Cryptocurrency Taxes: Navigating an Uncertain Environment

Cryptocurrency Taxes: A Brief History

Upon my introduction to the idea of cryptocurrency, I promptly put on my CPA hat and realized the importance of educating clients on the short-term tax and compliance ramifications of cryptocurrencies in the broader marketplace. More specifically, it is imperative to understand that the tax implications of cryptocurrency can no longer be ignored, especially given the recent interest the IRS has taken in exchanges like Coinbase. Furthermore, the IRS has done its own due diligence in trying to identify whether or not individuals engaging in cryptocurrency transactions have been accurately reporting their activities, and their findings are, to some in the cryptocurrency space, laughable. Per the IRS, about only 802 people reported gains from cryptocurrency trading in the year 2016. While there aren’t publicly available records that allow us to compare whether or not that is an accurate amount, my personal opinion is that it is nowhere near the amount of people who should have been reporting gains and losses from cryptocurrency. As such, I’d have to imagine that cryptocurrency tax evasion has to be at the forefront of the IRS’ enforcement agenda in the near future.

While this article is certainly not meant to be fear-mongering propaganda, it is important to recognize that this is very much a real issue facing many early adopters. (Many of whom are sitting on a substantial amount of cryptocurrency wealth.) As a practitioner, my job is to arm clients with as much information as possible to help them make the appropriate decisions with respect to their tax reporting obligations. Therefore, the goal is to spell out all of the different tax and compliance aspects for cryptocurrency as clearly and accurately as possible. However, as you’ll see throughout the remainder of this article, there still exists a great amount of uncertainty with respect to cryptocurrency taxes.

To start at the most granular level, it’s important to understand what different types of activities involving cryptocurrency create a taxable event. Generally speaking, people who engage in cryptocurrency activities are either miners or traders, and the tax implications are very different for these two groups. In addition, we’ll examine some of the more specific tax issues facing cryptocurrency, such as the application of 1031 like-kind exchanges and FBAR reporting requirements. Lastly, we’ll discuss the future of cryptocurrency and some strategies that may help reduce taxes for those facing tax consequences of their cryptocurrency activities.

Cryptocurrency Taxes on Miners

To those who are unaware of what a ‘miner’ of cryptocurrency is, it is essentially an individual or group who has employed the use of mining “rigs” to help verify transactions on the blockchain. As a result of their efforts, they are rewarded with some sum of a particular cryptocurrency. While I won’t pretend to understand the nuances of the underlying technology, I can speak to the stance the IRS has taken on such activities. The IRS has taken the stance that cryptocurrency mining activities are considered ‘ordinary income,’ essentially no different than earning money as payment for services rendered. Depending on the legal structure (or lack thereof) through which you’ve engaged in cryptocurrency mining activities, your taxes are either reported on Schedule C of your individual tax return or on the respective entity tax return (i.e. Partnership 1065, C-Corp 1120 or S-Corp 1120S). An additional complication is that you have to report income at the value of the cryptocurrency in USD as of the date that you received it. Therefore, meticulous record-keeping is imperative to being able to accurately compute and report taxable income.

This creates a challenging tax situation for cryptocurrency miners for a myriad of reasons. First, if you mine cryptocurrency with the intent to hold, you run into a liquidity issue when it comes time to pay taxes. As a simple example, let’s say you mined 1 Bitcoin in 2017, and it was valued at $15,000 at the point in time at which you received it in your wallet. (It is, in reality, much more complicated than this, but we’ll use this to demonstrate the concept overall.) Under this fact pattern, you owe taxes on $15,000 worth of ordinary income, despite the fact that you have not yet converted this cryptocurrency to fiat currency (i.e. USD). Suppose you owe an effective federal income tax rate of 25% on this $15,000 worth of income. In this scenario, you’d owe $3,750 worth of federal income taxes on cryptocurrency which you had not yet converted to USD. At the present moment, the United States Treasury does not accept tax payments in cryptocurrency, so you’d be forced to either convert your cryptocurrency to USD to cover your tax obligation or to use other funds to pay the taxes. Furthermore, it becomes even more complicated if you mined the Bitcoin at a value of $15,000 and, between the time at which you mined it and the time at which you sold it, it either appreciated or depreciated in value. This triggers an entirely different set of tax obligations, which we’ll discuss in the next section. Needless to say, you’re starting to understand why it’s a headache to stay compliant.

Cryptocurrency Taxes on Traders

If you’re like most casual early adopters of cryptocurrencies, you fall under somewhere under the following fact pattern:

Invested in cryptocurrency
Experienced gains or losses in cryptocurrency
Exchanged your cryptocurrency after a loss or gain for either another cryptocurrency, fiat currency (USD) or goods/services.

