The IRS announced a Virtual Currency Compliance campaign to address tax noncompliance related to the use of virtual currency through outreach and examinations of taxpayers. The IRS will remain actively engaged in addressing non-compliance related to virtual currency transactions through a variety of efforts, ranging from taxpayer education to audits to criminal investigations.
The Internal Revenue Service began sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax from virtual currency transactions or did not report their transactions properly. These efforts will continue.
This guide is intended to provide an overview of the various tax and reporting obligations that might arise in the process of acquiring, disposing and engaging in Virtual Currency transactions. It is also will serve as a guide as to how to handle situations where the taxpayer may not have been aware of these tax and reporting obligations and how to resolve past issues.
IRS Guidance on the Taxation of Virtual Currency
In March 2014, the IRS published Notice 2014-21 (the “Notice”) – the only guidance the IRS has published to date on taxation of cryptocurrencies. As a threshold matter, the IRS analyzed whether a cryptocurrency should be classified as a currency or property for U.S. income tax purposes. In general, a “virtual currency” is defined as a “digital representations of value that functions as a medium of exchange, a unit of account, and/or a store of value.”
A convertible virtual currency is defined as a subcategory of a virtual currency or one “that has an equivalent value in real currency, or that acts as a substitute for real currency.” The Notice presumably, therefore, does not address the taxation of other forms of cryptocurrencies, such as for example, those with smart contract features (e.g., ethereum). Very generally, a “smart contract” refers to a computer protocol that automatically executes the terms of a bilateral or multi party agreement(s) without an intermediary. [190 T.M., II.A.].
Virtual currency is treated as property for federal income tax purposes. General tax principles applicable to property transactions apply to transactions using virtual currency. Therefore, the rules applicable to foreign currency transactions under Subpart J of the Internal Revenue Code (“IRC”) are not applicable and thus virtual currencies cannot generate foreign currency gain or loss for U.S. federal income tax purposes. See Notice 2014-21.
A taxpayer who receives virtual currency as a payment for goods or services must include in its gross income the fair market value of the virtual currency measured in U.S. dollars, as of the date that virtual currency was received. See IRS Publication 525 , Taxable and Nontaxable Income for more information on miscellaneous income from exchanges involving property or services. Furthermore, the basis of virtual currency a taxpayer receives as payment for goods or services is the fair market value of the virtual currency in U.S. dollars as of the date of the receipt. [Notice 2014-21 ; 190 T.M., V.B.].
Tax lawyers and accountants have raised many issues that require further clarification. For instance, the meaning of the term “received” is an area which creates confusion. The American Bar Association (“ABA”) Tax Section in their comments to the IRS have asked whether a virtual currency (such as a bitcoin) is deemed received on the date earned or received when record ownership is transferred. [ABA Tax Section, “Comments on Notice 2014-21 ,” at 4 (“When is virtual currency received”) (Mar. 24, 2015)].
If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. Similarly, the taxpayer recognizes loss if the fair market value of the property received is less than the adjusted basis of the virtual currency.
— In general, §1012 provides that a taxpayer’s basis in property is its cost. Section 1016 provides the rules with respect to adjustment to costs (i.e., stock splits, stock dividends, corporate reorganizations, etc.).
— In the context of virtual currencies, in determining basis or cost at the time of sale, careful review of the basis allocations is warranted. [ Notice 2014-21 ]
The character of the gain or loss will depend on whether the virtual currency is a capital asset (e.g., stock, bonds, and other investment property) in the hands of the taxpayer. Alternatively, a virtual currency that is not treated as a capital asset will yield either ordinary gain or loss to the taxpayer on its sale or exchange. Inventory and other property held for sale to customers or in a business are treated as property that is not a capital asset. [ Notice 2014-21 ; IR-2014-36 ; 190 T.M., II.A. ]
How Am I Taxed If I Pay for Goods or Services with Virtual Currency?
Virtual currency owners should be aware that using such currency to make payments is a taxable event. This means that if the value of the virtual currency has appreciated in the hands of the payor, then the payor would owe tax on the amount of that appreciation at the time the virtual currency is used to pay for goods or services.
For example, if you purchase a bitcoin for $10,000 and use it to buy a vehicle for $12,000, you would owe taxes on the $2,000 increase in value. In other words, using virtual currency to pay for goods or services is taxed in the same way as selling the virtual currency for cash and then using the cash proceeds to pay for the goods or services.
How Are Capital Gains and Losses From Virtual Currencies Tracked?
The IRS has not addressed how to track the computation of capital gains and losses (basis and fair market value) in the context of “convertible” virtual currencies. A “convertible” virtual currency (e.g., a bitcoin) is one that can be freely exchanged into another virtual currency without regulatory oversight.
When a virtual currency is used to purchase goods or services, a transaction occurs where parties are required to track the fair market value (FMV) of the currency at the time of the transaction. The taxpayers cost or basis will determine whether a gain or loss has occurred as well as its duration (short-term or long- term transaction). [190 T.M., III.J.].
Additional Rules concerning Cryptocurrency
There are a a number of other aspects to accounting for and the taxation of cryptocurrency. Many of these are covered in our free Cryptocurrency tax guide. If you have additional questions or concerns regarding your personal tax situation, please contact our office for a free, confidential consultation.