Cryptocurrencies, or virtual currencies, represent a fascinating new area of finance. But what are cryptocurrencies, and how do they work? If you’re considering a journey into the world of virtual currencies, you’ll need a professional, licensed cryptocurrency accountant to help plan an effective taxation and valuation strategy.
This article will provide an in-depth analysis of cryptocurrencies and IRS policies — no more rummaging around complicated tax publications!
What Are Cryptocurrencies?
Cryptocurrencies are digital currencies based on blockchain technology. In practical terms, cryptocurrencies are simply a decentralized medium of exchange. People can trade cryptocurrencies in lieu of traditional government-backed currency.
The following are the largest and most widely used cryptocurrencies on the market today:
How Do They Work?
Cryptocurrencies use blockchain technology — a public, open ledger of all transactions. This ledger updates every time a cryptocurrency transaction occurs. Given the transparent nature of the “chain,” it’s impossible to falsify data.
The IRS and Cryptocurrencies
The IRS has not provided any new major information on cryptocurrencies since 2014 — an eternity in this business!
Dealing with the specific nuances of cryptocurrency can be difficult; bringing in Founder’s CPA can be a real lifesaver.
Cryptocurrencies Are Not Currency
Per Notice 2014-21, the IRS maintains that all cryptocurrencies are “digital representations of value” used as a medium of exchange. Most importantly, no digital currency has “legal tender status” in any part of the United States.
How Are Virtual Currencies Viewed for Federal Taxation?
Virtual currencies are not considered to be currency by the IRS. Instead, tax law treats virtual currencies as property.
The same tax principles that apply to property apply to virtual currency. As such, you do not magically owe taxes on the virtual currencies you hold. To owe taxes, there must be a taxable event — you must sell, purchase, or trade your property. So long as you hold cryptocurrency as property, you won’t owe any taxes.
Fair Market Value
The IRS states that you must report all virtual currency transactions in U.S. dollars.
In practical terms, you determine the fair market value (FMV) at the moment you exchange the virtual currency for U.S. dollars. Of course, if a virtual currency is available for public exchange (say, on Coinbase), the fair market value is easy to determine. In the eyes of the IRS, fair market value is best determined by the market — if a currency has listed rates on an open exchange, there’s your FMV.
The IRS covers all its bases here — if you convert virtual currency into a non-U.S. dollar currency, the FMV is still based on the converted value in U.S. dollars.
As a rule, remember that the IRS determines the FMV at the time you acquire the virtual currency.
Taxable Events and Cryptocurrencies
A taxable event is any transaction or event that results in a tax consequence for the party or person performing the transaction. The following are all examples of taxable events:
- Realizing capital gains
- Exercising stock options
- Receiving interest or dividends
Anytime you exchange currency for goods or services, the IRS considers that to be a taxable event.
Imagine you buy a Bitcoin or two and sell it for a nice profit a few months later. Calculating the tax bill from that sale is not terribly complicated (see short-term capital gains below). However, things get really tricky when you start exchanging capital assets for other capital assets.
For example, instead of selling that single Bitcoin, you exchange it for Ethereum. In the eyes of the IRS, this is a taxable event — even though no U.S. dollars changed hands! Instead, you convert the value of the BTC to U.S. dollars. That new value determines the cost basis of the Ethereum acquisition.
Of course, cryptocurrency prices can fluctuate dramatically even within a single day. You need to use what the IRS calls a “consistent standard” for determining the exchange rate (usually the day’s closing value). It’s usually at this point where calling a professional cryptocurrency accountant like Founder’s CPA makes a lot of sense! Navigating the complexities of cryptocurrency tax compliance is not something you need to do alone, after all.
Gains and Losses
For investors, cryptocurrencies are generally treated as capital assets.
A taxpayer must create a taxable event (discussed above) in order to realize the gains or losses from cryptocurrency.
The IRS divides capital gains into two categories: short-term and long-term. Each category results in very different tax obligations.
