Important Considerations in the Tax Treatment of Cryptocurrency Transactions

By: Ron Dean, CPA/MST, Director of Tax Services

When it comes to a return on an investment, very few have provided a greater return in

2019 than the cryptocurrency Bitcoin. This highly volatile digital asset has seen its price skyrocket, increasing 200% over the last several months. With these types of returns, many investors are strongly enticed to invest over fear of missing out but investors may not realize and understand the tax treatment behind these investments. Unfortunately, as of right now, the only guidance we currently have from the Internal Revenue Service (IRS) is Notice 2014-21, which was issued in 2014. However, the IRS has indicated it would “soon” issue new guidance on the tax treatment of cryptocurrency, something investors, and the Restivo Monacelli team, will be watching for closely. n.

What is Cryptocurrency?

Cryptocurrency is a digital asset that uses encryption techniques (cryptograph) to secure and verify transactions. While most typical currencies are issued by a central bank, cryptocurrency is decentralized through the use of blockchain technology. As a result, cryptocurrency cuts out the need for banks to facilitate transactions by using a peer-to-peer system to securely and freely exchange the digital asset.

The digital asset is created through a complex mining process that utilizes specialized hardware and software to process transactions to release new cryptocurrency into circulation. Most taxpayers who are interested in cryptocurrency won’t mine the digital asset by themselves but will instead purchase them on one of the various exchanges and either hold for investment, exchange for other cryptocurrencies, or exchange for goods or services.

Although Bitcoin is considered the preeminent cryptocurrency, there are many other alternative cryptocurrencies, each with different purposes or specifications. An alternative cryptocurrency that has been trending is Facebook’s recently announced “Libra” which is backed by some major corporations and may rival Bitcoin once it hits the market.

IRS Treatment - Investors

As previously discussed, the only guidance we currently have from the IRS is Notice 2014-21. In that Notice, the IRS has established that cryptocurrency is treated as property and is, therefore, subject to the same general tax principles that apply to property. Consequently, investors in cryptocurrency will typically receive capital gain treatment. Below are a few examples to illustrate the current tax treatments:

Example 1

On January 1, 2019, G purchases one bitcoin for $10,000. On May 31, 2019, G sells the same Bitcoin for $12,000. G has a short term capital gain of $2,000, which is taxed at ordinary income tax rates.

Example 2

On January 1, 2019, G purchases one bitcoin for $10,000. On July 31, 2020, G sells the same Bitcoin for $20,000. G has a long term capital gain of $10,000, which is taxed at favorable capital gain tax rates.

Taxpayers may be surprised with the amount of gain they recognize when it comes to exchanges between cryptocurrencies. In these circumstances, a taxpayer could swap cryptocurrencies and still have a recognized gain even through the taxpayer received no cash in the transaction.

Example 3

On January 1, 2019, G purchases one bitcoin for $10,000. On July 31, 2020, when the value of the bitcoin is $15,000, G exchanges the one bitcoin for one hundred ethereum (a separate cryptocurrency) at a price of $150 per ethereum. This exchange will trigger a recognized gain of $5,000 (value of one hundred ethereum, $15,000, less original purchase price of one bitcoin ($10,000) even though G never received any cash.

Some taxpayers may look to alleviate a portion or all of the recognized gain through IRC Sec. 1031 treatment (like kind exchange). However, investors should be aware that the recently passed Tax Cuts and Jobs Act eliminated IRC Sec. 1031 treatment for all property except real property beginning with the 2018 tax year.

IRS Treatment – Miners

Taxpayers who mine cryptocurrency actually have two separate tax transactions to report. The first occurs when the cryptocurrency is actually mined by a taxpayer through the use of specialized computer hardware and software. The taxpayer needs to include in gross income the fair market value of the cryptocurrency mined as of the date of receipt. The gross income from the mining operation is taxed at ordinary income tax rates. Furthermore, if the mining operations constitute an IRC Sec. 162 trade or business, than any mining related expenses would be deductible against the gross income. Keep in mind the net income could be subject to self-employment taxes.

The second tax transaction occurs when the mined cryptocurrency is sold or exchanged. There are some questions with regards to this tax treatment. Some have taken a position that the mined cryptocurrency is “inventory,” meaning when it is sold it should be subject to ordinary income tax rates. The other position is that the sale or exchange of mined cryptocurrency should receive capital gain treatment. The character of the gain or loss generally depends on whether the digital asset is a capital asset (or is not a capital asset) in the hands of the taxpayer. In property transactions, we typically look at the definition of a dealer versus an investor to determine the character of the gain.

Other Considerations

Cryptocurrency is typically transferred on one of the various cryptocurrency exchanges. Unfortunately none of these exchanges issue monthly statements or year-end 1099’s to report the transactions that occurred during the year. Therefore, it is up to each taxpayer to keep track of these transactions during the year. Most exchanges allow you to download your transaction history over a period of time.

Typically, cryptocurrency is stored either on an exchange or a virtual wallet. Taxpayers need to understand where these digital assets are stored as this may require the taxpayer to file an FBAR (Report of Foreign Bank and Financial Accounts) or a Form 8938 (State of Specified Foreign Financial Assets) depending on the value of the assets.

Finally, determining the fair market value for these digital assets can be challenging. Separate exchanges may value a cryptocurrency differently. Proper valuation is needed not only for recognized gain transactions and potential foreign compliance requirements but also if investors want to take advantage of a popular trend to donate cryptocurrency to a valid 501(c)(3) charitable organization. This is considered a non-cash charitable contribution and a proper fair market value is needed in order to deduct the amount as a charitable contribution.

Final Thoughts

It remains to be seen if cryptocurrency is an investment fad or the evolution of currency. Although the digital asset is extremely popular, especially with millennials, there seems to be some contention with the current political administration on cryptocurrency. Nevertheless, we are still waiting on significant guidance from the IRS as it relates to various questions with the digital asset.

If you are currently investing or interested in investing in cryptocurrency, we can help answer your specific questions and formulate a strategy to minimize your tax liabilities. Contact us today at 401-273-7600.

By: Ron Dean, CPA/MST, Director of Tax Services at Restivo Monacelli, an innovative tax, accounting and business advisory firm with offices in Providence, RI and Boca Raton, FL. As a Certified Public Accountant (CPA) with nearly a decade of experience, Ron leads the firm's prominent tax practice and provides creative tax strategies that ensure compliance, minimize tax burdens and protect clients' income.

In addition to his client-facing role, Ron oversees a team of managers, supervisors, senior and staff accountants, playing a significant role in their training and development. Ron and his team leverage their depth of expertise to deliver forward-thinking tax strategies and solutions to the firm's growing client base.

After earning his B.S. in Accounting from one of the New England's most renowned business schools, Ron launched his career at Restivo Monacelli as a Staff Accountant in 2008 and steadily climbed the ranks to his current position by taking advantage of the firm's numerous growth and development opportunities.