As digital currencies become more and more ubiquitous in the domestic and international marketplace, both in terms of investment speculation and usage as a medium of exchange, tax authorities in the United States and internationally are making every effort to keep up. Unfortunately, the lack of clear guidance is only part of the problem as the very nature of cryptocurrencies poses a significant hurdle for taxpayers in tracking and reporting taxable gains and losses, and it is a problem that is getting more challenging.
The Internal Revenue Service (IRS), in Notice 2014-21, held that cryptocurrency is treated as property for federal tax purposes. This treatment has important implications. As property, cryptocurrency gains or losses must be recognized every time cryptocurrency is sold or used to make a purchase of goods or services. When the currency is traded for cash, it will be treated as investment income, for which long-term and short-term gain/loss rules apply.
Two of the more common instances where taxpayers may not realize the need to recognize gain or loss comes in the form of exchanging one cryptocurrency for another and in “mining” cryptocurrency. Since cryptocurrencies are property, exchanging one cryptocurrency for another one triggers a taxable event. Additionally, when cryptocurrencies are “mined”, the fair market value (FMV) of the mined currency must be included in taxable income.
When a cryptocurrency is used to make a purchase, pay wages, or pay for other services, the recipient must recognize income the FMV of the currency at the time of purchase. Thus, it would be included in income in much the same way as cash payments would be. At the same time, the purchaser must recognize gain or loss on the cryptocurrency used to make the purchase. This level of tracking gains and losses when using cryptocurrency for everyday purchases will become increasingly difficult as cryptocurrency becomes more widely accepted by vendors.
Clearly, this need to recognize gain or loss on virtually every transaction is cumbersome. Most property, both tangible and intangible, is not subject to the enormously wide range of transactions that cryptocurrencies are, and this is due to the unique position in which cryptocurrencies find themselves. Cryptocurrencies have functional aspects of a security, property, and a currency all at once, and this means they defy any sort of easy set of rules for tax treatment.
Individuals can hold cryptocurrency in individual digital wallets or trade through exchanges. Exchanges serve as facilitators which allow users to buy and sell cryptocurrencies for traditional currency, exchange cryptocurrencies, and generally serve to facilitate cryptocurrency transactions. Wallets, on the other hand, are private and serve a single user. Wallets literally act as a digital wallet, where the user can receive, transmit, and store cryptocurrencies.
Unfortunately, with wallets and most exchanges, a taxpayer will not receive a simplified tax document like a 1099. Only a few exchanges, generally those going through a traditional broker such as Robinhood, issue 1099s related to cryptocurrency. This is because most exchanges allow transactions with other exchanges and as a result, cannot effectively track basis in assets as they move around between exchanges. Most exchanges do provide some form of transaction summary, but these generally require specialized software to generate usable data for tax reporting.
Most exchanges do not handle all forms of cryptocurrencies, and new cryptocurrencies are continuously being created. This forces investors to use multiple exchanges and move cryptocurrencies between them. As many exchanges are not domestic to the United States, taxpayers may end up having digital assets in both domestic and foreign exchanges. This results in the need for foreign reporting, while also possibly subjecting the user to different tax jurisdictions and different income tax rules. For instance, Foreign Bank Account Reporting rules are changing to include cryptocurrency accounts for 2021. Foreign filings are often cumbersome, and stiff penalties come for noncompliance.
It is essential that taxpayers trading and investing in cryptocurrencies consider whether they have appropriate arrangements in place to track and accurately report the transactions. This becomes even more critical as the IRS has announced cryptocurrency as a focus point going forward and will move to expand auditing and compliance enforcement related to cryptocurrency.
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The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.