Investing in Cryptocurrency? The Tax Implications You Should Consider
Known for their lack of centralized regulation and government oversight, cryptocurrencies have become an increasingly popular option for investors. But as digital currencies become more prominent, they are drawing increased attention from the federal government. Cryptocurrency reporting noncompliance is rampant, and the IRS is increasing enforcement on virtual currency issues. In light of this, what tax implications should you consider before investing in cryptocurrencies?
In the absence of overarching, broad guidance from the IRS, there are still many unanswered questions. However, the limited guidance the IRS has issued, along with a district court case, provides some direction for investors.
First, it is important to understand the difference between “Bitcoin,” “blockchain,” and “cryptocurrency.” Most use the terms interchangeably, but they are not synonymous.
- Blockchain is an online, decentralized ledger which keeps track of all transactions taking place on a peer-to-peer network. The aspect that makes this technology so fascinating is that it allows buyers and sellers to make verified transactions without the need to go through a centralized third party such as a bank or credit card company. This technology can be applied to a wide variety of businesses because it is a form of process improvement, allowing for the elimination of a third party to verify the transaction and thus lowering transaction costs for the entire marketplace.
- Cryptocurrency is an alternative, digital currency that uses blockchain to facilitate transactions. Most cryptocurrencies are decentralized and are currently used as a store of value – a sort of digital gold – rather than a payment method. Bitcoin is the largest and most popular cryptocurrency available.
IRS Notice 2014-21
In 2014 the IRS issued guidance on the tax treatment of transactions using cryptocurrencies. Per this notice, the IRS is treating Bitcoin (and all other cryptocurrency) as property rather than foreign currency. Put simply, this means that an investment in Bitcoin is similar to an investment in stocks or bonds. The investor will have to keep track of their basis (the U.S. dollar value at the time of purchase) in the cryptocurrency and will not be subject to any tax until that cryptocurrency is sold or exchanged. Any gain on a sale would be taxed as a capital gain – either short-term (if held less than 12 months) or long-term (if held more than 12 months). Because cryptocurrencies are not treated as a foreign currency, losses are capital losses that are subject to the general limitations imposed on the deductibility of capital losses. Other cryptocurrency transactions, such as receiving it as a form of payment for goods and services, are treated as any other form of income. This means that if you were to receive a cryptocurrency in exchange for goods and services, the U.S. dollar value of the cryptocurrency at the time of the transaction would be included in your gross income for the year.
The main challenge that investing in cryptocurrencies presents is the ability to keep track of fluctuating values. Currently, investors are not issued a 1099-B that reports gain or loss detail. It is the investor’s responsibility to track the value of the investment and report any gains or losses on their tax return.
U.S. v. Coinbase, Inc.
Investors in Bitcoin and other cryptocurrencies need to be aware of the IRS’s recent focus on enforcement of these types of transactions. In November 2017, the IRS won a U.S. District Court decision against Coinbase, Inc., the largest domestic cryptocurrency exchange. Under this decision, Coinbase was ordered to produce the taxpayer ID number, name, birthday, address, and account activity records of any user who bought, sold, sent, or received at least $20,000 in any one transaction type for the years 2013-2015.
The IRS estimated that only 800-900 persons reported transactions related to Bitcoin cryptocurrency on their 2013-2015 tax returns. However, Coinbase reported that for each of those years an average of more than 14,000 users either bought, sold, sent, or received at least $20,000 worth of Bitcoin. This discrepancy shows that most Coinbase users were not reporting their Bitcoin gains. This was a big win for the IRS and will almost certainly result in a number of future audits and lawsuits.
If you are an investor in cryptocurrencies it is very important that you discuss the investment with your KSM advisor. The tax implications are currently developing, but with increased IRS scrutiny, it is important to make sure that you are tracking and reporting all necessary components.
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