Starting from its genesis on Jan. 3, 2009, the taxation of Bitcoin transactions, as well as other cryptocurrencies (further referred to as “Altcoins”) that emerged using Bitcoin’s open source code, has been the subject of conversation for many novice investors and crypto enthusiasts alike. However, it was not until the sudden increase to the total market capitalization in 2017 that the conversations really started to heat up.
In the span of one year, the total market capitalization encompassing all cryptocurrencies skyrocketed from $17 billion on Jan. 7, 2017 to $828 billion on Jan. 7, 2018, a total increase of 4,870 percent (data provided by CoinMarketCap). Other Altcoins such as Ripple (36,000 percent) and Ethereum (9,160 percent) saw much larger increases than that of Bitcoin (1,320 percent) over the same span of time. However, Bitcoin has received a bulk of recognition for the market’s overall performance. For those savvy or lucky enough to have invested early in the growth process, this sudden growth made millionaires of thousands overnight. Nevertheless, this success has forced many to run for answers relating to the taxation of their newfound fortune, and the aim of this blog is to help answer most, if not all of those questions.
What transactions trigger a taxable event?
A taxable event has is triggered every time a cryptocurrency does one of the below:
Exchanged for another cryptocurrency
Used to make purchases
Received for the exchange of services performed or products sold
How are gains and losses computed?
The Internal Revenue Service (IRS) has issued some guidance (“Notice 2014-21”) as to acceptable methods for determining both cost basis and fair market value (FMV) of sold and disposed cryptocurrencies. One of the most important measures a taxpayer can take throughout the year to ensure accurate and optimal reporting is to keep track of the FMV in U.S. dollars of the transacted cryptocurrency the moment of the triggering transaction, as this will help to determine the gain or loss to recognize on that year’s tax return. With high trade volumes in an unregulated market, market volatility can render using the average daily FMV for that cryptocurrency useless and ultimately result in inaccurate reporting.
What about for “day traders”?
For “day traders” with thousands of transactions each year, the administrative burden of recording every transaction may be seen as too cumbersome of a task. For instances such as these, the IRS allows for a taxpayer to use any method for determining the gain or loss, just as long as the method is reasonable and consistently applied. One such method would be a “fund balance” approach, where the gain or loss for that year would be determined by computing the difference between the FMV at the opening and closing of that tax year (i.e. a fund balance increase from $10,000 to $25,000 throughout the year would result in a $15,000 short-term capital gain). A disadvantage to using an approach such as this would be the inability for the taxpayer to establish a long-term holding period, and ultimately resulting in short-term capital gain treatment of the sale or disposition of said cryptocurrency.
How are transactions taxed?
The U.S. federal tax law treats cryptocurrency as property, and the character of the gain or loss on the sale or disposition of that property general depends on whether the cryptocurrency is held as a capital asset in the hands of the taxpayer (similar to stocks, bonds, and other investment property) or ordinary income property (such as inventory). Most taxpayers will realize a capital gain or loss on the sale or exchange of cryptocurrency. The nature of that capital gain will depend on the holding period of the cryptocurrency sold or disposed, with long-term capital gain treatment for all cryptocurrencies held for over one year.
What is the tax treatment for cryptocurrencies “mined”?
“Mining” is when one’s computer resources are used to validate transactions and maintain the public transaction ledger in exchange for a block reward, commonly paid in the form of the cryptocurrency mined. U.S. federal tax law requires that the FMV of the cryptocurrency mined as of the date of receipt be included in gross income. The costs associated with the mining of the cryptocurrency (e.g. electricity, graphic cards, etc.) can then be expensed to offset the gross income received. This net income may also be subject to self-employment taxes should the taxpayer be in the active trade or business of mining cryptocurrencies. Furthermore, a gain or loss is triggered once a taxable event occurs as discussed above. The cost basis in that situation would then be determined by the amount of net income recognized on the mining of the cryptocurrency and the holding period established on the date of receipt.
What transactions do not trigger a taxable event?
A taxable event is not triggered when one of these occurs:
The taxpayer purchases coin with real currency (e.g. U.S. dollars, Euros, etc.)
The taxpayer transfers U.S. dollar equivalents out of an exchange and into their bank account
The taxpayer moves cryptocurrency from one exchange to another exchange
The taxpayer moves cryptocurrency from an exchange to a wallet
A “hard fork” occurs
Are there penalties for not reporting cryptocurrency transactions in a proper manner?
Taxpayers may be subject to penalties for failure to comply with U.S. federal, state, and local tax laws. These may be accuracy related, as well as underpayment and failure to file penalties. However, penalty relief may be available should the taxpayer establish that the underreporting was due to a reasonable cause.
Regardless of your belief in the durability and ultimate globalization of the cryptocurrency marketplace, it is important to know where you stand when it comes to a reportable taxable event that you may be involved in. For help determining just that, and to ensure your good standing with the various taxing authorities, please contact our Tax Team by calling 310.873.1600.