In the above scenario, the taxable event falls under step #3. The IRS has taken the position that gains or losses on the sale or exchange of cryptocurrencies should be treated in the same manner as ‘listed property’ and reported on Schedule D of your individual (or business) tax return. In layman’s terms, this means that anytime you purchased cryptocurrency and then either sold it for fiat currency (USD), exchanged it for another cryptocurrency, or purchased goods and the value of the original cryptocurrency in question appreciated (or lost value), you have a taxable event. Let us consider the following example:

On 01/01/2017, you purchased 1 unit of cryptocurrency X at a price of $500. On 06/01/2017, that same unit of cryptocurrency is now worth $15,000. You then exchange the original cryptocurrency for another cryptocurrency and buy $15,000 worth of cryptocurrency Y. In this situation, your taxable gain is $14,500 worth of short-term capital gains taxed at your ordinary income tax rates, despite the fact that you didn’t realize any amounts in USD as a result of your exchange. The same fact pattern is true for the purchase of goods (i.e. purchasing pizza from your friend or equipment using cryptocurrency) or the exchange of cryptocurrency for USD. In all three scenarios, you are required to calculate the difference between the ‘cost basis’ of the original cryptocurrency you purchased (aka the original purchase price) and the appreciated value of the cryptocurrency at the point in which you liquidated or exchanged it for something else. The difference between these two amounts is considered your ‘capital gain’ (or loss). You will use Form 8949 to calculate your gains and losses and summarize them on Schedule D of your tax return. Properly calculating the gains or losses on a per trade basis on form 8949 can be time consuming and less than simple. This differs from day traders of stocks, who usually receive form 1099-B from their brokerage account, which calculates the gains/losses on the trades for them. Unfortunately, exchanges like Coinbase aren’t currently doing this, which makes matters more complicated for traders of cryptocurrencies as the responsibility to calculate gains or losses falls upon the trader himself. To complicate it further, there are various valuation methods that can be used to calculate gains or losses, and one may be more advantageous than the other for your purposes. When we work with clients, we help them understand their options and choose the method that fits best with their long term goals and strategy.

An additional consideration pertains to what tax rates are applied to these gains and losses. Generally speaking, if you hold the cryptocurrency for a period of greater than 365 days, you are able to receive preferential tax treatment in the form of long term capital gains rates, which vary from 0% to 15% or 20%, depending on your individual income tax bracket. However, if you hold the cryptocurrency assets for less than one year, you pay income tax on the gains at ordinary income tax rates and lose any special benefit afforded to long term capital gains.

While the approach to taxation for these cryptocurrencies is relatively easy to understand, executing and information gathering to accurately report the tax obligations is quite tricky. For many cryptocurrency speculators, it is not uncommon to have hundreds or thousands of cryptocurrency trades that may need to be reported. Further, trades may happen across a variety of exchanges and in a number of different coins. The challenge with this is identifying a consistent means of reporting these trades that allows taxpayers to accurately report the basis of cryptocurrency assets that were exchanged or sold in a given transaction. Needless to say, the accurate reporting of cryptocurrency gains and losses is no easy task and should be done carefully under the guidance of a licensed professional.

Cryptocurrency Taxes: 1031 Like-Kind Exchanges?

Another cryptocurrency related challenge pertains to the application of a 1031 like-kind exchange for cryptocurrencies. As of yet, the IRS has not provided definitive guidance on the applicability of 1031 Like-kind exchanges in the context of cryptocurrency for the 2017 tax year. (Changes to the tax code in 2018 eliminate uncertainty as to the application of the 1031 like-kind treatment of cryptocurrency for future years, however.)

As such, the guidance is convoluted at best. While the IRS has stated that it treats cryptocurrency as listed property, which could imply that 1031 like-kind exchanges would apply, it subsequently disallows this treatment in 2018. Further, 1031 like-kind exchanges are not allowed when you exchange one currency for another or one type of stock for another. To put it simply, the IRS has taken neither a stance that they’re accepting 1031 like-kind treatment for cryptocurrency in 2017, nor are they taking a stance that they’re not. Therefore, it will be an interesting topic to follow in the near future as the IRS clarifies its stance on cryptocurrency for the purposes of 1031 like-kind exchanges. My opinion is that 1031 like-kind exchanges ultimately shouldn’t apply to cryptocurrency. I base that opinion on the fact that I believe a cryptocurrency, in its present state, falls somewhere between a stock and currency in substance. As such, I would argue that it should follow the same fact pattern as currencies and stocks.

Update: Since the writing of this article, we’ve received clarifying guidance that 1031 like-kind exchanges do not apply to cryptocurrency for years 2018 and beyond.

Cryptocurrency Taxes: FBAR Reporting?

