“Cryptocurrency” — the very name sounds mysterious. When it comes to cryptocurrencies such as Bitcoin and Ether and their taxation, that sense of ambiguity remains, even for tax professionals. However, with the rise in use of these cryptocurrencies, it is important to understand the U.S. tax treatment of cryptocurrencies for planning and compliance purposes.
Cryptocurrencies have evolved into a “virtual currency” that anyone can buy or sell through online exchanges. As such, their values may fluctuate wildly, making them attractive to investors. They can be traded, bartered or exchanged for fiat, services or other cryptocurrency. They can also be “mined” on the internet using complex algorithms and specialized computers that search for and uncover new cryptocurrency values.
How Does the IRS View Cryptocurrencies?
In 2014, the IRS released IRS Notice 2014-21. It declared that for U.S. income tax purposes, a cryptocurrency is property and not a currency. Depending on the facts, that means the character of the cryptocurrency could be business property, investment property, or other property. Therefore, the general U.S. tax principles that apply to any property transaction should be applied to exchanges of cryptocurrencies. Cryptocurrencies, held for investment, and sold for a gain are subject to short term or long term capital gains tax. Conversely, those investment-held cryptocurrencies sold for a loss are able to utilize a capital loss.
The IRS notice does not resolve all issues related to reporting requirements or taxation. Some of the unresolved issues are:
- Foreign account reporting
- Cryptocurrency as “like-kind” exchanges
- Taxation of Crypto-forks
FBAR Reporting – Under the provisions of the Bank Secrecy Act, U.S. persons holding “offshore bank accounts” in excess of $10,000 in a given tax year are obligated to report those assets on a Report of Foreign Bank and Financial Accounts (FBAR). As Bitcoins can be deposited and held in a foreign account, when they are, are they “currency” and subject to FBAR reporting? The current guidance put out by the IRS is vague on the matter. At the initial issuance of Notice 2014-21, the agency seemed to indicate that cryptocurrency accounts were not reportable under FATCA regulations. However, since then, more recent enforcement actions taken by the IRS would seem to indicate that the agency is reconsidering the need for FBAR disclosures.
“Like-kind” Exchange – Effective January 1, 2018 Section 1031 of the Internal Revenue Code was modified to read as follows – “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.” Accordingly, cryptocurrencies are not property eligible for like-kind exchanges beginning in 2018.
The law in effect prior to 2018 made reference only to property, not real property. For earlier years, can an argument be made that cryptocurrencies are eligible for like-kind exchanges? First you must meet the two requirements 1) eligible property 2) like-kind. While cryptocurrencies qualified as eligible property the exchange of Bitcoin for XRP (Ripple) may not be like-kind. Absent specific guidance, the IRS requires considerations of the following – age, character, purpose, quality, quantity, etc. A review of the underlying technology and purpose of each show material differences, clouding whether XRP and Bitcoin, not “like-kind” even though they are both crypto currencies.
- Bitcoin is a type of digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank (decentralized).
- XRP is a type of digital currency in which all tokens were created at the creation of the cryptocurrency by the creator (Ripple Labs). The verification of transfer of funds occurs through nodes controlled by Ripple Labs and the financial institutions which support the cryptocurrency (centralized).
Cryptocurrency Mining – A business involved in “cryptocurrency mining”, which is the use of sophisticated algorithms and computer programs to verify crypto-transactions and thereby change the value of the coin, or create new coins, would have to recognize income according to the value of the coin when received.
Crypto-forking – Cryptocurrencies can “fork,” or split in two. When a cryptocurrency forks, the result is two distinct coins, with two different ledgers, and different unique sets of code, but both originating from the blockchain. Can this be looked at the same way a “corporate spinoff” for taxation purposes? Probably not. As stated earlier, the IRS treats crypto-coins as property, and not stock. However, in the absence of any guidance as of yet from the IRS, all facts and circumstances should be discussed to determine if gains made from such forks, such as last year’s hard fork of Bitcoin into Bitcoin Cash, are considered taxable income.
How MBAF Can Help
These are just a few of the issues raised by the increasingly popular use of Bitcoin, Ether and other coins. No doubt cryptocurrencies will continue to be prevalent, particularly in certain circles. As we know that many of our own clientele transact in cryptocurrencies, we are even considering options to accept crypto payments for accounting services, to evolve in order to better serve the needs of our clients.
Here at MBAF, we will continue to closely monitor the growth of cryptocurrencies, and watch for new regulations that may come to bear regarding their use. As new regulations regarding the use and taxation of cryptocurrencies come into effect, our tax and accounting experts will be sure to be able to help you to modify your income tax strategies, as well as ensure compliance with any such new regulations.
Compliance with and understanding the reporting and taxation of exchanges involving cryptocurrencies can be quite complex. If you would like to benefit from our expertise in these areas, or if you have further questions on this Advisory, do not hesitate to contact our Tax and Accounting Specialists, or call us at 1-800-239-1474.