For our purposes, note that the holding period (or the length of time you hold a cryptocurrency before selling it) is one year. The IRS considers an investment held shorter than one year as short-term; longer than one year, long-term.
The tax you pay on cryptocurrency changes depending on how long you held the investment.
Imagine the following:
- You purchase a single Bitcoin for $100.
- You sell that single Bitcoin for $200, six months after your initial purchase.
- That $100 profit is subject to short-term capital gains tax.
The IRS taxes short-term capital gains as ordinary income. The profit from the sale is the realized gain. Given that you held the investment for less than a year, you pay tax at your ordinary federal income tax bracket.
Likewise, take the following example:
- You purchase a single Bitcoin at $100.
- You sell that single Bitcoin for $50, six months after your initial purchase.
- You can deduct that $50 loss on your tax return, up to $3,000 annually.
The IRS treats long-term capital gains much differently than their short-term counterparts. For most investors, long-term capital gains result in a far lower tax bill.
Imagine the following:
- You purchase a single Bitcoin for $100.
- You sell that single Bitcoin for $200, a year and a day after your initial purchase.
- That $100 profit is subject to long-term capital gains tax.
Taxes for long-term capital gains are far less complicated. The IRS has only three tax brackets:
- 0%, for single earners with income between $0 and $39,375.
- 15%, for single earners with income between $39,376 and $434,550.
- 20%, for single earners with income over $434,551.
The IRS adjusts the brackets accordingly for married investors filing jointly (or those qualifying as a head of household).
Like short-term capital losses, you can deduct long-term capital losses on your tax return. The IRS matches short-term losses to short-term gains and likewise for long-term gains/losses. To illustrate this, take the following:
- You have $5,000 in short-term gain for BTC.
- You have $3,000 in short-term loss for ETH.
- You have $3,000 in short-term loss for LTC.
- The resulting $1,000 short-term loss is deductible.
The IRS allows you to deduct up to $3,000 worth of net capital loss (single filer). It is possible to carry over net capital loss to later tax years.
Importance of Tax Compliance
When cryptocurrencies burst onto the world’s financial scene in 2009, many people thought it would mark an end to traditional, government-backed currencies.
Clearly, that hasn’t happened! Instead, cryptocurrencies have become popular investment options. Anyone can set up a cryptocurrency wallet and investment profile and start trading.
Tax compliance for cryptocurrency investors has never been more important. As virtual currencies become more mainstream, the IRS continues to step up its efforts to ensure that all crypto traders pay their fair share.
The penalties for tax non-compliance are severe. Willful avoidance of tax obligations is punishable by law and heavy penalties — don’t risk it. If you’re involved in the world of virtual currency, you’re going to want expert help to ensure you are compliant with tax law. Founder’s CPA is an excellent resource for startups, small businesses, and cryptocurrency investors.
Forms Used to Report Capital Gains and Losses
Unfortunately for active investors, you will need to list each virtual currency transaction on Form 8949. You’ll need:
- Date acquired
- Date sold or disposed
- Cost or other basis
- Total gain or loss
And you’ll need that for each transaction, trade, or sale.
Once that’s finished, fill out your Schedule D with the results you obtained from Form 8949.
That Sounds Terrible. What Else Can I Do?
You’re right. If you’re a high-volume investor, tabulating all your cryptocurrency transactions is a proverbial nightmare. Many popular virtual currency exchanges have limited tax support — meaning you’ll need to check all your transactions by hand. On top of that, calculating the cost basis for cryptocurrency exchanges (BTC to ETH, for example) can be a real nightmare.
Cryptocurrency Accountants: Making Sense of Virtual Currency
Bringing in professional cryptocurrency accountants like Founder’s CPA Group is an excellent alternative. Calculating your tax obligation on your cryptocurrency investments is not something you want to risk — mistakes are expensive! Founder’s CPA specializes in startups, small businesses, and investors who can’t afford to risk non-compliance with the IRS.
Give Founder’s CPA a call — our consultations are free and we’re happy to answer any questions you may have.