Preparing for Your Cryptocurrency Tax Obligations

As the saying goes, it is best to “be prepared” for any situation that arises. When it comes to cryptocurrencies, this statement could not ring truer. Waiting until next April to think about the tax implications of virtual currency transactions will make the tax preparation process difficult and burdensome, and it is a surefire way for taxpayers to miss out on any tax-saving and planning opportunities.

Tax Outcomes for Cryptocurrency Use Scenarios

The IRS views virtual currencies as property no matter their use. There are two main ways that taxpayers use cryptocurrencies, and both scenarios will have similar tax outcomes.

As an investment

Oddly enough, even though Bitcoin and Litecoin are called “cryptocurrencies,” most people think of them as investment products rather than currencies. Like other investments (such as stocks, bonds, and real estate), cryptocurrencies can be purchased, held for a period, and then sold for a profit. The tax laws governing property transactions will rule in this scenario. Let’s look at an example:

EXAMPLE 1:

Jane purchases 1/10th of a Bitcoin for $500. Eight months later, she sells her share of the Bitcoin for $750. Jane would have to report a short-term capital gain of $250 on her tax return in the year that the sale occurred.

As a currency

Some vendors do accept virtual currencies as valid forms of payment. For example, Expedia users can select “Bitcoin” as the payment option when making a hotel booking rather than paying by credit card. Because the IRS views cryptocurrencies as property, the taxpayer would calculate the taxable gain or loss on the currency transaction just like in any other property transaction. Let’s look at an example:

EXAMPLE 2:

Jacob purchases two units of Litecoin for $100 each. A year and a half later, the price of Litecoin has increased to $125 per unit. At that time, he books a hotel on Expedia.com for $250 and uses his two units of Litecoin to make the purchase. Jacob would have to report a long-term capital gain of $50 ($250 less his $200 initial investment) on his tax return in the year he used Litecoin as legal tender.

Earning Virtual Currency

If you are on the opposite side of the transaction and earning (rather than using) cryptocurrency, then the tax ramification is the same as if you’re paid with any other type of property. A worker who performs services in return for property will need to recognize ordinary income based on the value of the property received. In the context of cryptocurrency, the worker would recognize income based on the value of that cryptocurrency when they earn those coins.

If you’re a business contemplating paying your employees in virtual currency, keep in mind that the same payroll withholding rules apply as if you were paying in US dollars. The business would need to withhold enough of the cryptocurrency to cover the employee’s payroll and withholding taxes. The IRS does not currently accept cryptocurrency, so the company would need to convert to US dollars to remit those taxes to the government. The same filing requirements also exist in regards to 1099 and W-2s for individuals paid in cryptocurrencies.

What Does the IRS Know?

The IRS is clear in its intent to crack down on users of cryptocurrencies. As discussed in this article, the outcome of the IRS court case United States v. Coinbase, Inc. required the virtual currency exchange company Coinbase to release the identifying information of some of its users. The court order is moving forward. In fact, Coinbase recently notified 13,000 customers that it would be releasing their data to the IRS.

During the proceedings, the IRS argued that taxpayers have openly admitted to using cryptocurrency as a tax-avoidance scheme. Even taxpayers who are uninvolved in this particular case should take note: the IRS recognizes just how much lost tax revenue there could be in cryptocurrency transactions, and it is taking steps to find and penalize noncompliant individuals.

Human Help with Digital Currency

A good taxpayer should be confident, but not foolhardy. Rather than having confidence that the IRS will overlook your virtual currencies, you should report your transactions honestly. If you keep good records of your cryptocurrency transactions, then you will be well prepared to file your return next year. Questions? Your CRI professional is at the ready with a foundation of knowledge to help you navigate the ever-changing world of digital currency, so contact us today!