Much like the application of 1031 like-kind exchanges to cryptocurrency, there remains a great amount of uncertainty as to whether or not US based individuals who own cryptocurrency in a non-US based exchange or wallet are required to report accounts holding more than $10,000 in accordance with the Bank Secrecy Act by filing a report with the Financial Crimes Enforcement Network (FinCEN). Once again, the lack of definitive guidance cultivates an environment of uncertainty on how to approach this issue. The IRS did state back in 2014 that it wasn’t requiring FBAR reporting in 2014 but that it may revisit this decision in the future. Given the current lack of clearly defined guidance and the steep penalties for failure to adhere to the FBAR reporting requirements, it becomes an interesting risk management issue for cryptocurrency holders. Under the most conservative approach, we’ve been advising clients who hold over $10,000 in cryptocurrency in a foreign exchange or wallet to follow the reporting requirements set forth by the Bank Secrecy Act. However, the last piece of definitive guidance we have is from 2014 and we’re not aware of any changes to that stance.

Update: Since the writing of this original article, we’ve received guidance that cryptocurrency is not subject to FBAR reporting.

Cryptocurrency Taxes: Strategies for Minimizing Taxes

Those who have followed the evolution of cryptocurrency closely know that its roots are deeply engrained in a very loyal following. Much of the early and fanatic adopters of cryptocurrency believe deeply in the libertarian school of thought. As a byproduct of this, perhaps the most commonly asked question I field from cryptocurrency enthusiasts falls under the topic of how to legally avoid paying more taxes than they are obligated to. While this is certainly a defensible approach that tax advisors can assist in (again, emphasis on the word legally), there is also another subset of users who ask something along the lines of “Do I actually have to pay taxes? How will they know if I don’t report it?” My answer to this question is always the same. Under Section 7201 of the tax law, any individually who willfully attempts in any manner to evade taxes is committing a crime. Plain and simple. However, for clients who are looking for ways to legally avoid (not evade) taxes, we are more than welcome to discuss various strategies afforded to them under the current tax code.

Conclusion and the Future of Cryptocurrency Taxes

The world of cryptocurrency offers an exciting opportunity for innovation and disruption of the traditional means of value exchange. However, with this exciting opportunity comes the obligation to adhere to the compliance and tax obligations set forth by the various governing bodies that enforce the rules we must follow. Therefore, it is imperative that those who have prospered from the early adoption of cryptocurrency activities be aware of the tax and compliance obligations that they now must follow, as the failure to do so could be disastrous for their future prospects.

Unfortunately, the current regulatory landscape is lacking in enough definitive guidance in areas like FBAR reporting and 1031 like-kind exchange feasibility for 2017 (UPDATE: We now have clarifying guidance that FBAR and 1031 do not apply to cryptocurrencies). Furthermore, companies like Coinbase do not issue a Form 1099-B to its users, which would make tax reporting much easier (assuming your trades existed only within the Coinbase platform, which for most is not the case). It is clear that these areas are pain points for users of virtual currency, but perhaps the most impeding of all the issues faced is the taxability of exchanging cryptocurrency for tangible goods, which was the ultimate goal Satoshi Nakamoto set out to accomplish when he brought Bitcoin to the marketplace.

If the stance of the IRS remains that any appreciation of cryptocurrency used to purchase goods or services is a taxable event, then it creates a compliance nightmare that threatens the widespread adoption of such virtual currencies. This would mean that users of virtual currency would need to be able to meticulously track the value of the cryptocurrency as of its date of purchase or issuance as well as the value as of the date it was used to purchase something. If you imagine this in the context of our regular spending patterns of multiple transactions per day, it is burdensome if not outright impossible to comply with.

As it stands, it is hard to see widespread adoption of cryptocurrency as a means to facilitate the exchange of goods or services until this problem is solved. One possible solution is to truly treat cryptocurrencies as a currency for tax purposes, which would help avoid the aforementioned compliance nightmare. However, this treatment would have its own set of challenges, as it could allow some users of cryptocurrency who hold coins with built in gains to avoid paying taxes on their increased purchasing power (assuming it is of a nominal amount and the virtual currency is held for personal use). Perhaps the best solution is to continue to treat cryptocurrency as listed property up until the point at which the price has stabilized enough to allow the IRS to capture the taxable gains on early adopters who accumulated significant wealth. Regardless of what happens, it is clear that cryptocurrency is here to stay. It’s just a matter of how regulations will respond and whether or not it will embrace this new technology or if regulations will continue to make life difficult for users of cryptocurrency.

To comply with certain U.S. Treasury regulations, you are hereby informed that, unless expressly stated otherwise, any U.S. Federal tax advice contained in the text of this e-mail is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed by the Internal Revenue Service.

Further, please consult with me personally before acting upon or relying upon any information contained within this post.

Curt Mastio