fortunately, the other certainty, death, is a little less morbid. The Beatles sang "I'm the taxman and you're working for no one but me." Over the past two centuries, large political movements have risen and fallen based on radically reforming the American tax code, but one thing remains constant: Everyone pays the taxman.
Given the radically new nature and anonymous characteristics of cryptocurrencies, buyers and sellers of this new asset class may have believed they were exempt from one of life's certainties but, sadly, this is not the case. In fact, for U.S. cryptocurrency owners, there are several things to know about the tax implications of buying and selling their favorite virtual currency.
1. Treated as property, not currency
The first thing that cryptocurrency owners need to know is that, for all intents and purposes, bitcoin and other virtual currencies are treated as property by the IRS. In Notice 2014-21, the IRS gives official guidance on what it defines as virtual currency, saying, "For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency." In a reminder just last month, the IRS reiterated this guidance, "Virtual currency transactions are taxable by law just like transactions in any other property."
The IRS explicitly states this means that virtual currencies are not to be treated as currencies, meaning the foreign currency tax laws regulating the gains and losses of currencies are not applicable to bitcoin or other cryptocurrencies.
2. Wages and income
When employees receive cryptocurrencies as compensation for services rendered, they are taxable. This means, like any other form of wages, they are subject to payroll taxes and federal income tax withholding and employers need to report it on a W-2 form.
If independent contractors receive virtual currency as a form of payment for services rendered, it is counted as self-employment income and is subject to all the rules and regulations governing self-employment income.
3. Declaring capital gains and losses
Like stocks, bonds, and other investment assets, the buying and selling of virtual currencies triggers capital gains and losses. While a lot goes into knowing all the ins and outs of capital gains and losses, there are a couple things all investors should know.
First, assets held for under one year are taxed as ordinary income. Assets held longer than a year are taxed at 0%, 15%, or 20% based on your tax bracket. This gives the HODL crowd (hold on for dear life) a decided advantage over short-term speculators.
The exchange of a bitcoin for another type of cryptocurrency is a taxable event. Ditto for converting a cryptocurrency to U.S. dollars or foreign currency.
4. Determining fair market value
So what if workers were paid in bitcoin last summer and sold it in December, near bitcoin's peak? Does that count as income or a capital gain? Both, as it turns out.
First, the IRS guides that what counts as income depends upon the fair market value of the cryptocurrency on the date it was received as measured in U.S. dollars. The capital gain (or loss) would be the amount the cryptocurrency was sold above or below that amount. For example, if a cryptocurrency was worth $100 when it was received as wages but later sold when its value had doubled to $200, only the $100 value would be taxed as income. The sale would trigger a $100 capital gain to be reported.
5. What about bitcoin mining?
If mining for bitcoins or other cryptocurrencies is undertaken by a taxpayer (and not as an employee of a company) then the fair market value of the coin the day it was successfully mined is counted as ordinary income.
6. What about ICOs?
An ICO, or initial coin offering, is the creation of a new cryptocurrency to raise capital. While I could not find any official guidance from the IRS on capital raised through ICOs, this CNBC article states ICOs are to be counted as ordinary income for both individuals and businesses since they are not listed as a tax-free method for raising capital by the IRS.
7. How do I report my cryptocurrency tax gains and losses?
Unfortunately, cryptocurrency exchanges are not obligated to provide taxpayers with 1099 forms or even an individual's cost basis for their cryptocurrency investments. Coinbase now provides customers who have received $20,000 in virtual currency sales from at least 200 different transactions in a calendar year a Form 1099-K. Other popular exchanges, such as Kraken, offer no such support, even for high volume customers. This means it is imperative for each investor to keep careful track of their cryptocurrency transactions.
8. Steep punishment for tax evasion
Although it appears a good number of bitcoin investors are prepared to commit tax fraud this year, the crime is not worth the time. Literally!
Anyone caught not reporting the right amount of gains from virtual currency investments can be audited and held liable with penalties and fines. It gets worse. This is straight from the horse's mouth:
"In more extreme situations, taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions. Criminal charges could include tax evasion and filing a false tax return. Anyone convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Anyone convicted of filing a false return is subject to a prison term of up to three years and a fine of up to $250,000."
Yikes! Much better to pay taxes on your gains and avoid the consequences for trying to get away with a fast one.
Nobody likes paying taxes, but filing returns while taking into account the buying and selling of cryptocurrencies, an asset class still in its nascent stage, can be especially trying. Yet understanding these key facts will hopefully make the process much more transparent, if not more enjoyable.
Matthew Cochrane has no positions in any cryptocurrencies mentioned. The Motley Fool has no position in any cryptocurrencies mentioned. The Motley Fool has a disclosure policy.