Since its inception in 2008, cryptocurrency has become a game changer in how economic exchanges are transacted.
Given that cryptocurrency is a decentralized non-traditional currency, many questions have arisen regarding how crypto should be classified and how crypto transactions should be treated for tax purposes.
In this blog, we give an overview of how cryptocurrency works and a summary of the guidance that the IRS has thus far published to help taxpayers properly report and pay tax on their crypto transactions.
How Cryptocurrency Works
In brief, cryptocurrencies are decentralized digital assets that use computer-generated cryptography as an encryption mechanism for security. This means that control and decision-making does not stem from a centralized entity, but rather a distributed network.
Cryptocurrencies are created by computing processes inside a so-called “blockchain.” They’re designed to be private and portable/transferrable.
Cryptocurrencies are managed inside a so-called cryptocurrency “wallet” that hold the keys that are needed to “decrypt” the cryptocurrency, so it is usable by the consumer. The wallet keys also enable the consumer, among other things, to convert dollars to cryptocurrencies and to transfer funds between crypto markets.
It may be helpful to think of cryptocurrency in its capacity as a commodity, like gold. Similar to gold, cryptocurrency is mined, but with a computer program rather than a drill. The program, called a “mining rig,” is connected a blockchain network, which works to create or conduct monetary transactions.
A new cryptocurrency coin is mined approximately every 10 minutes – with networks of computers and programs (called “nodes”) competing to mine the coin first, winning the coin (a process called “proof of work”). Those who mine the coins also serve as the auditors, which many argue, together with decentralization of the process, creates risks of scheming and fraud.
Bitcoin was the first cryptocurrency, mined in 2008. Since its inception, the crypto world has expanded to well over 6,000 currencies that have been mined and transacted. This giant, complex, and mostly unregulated market has brought about many tax and accounting questions and uncertainties.
Uses for Cryptocurrency
Most people using cryptocurrency have one or more of these goals in mind:
Investment – The crypto market is a major emerging investment market for people looking to grow money quickly and privately. The fact that crypto is so lightly regulated arguably makes for a somewhat precarious investment market, so investors need to determine their risk appetite when investing.
Everyday transactions – Slowly but surely, more and more well-known vendors are starting to accept cryptocurrency as payment. These include Barnes & Noble, Nordstrom, Office Depot, and Starbucks, just to name a few.
Raising capital – Like an IPO, an initial coin offering (ICO) is an emerging alternative for raising capital for a new company. This aspect of crypto has yet to become as popular due to the complexity of the process, among other things.
IRS Guidance and FAQs
As some of you may have already noticed, the U.S. federal income tax return (Form 1040) recently added a new question specifically about virtual currency. The tax return now asks - did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency (e.g., cryptocurrency)?
The addition of this question signals the seriousness of the issue in the eyes of the IRS and portends the intense focus that the IRS will have on cryptocurrency issues moving forward. As such, it is important to understand the official guidance that has come out on the topic.
Given that cryptocurrency is a fairly new economic concept, there is still a dearth of authoritative guidance as to its treatment under U.S. tax law. However, some guidance has more recently been provided.
IRS provided the first tax guidance in the form of a notice (Notice 2014-21, 2014-16 IRB 938). In the notice, the IRS clarified, importantly, that cryptocurrency is property (rather than currency) for federal income tax purposes. As such, a sale of cryptocurrency, like other property, can trigger a gain or loss for tax purposes. We note that due the Notice’s vagueness, some commentators have suggested that there is ambiguity as to whether the Notice should apply to utility tokens or equity tokens.
Given that the Trump Tax Reform limited the like-kind exchange exception to real estate, exchanges of crypto for other crypto should presumably be treated as taxable events triggering gain or loss (even for exchanges that are not cashed out). As such, care should be taken to track realized gains and losses and match purchases and sales to properly report the gains and losses on your tax return.
Further guidance was then issued under Revenue Ruling 2019-24, which states that a taxpayer has gross income, which is ordinary in character, as a result of an airdrop of new cryptocurrency units following a so-called hard fork (a change to the protocol of a blockchain). The ruling specifies that the gross income inclusion is triggered when the taxpayer has dominion and control over the new cryptocurrency at the time of the airdrop, i.e., when it is recorded on the distributed ledger, because the taxpayer at that point has the ability to dispose of the new cryptocurrency.
The IRS website now has a page with FAQs dedicated to cryptocurrency, which provide some helpful answers to specific tax questions about crypto transactions. The FAQ page can be found here:
How We Can Help
Expat Tax Professionals has been carefully following the tax guidance on cryptocurrency, allowing us to advise clients using the best available information. In this regard, we can help crypto holders and investors in both the areas of tax compliance and consulting.
In order to properly report your cryptocurrency transactions on your tax return, we can advise on the following, among other things:
• The tax implications of your particular transaction, or series/groups of transactions
• Determining the basis and fair market value of cryptocurrency
• Reporting crypto gains and/or losses, as well as other crypto streams of income on your income tax return (Form 1040)
• Potential tax withholding obligations
• The tax implications of a hard fork, including if the taxpayer does not receive units of a new cryptocurrency
• The tax implications of a cryptocurrency airdrop, including if the taxpayer receives units of new cryptocurrency
As a U.S. expat, your crypto activities likely have U.S. tax and reporting implications along with certain international tax aspects to consider. Contact us today to see how we can help you with your tax needs.