A Quick Guide on Cryptocurrency Including Related Tax Matters

This purpose of the series of FAQs below is to, first, provide a basic introduction to cryptocurrency and then address the tax attributes that will impact taxpayers when filing their returns.

What is cryptocurrency?

Cryptocurrency is a decentralized digital representation of value, that functions as a unit of account, a store of value, and a medium of exchange. It’s not issued or backed by a government and eliminates the need for transitional intermediaries like banks and governments to make financial transactions.

What are some key terms?

Types of Cryptocurrencies – Some of the most popular are Bitcoin, Ethereum, Litecoin, Dogecoin and Bitcoin Cash.

Blockchain – A digitized public ledger that facilitates secure peer-to-peer transactions without the need of a regulated third party.

Block – A blockchain is made up of blocks, that holds historical records of all cryptocurrency transactions until full.

Cryptocurrency exchange – A marketplace where you can buy and sell cryptocurrencies, some examples are Coinbase, Gemini, Kraken and KuCoin.

Wallet – An app that allows a place to securely keep your digital assets.

Private Key – Acts as a password to access your wallet.

Initial Coin Offering – A company can create a new cryptocurrency and put some of the initial batch of coins up for sale to build a user base.

Airdrop – Free tokens sent to wallets in return for a social media post or marketing of the virtual currency.

Hard Fork – When a single cryptocurrency splits in two. This may result in the creation of a new cryptocurrency on a new ledger in addition to the legacy cryptocurrency that runs parallel with the original.

How is cryptocurrency taxed?

Cryptocurrency is treated as property for federal tax purposes. The gain or loss is based on the difference between the taxpayer’s basis in the property and its fair market value (“FMV”). A taxable transaction occurs every time cryptocurrency is used for the exchange of goods or services.  Accordingly, every time it is exchanged, there is a reportable transaction marking a gain or loss on the exchange.

Some tax principles that apply to virtual currency are:

  • A payment using virtual currency is subject to information reporting to the same extent as any other payment made in property.
  • Payments using virtual currency made to independent contractors and other service providers are taxable, and self-employment tax rules generally apply. Normally, payers must issue Form 1099-MISC.
  • Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2 and are subject to federal income tax withholding and payroll taxes.
  • Certain third parties who settle payments made in virtual currency on behalf of merchants that accept virtual currency from their customers are required to report payments to those merchants on Form 1099-K, Payment Card and Third-Party Network Transactions.
  • The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
  • Airdrop marketing giveaways are taxed as ordinary income, valued on the date the cryptocurrency is received.
  • Cryptocurrency that goes through a hard fork, the new forked cryptocurrency received is taxed as ordinary income.
  • Gifting of cryptocurrency falls under the gift exemption rules and gifts up to $15,000 per recipient are not subject to gift tax and the recipient will inherit the donor’s tax basis.
  • Cryptocurrency does not qualify as like kind property, in part because it is not real estate.  Exchanges for one cryptocurrency for another is therefore a taxable event.
  • Since cryptocurrency is property and not cash or securities, FBAR & FATCA generally should not apply unless the cryptocurrencies are exchanged for foreign currency and the FBAR and FATCA thresholds are met.

Which accounting method to use for determining basis for purposes of calculating a gain or loss on disposition?

Since cryptocurrency is a considered a capital asset, the basis will need to be accounted for.

The default method for the IRS in determining basis is first in, first out (FIFO). The first coin purchased is the first coin that is counted for a sale.

Should you wish to use a different basis, there currently is no need to elect a new method, but IRS guidelines request that you keep detailed records that can identify the method you are choosing.  Alternative basis methods are as follows:

  • Last-in first-out, the last coin acquired will become the first coin that you sell
  • Highest-in, first-out (HIFO), you sell the highest cost base first. Assuming adequate records are kept, this will be the most advantageous method of tax accounting for taxpayers

What resources have the IRS provided to guide taxpayers in accounting for cryptocurrency and understanding the tax impact of cryptocurrency?

The IRS and FASB have provided several guides including the following:

  • Notice 2014-21
  • Revenue Ruling 2019-24
  • IRS FAQ on Virtual Currency Transactions

The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.