Cryptocurrency: The challenges of money and technology combined

Cryptocurrency, initial coin offerings, bitcoin

Despite their rapid rise in popularity and monetary value, virtual currencies are not well understood. One analyst described cryptocurrency as everything you don’t know about money combined with everything you don’t know about technology. For those who own one of these new virtual currencies, the famous investment strategy of legendary investor Peter Lynch doubles as profound tax advice- Know What You Own. The rapid rise and fall of cryptocurrency asset valuations and a maze of complicated tax regulations can leave unwary investors long on tax and short on cash.

In an attempt to clarify the taxation of virtual currencies, the Internal Revenue Service (“IRS”) issued Notice 2014-21.  For tax purposes, The IRS defines virtual currency as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Businesses and individuals commonly accept virtual currencies as a means of payment similarly to paper money, but these currencies do not have legal tender status in any jurisdiction. The IRS treats all virtual currencies as property for U.S. tax purposes.

The exchange, sale or receipt of property is generally a taxable event unless specific tax guidance deems the transaction non-taxable such as a 1031 exchange or a non-taxable gift. To determine gain or loss on a taxable transaction, the owner of virtual currency must determine their basis in the currency. The basis in virtual currency equals the fair market value of the virtual currency at the date of receipt. If a virtual currency is exchange listed and the value on the exchange is determined based on supply and demand, the value reported on the listed exchanged is the fair market value for tax purposes. One particular challenge with determining basis in virtual currency is the high frequency of currency trades. Virtual currencies are frequently traded on exchanges such as Coinbase. For instance, an investor may purchase Bitcoin, trade the Bitcoin for LiteCoin and then trade a portion of the LiteCoin for Ethereum. Each trade or exchange in this transaction is a taxable event.  However, maintaining adequate records to determine the fair market value of the assets given and received at each exchange date is a challenge. One practical solution is to maintain a separate digital wallet for each type of virtual currency held.

Once gain or loss is determined, a secondary question must be answered about the nature of the gain. Is the gain capital or ordinary? The character of the gain or loss is based on whether the virtual currency asset is a capital asset or an ordinary income asset in the hands of the taxpayer. Internal Revenue Code Section 1221 defines capital assets. Conveniently, every asset that is not defined as a capital asset is considered an ordinary income asset.

The mining of virtual currencies also triggers a taxable event when the currency is successfully mined. The value of the virtual currency is includable in taxable income as of the date the currency is mined.   Mining can be a particularly painful trap. Consider a taxpayer who mines Bitcoin. The taxpayer successfully mined Bitcoin in January 2018 when the fair market value was $15,000 per coin. The coin was stored in a digital wallet after being mined and has not been sold. On the taxpayer’s 2018 tax return, assuming the coin is not sold, the taxpayer will have to report $15,000 of income for the coin that may have already lost two-thirds of its value.

The dynamic fluctuation of virtual currency valuation also poses risks. Consider the case of a business owner who accepts Ethereum as payment for her widgets. Her widgets cost $200 each to produce. The Ethereum is worth $1,000 at the time the owner receives the payment. But, the coin drops the same day to only $800 before the owner can convert it to cash. The owner may have made $800 on her sale, but she quickly lost $200 due to the decrease in value of the virtual currency.  To make matters worse, her gain on the sale of the widget is ordinary income while her loss on the currency is capital. A bad result for tax purposes!

Virtual currency investors also must consider other tax issues such as self-employment tax, 1099 reporting and international tax compliance for cross-border virtual currency transactions.  Virtual currencies have escaped meticulous IRS attention despite their popularity for a number of reasons including the complexity of virtual currency, lack of required reporting by exchanges and a lack of staff to draft and enforce new regulations. However, the IRS is now taking significant action. The IRS has issued a summons to Coinbase, one of the largest virtual currency exchanges, requesting transaction data on all users who exchanged currency between 2013 through 2015.

The increasing popularity of virtual currency may be a short-term fad. Or perhaps it is an inflection point in global currency. One thing is certain. Knowing what you own is a tax strategy that will always be germane.

We Can Help

Elliott Davis has a team of experienced finance and tax advisors who can assist you with navigating the complexities of cryptocurrencies including understanding risks, opportunities, tax reporting requirements and tax consequences.

For more information on how we can help, contact Joe Poore.