Virtual currencies and their associated blockchain technology are poised to revolutionize money, banking, and transfers of title of all kinds. But there is a lot of confusion when it comes to these digital assets and income taxes.
With the news of the tax reform act of 2017, everybody is really concerned about virtual currency or crypto currencies and taxation. Whether you hold bitcoin, lightcoin, dash, ethereum, or any of the other altcoins, taxes are now a reality four holders, traders, and investors.
The guidance issued by the IRS back in 2014 stated that crypto currencies are a digital asset and can be treated as property for tax purposes. And from that decision, all of the other tax treatment rules derive.
Basically your cryptocurrency taxes are going to fall into three different buckets.
Short Term Capital Gains
The first and probably most common is short term capital gains. Short term capital gains are when you buy and sell property but hold it for less than one year. A lot of crypto currencies in the alternative coin or “altcoin” space are less than a year old. So if you bought them through an ICO then by definition you have a short term capital gain. Short term gains get reported on your Form 8949 and Scheduled D, but are taxed at ordinary income tax rates. So that means that whatever tax bracket you’re in, that’s the amount of income tax that you’ll be paying all those gains.
If you are a cryptocurrency trader as your business, then things will be a little different. Your coins will be inventory and all your profits will be ordinary income. Like most things in the world of taxes, this comes down to facts and circumstances as to whether you are just an active trader or crypto is your trade or business.
Long Term Capital Gains
The second bucket that your crypto currencies will fall into tax wise is long-term capital gains. Long-term capital gains are the same short term, but for when you hold them for more than a year. The tax rates for long-term capital gains are much more advantageous compared to short term. Long-term capital gains are taxed at 0%, 15%, or 20% depending on your total taxable income and what bracket you fall into.
The last bucket that will apply to fewer people in the crypto currency world is ordinary income. You’ll get ordinary income when you mine for a crypto currency, receive a bonus or airdrop, or master node payout. The amount of ordinary income you receive is equal to the fair market value of the crypto currency you receive at the moment you receive it. How ordinary income is reporting will depend on what tax structure you’re dealing with. If you’re operating as a sole proprietor then it would be reported as sales income on a schedule C. If you are operating in a corporate or partnership entity, then it would just be part of your gross revenue or sales.
There are two interesting effects that happen with this ordinary income. If you operate in a partnership or as a sole proprietor, then you will probably have self employment tax consequences. That can be up to 15.3% additional tax depending on your other tax circumstances.
Ordinary Income and Subsequent Basis
The other interesting thing that happens when of ordinary income encrypted currencies is that the property that you gain then becomes Capital Property and your basis is the valuation at which you received the crypto. But
An example will make easier to see.
So let’s say you’re mining ethereum, as I like to do, and you receive 0.5 ethereum and during 2017 and the price on that particular moment was $516. 0.5 multiplied by $516 means that you have ordinary income of $258. So that $258 becomes ordinary income and now your basis in those ethereum are now $258. So if you later on sell that at $900 per ethereum for a total of $450 two years later, then you have a $192 long-term capital gain.
If you’re familiar way of company stock investments it’s very similar to an automatic 83-b election.
Spending Your Cryptos
So if crypto currency like bitcoin and dash are taxed as property, then there’s a problem that happens when you choose to spend your crypto. Because that becomes a barter transaction. At that point you have two pick up the capital gain, pay taxes on it, and factor that in two for purchase.
So let’s say you spend $500 and be calling on a new computer. Your basis in that they claim is $300. So you have a $200 capital gain. And you got the computer for it. The computer might be able to be depreciated, but that will depend on your facts and circumstances.
But you pay tax on that $200 gain. If it’s a long-term capital gain, it might be as high as $40.00. If it’s a short term capital gain, it might be as high as $80.00. So you think you spent $500 on the new computer, but you actually spent maybe $540 or $580. That has to be accounted for in your purchasing decision. It might be worth spending the tax on that transaction for ease of use, ease of purchase, having a vendor that will give you what you need.
But you should be aware of this when going into it.
This is very different from when you spend regular old US Dollars. You are not taxed on the change in value of the dollar from when you received it to when you spent it. Even though the value of the dollar absolutely does change through inflation and the foreign exchange markets.
So taxing cryptocurrency as property creates an extra tax drag on its use as currency. That $40 or $80 tax as in the example above is a real disadvantage when trying to use your bitcoin as a payment method. I will leave it to the talking heads as to whether this is a side effect of the cryptocurrency regulations or a deliberate shot at crypto from the banking sector.
The big news from the tax reform act passed in December of 2017 is that crypto currencies are specifically no longer permitted for like kind exchanges. This is sort of a hysterical non-sequitor because nobody was actually doing like- kind exchanges with crypto currency.
In order for like-kind exchange to occur you have to use a 1031 qualified intermediary to process the transactions. You can’t just sell one thing, buy another, and decide it’s a like kind exchange. There are formalities that have to be followed. The most important of which is that you cannot actually receive the money. It is held in escrow on your behalf by the qualified intermediary while you identify and purchase the subsequent property.
So in virtually every case, this was never applicable anyways.
Reporting of virtual currency transactions
So you might be wondering how the government is going to enforce all this because part of the nature of virtual currencies is that your identity is not tied to the wallet, unlike using a credit card or bank transfer. Similar to how old stocks, bonds, and similar capital property is reported, the cryptocurrency exchanges like Kraken and Coinbase will be reporting everything associated with a tax ID number, that’s going to be your social security number or corporate EIN, to the IRS at the end of the year. This is part of the reason that all the big exchanges have started collecting personal data under the know your customer (KYC) and anti-money laundering (AML) regulations. So all transactions that occur on a regulated exchange will be included in your IRS transcripts.
From coinbase.com’s support page:
“In the U.S., Coinbase files Form 1099-K for qualifying customers that have received cash into their account in volumes at or above the required reporting threshold (more than 200 receipt transactions which amount to greater than $20,000 during the calendar year). This includes business use accounts (see more detail below), as well as GDAX accounts in which sales of cryptocurrency for cash have occurred that exceed the thresholds.”
A 1099-K is not a statement of income. It is a statement that the processor, like PayPal, Coinbase, or a merchant services processor, is telling the IRS that “this many dollars was passed through our platform on behalf of this taxpayer.” Those transactions might be income or simply transfers.
For transactions that do not occur on a virtual currency exchange, then it is up to you to report the transactions accurately. And you do that in the same way as you report on exchange transactions. That’ll be through Form 8949 and Schedule D.
Many people ask if all transactions need to be reported, or only ones on exchanges or only over $600. The fact of the matter is under US tax law, all income from all sources must be reported on your tax return. So that includes off-exchange transactions and small transactions under $600.
The $600 rule has to do with whether or not you are required to issue a 1099-MISC by January 31 of the following year when paying for goods or services to an individual. If you pay your neighbor $1,328 in bitcoin to mow your lawn for the year, then you should be issuing a 1099-MISC for that amount with a copy sent to the recipient as well as the IRS.
Virtual Currency Transfers
Are transactions from the exchange to my cryptocurrency wallet taxable?
The short answer is no. When you make a transfer of your property from one place you own to another place you own, that is not a taxable event. The tricky part comes and where are the exchange might report it as a sale. They shouldn’t, but I’ve seen stock exchanges and brokers report all kind of strange things. So you might have to correct a filing with your tax return. And there is a code B that you can file on your form 8949 to correct issues like that.
IRS Notice 2014-21: https://www.irs.gov/pub/irs-drop/n-14-21.pdf
Coinbase 1099-K Support: https://support.coinbase.com/customer/en/portal/articles/2721660-1099-k-tax-forms