With the increased use of technology, cryptocurrencies have now become mainstream. One of the biggest examples of these fast-growing cryptocurrencies is bitcoin. With its price going through the roof (before its recent decline), its acceptance as a form of payment is becoming more common. However, cryptocurrencies have federal income tax implications that you may not know of. This blog will go over everything you need to know about cryptocurrencies and the IRS!
What is Cryptocurrency?
First things first, what is cryptocurrency? Cryptocurrency is basically “digital money” that is issued and controlled by software developers which can be used as payment by willing parties. Also known as virtual currencies, they can be:
Stored for future use
Held for investment
Bitcoin is the most well-known example of cryptocurrency currently in place. Unlike conventional U.S. dollars, cryptocurrencies are not regulated. The most common way of obtaining cryptocurrencies is through ATMs or online exchanges. These mediums typically charge a nominal transaction fee. Its popularity has been proliferating due to the ability to avoid transaction fees that are usually charged by credit card companies and online payment processing services such as PayPal.
While cryptocurrencies are unregulated, every single transaction is digitally recorded on a distributed public ledger. Virtually anyone can download a copy of the blockchain and trace the path of cryptocurrency transactions. Distributed ledger technology utilizes independent digital systems to record, share, and synchronize transactions. The details are recorded in multiple places simultaneously with no administrative functionality or central data store.
The IRS Wants to Know About Your Cryptocurrency Transactions
The 2020 version of your IRS Form 1040 (the one you recently filed or will file soon) asks if you have received, sent, exchanged, sold, or otherwise acquired any financial interest on any virtual currency. If you have, then you’ll have to check the “yes” box. The very fact that this is being asked on the first page of your Form 1040 indicates that the IRS is getting serious about enforcing compliance with applicable tax rules. This is a fair warning, and you have to be ready to comply.
The instructions on the 2020 Form 1040 state the virtual currency transactions that you must check the “yes” box include but are not limited to:
The exchange of virtual currencies for goods or services
The receipt or transfer of free virtual currency (without having to pay)
The sale of virtual currencies
The exchanges of virtual currency for property
The disposition of a financial interest in virtual currency
Cryptocurrency Transaction Tax Basics
The IRS takes cryptocurrency as “property” for federal tax purposes. Because it is property, you have to report taxable gain or loss when you exchange it for goods, services, dollars, or different cryptocurrencies. If you fail to report your cryptocurrency transactions on your Form 1040, you could get audited and face interest penalties and, in extreme cases, criminal prosecution.
To get at the federal income tax results of a cryptocurrency transaction, the first thing you’ll have to do is calculate your fair market value (FMV) of the cryptocurrency on:
The date you received it, and
The date you use it to pay something
The current values of the cryptocurrencies with the most demand are listed on exchanges. Bitcoin and a number of other cryptocurrencies are listed there. For example, if one bitcoin is equal to $57,000 according to the Coinbase exchange, then if you buy one bitcoin with U.S. dollars at that price, your basis in bitcoin for federal income tax purposes would be $57,000.
As previously mentioned, when exchanging cryptocurrency for other property (including U.S. dollars, services, a different currency, or whatever), you must recognize taxable gain or loss the same way you would when you make a stock sale in your table breakage account.
You’ll have a taxable gain if the fair market value of what you got exceeded your basis in the cryptocurrency that you exchanged
You’ll have a taxable loss if the fair market value of what you got is less than your basis in cryptocurrency
It’s difficult to imagine that a cryptocurrency holding will be classified for federal tax purposes as anything other than a capital asset—even if you utilize it for personal transactions or to conduct business (as opposed to holding it for an investment). Therefore, the taxable gain or loss from exchanging a cryptocurrency will be either a short-term capital gain/loss or a long-term capital gain/loss depending on how long you held onto the cryptocurrency before applying it in a transaction.
Example: Jason uses one bitcoin to buy tax-deductible supplies for his booming sole proprietorship business. On the date of purchase, bitcoins are worth $55k each. So, he has a business deduction of $55k.
However, another piece to this transaction is the tax gain/loss from holding the bitcoin and spending it.
Let’s say Jason bought bitcoin in January of this year for only $31k. He has a $24k taxable gain from appreciation in the value of the bitcoin ($55k – $31k). The $24k gain is a short-term capital gain because he did not hold the bitcoin for more than one year.
Cryptocurrency Payments to Employees and Independent Contractors
If you utilize cryptocurrencies to pay for employee wages, the FMV of the currency counts as wages subject to federal income tax withholding:
As with any other wages paid to employees, you have to report the wages to the employee and the IRS via Form W-2.
If you utilize cryptocurrencies to pay for the services of an independent contractor, the FMV of the currency is subject to self-employment tax for the contractor. You are required to report the payment on Form 1099-NEC if payments go above $600 in that given year.
Tax Treatment of Cryptocurrency Receipts
If you accept cryptocurrency goods or services, you will have to determine the FMV of the currency on the transaction date to convert it to U.S. dollars. You’ll then have to calculate your taxable income or gain.
Example: Lucy sells a valuable painting that she restored for two bitcoins. On the date of sale, bitcoins are worth $55k each. Her tax basis in the painting is $47k. To report this transaction on her Form 1040, she’ll have to convert the two bitcoins to U.S. dollars ($55k x 2) -> $110k
The taxable gain on the sale is $63k ($110k – $47k). She will have to report $63k as income or gain on her form 1040. She also has to figure and report her gain/loss on the two bitcoins.
Whether you use cryptocurrency or not, it’s always a great idea to understand the basics of cryptocurrencies in regards to federal tax rules. With this information, you could determine all the federal income tax consequences of your cryptocurrency transactions. We hope this blog helped you get a basic understanding of cryptocurrency and the IRS. At MFI Works, we know these topics can be complicated, so don’t hesitate to contact us if you have any questions. To schedule a free initial business strategy session, click here.