Understanding the Tax Implications of Cryptocurrency

The IRS focuses on cryptocurrency for two primary reasons: trading cryptocurrency is a taxable event and converting cash into virtual currency is a way to launder money. This focus has resulted in the IRS releasing guidance on the reporting and taxation requirement for the sale, purchase, and trade of cryptocurrency—but some grey areas still remain.

Buying and Selling Cryptocurrency

On March 25, 2014, the IRS issued Notice 2014-21, which, for the first time, set forth the IRS position on the taxation of virtual currencies, such as bitcoin. According to the notice, “Virtual currency is treated as property for U.S. federal tax purposes.” The notice further stated, “General tax principles that apply to property transactions apply to transactions using virtual currency.”

In other words, the IRS is treating the income or gains from the sale of a virtual currency, such as bitcoin, as a capital asset that’s subject to either short-term (ordinary income tax rates) or long term capital gains tax rates, if the asset is held for more than twelve months. If it is, it’s taxed at 15% or 20%, based on income. 

By treating bitcoins and other virtual currencies as property instead of currency, the IRS is able to impose extensive record-keeping rules and significant taxes on its use. For record keeping purposes an individual’s cost basis is what they pay for the cryptocurrency and the spread is taxable when they use or sell the cryptocurrency, assuming it’s appreciated in value since purchase.

Mining Cryptocurrency

IRS Notice 2014-36, IRS Virtual Currency Guidance, states that taxpayers earn taxable income when they receive a block reward of virtual convertible currency for successfully mining a new block on the blockchain.

The taxable income earned is the determinable fair market value (FMV) in US dollars of the virtual convertible currency earned from the block reward. This income is considered ordinary income and the amount reportable is based on the FMV of the cryptocurrency at the time it was successfully mined.

Retirement-account investors interested in mining bitcoins—versus trading bitcoins—should be aware that such activity could be subject to the unrelated business taxable income tax rules if the mining is deemed a trade or business.

Tax-Free Exchange of Cryptocurrency

The IRS has yet to issue definitive guidance on whether or not an IRC Section 1031 like-kind exchange is allowable with cryptocurrency. 

Although cryptocurrency is treated as property by the IRS, and thus could be considered a qualifying asset under Section 1031 treatment, the IRS excludes assets treated as inventory or stock in trade from Section 1031 treatment. This makes a Section 1031 like-kind exchange effectively unavailable to bitcoin dealers and professional traders.

Additionally, no explicit guidance has been issued to clarify whether digital currencies are like kind with another, so it’s unknown whether different types of cryptocurrency could qualify for a Section 1031 like-kind exchange.   

Because of the lack of guidance on this subject, Section 1031 exchanges of different types of cryptocurrency aren’t guaranteed to be tax free. As such, the conservative approach would be to not claim Section 1031 on an exchange of one digital currency for another.

Foreign Reporting Requirements

Taxpayers must file Financial Crimes Enforcement Network (FinCEN) Form 114, Report of Foreign Bank and Financial Accounts, and Form 8938, Statement of Specified Foreign Financial Assets, if reporting thresholds are met for cryptocurrency held in a foreign account. 

For married joint filers, the thresholds for FinCEN Form 114 are an aggregate value of $10,000 or more at any point during the year and the reporting threshold for Form 8938 is an aggregate value of $100,000 or more on the last day of the year or an aggregate value of $150,000 or more at any point during the calendar year.

The FinCEN Form 114 is a standalone filing while the Form 8938 is filed with an individual’s tax return. Both forms are due by April 15, with the option to be extended until October 15. 

We’re Here to Help

For more information on how IRS guidance on cryptocurrency could affect your next tax return, contact your Moss Adams professional.