Recently, we have seen a growth in the sale or exchange of cryptocurrency, or the use of cryptocurrency to pay for goods or services. Unfortunately, guidance from the Internal Revenue Service (IRS) pertaining to related US income tax issues has not kept pace with the proliferation of cryptocurrency trading. This article highlights fundamental income US tax compliance issues for investors dealing or transacting in cryptocurrency. In March 2014, the IRS issued its only formal guidance on what it called “virtual” currency. The IRS Notice 2014-21 stated that virtual currency operates like “real” currency, as it is used as legal tender. It circulates and is customarily used and accepted as a medium of exchange, but it has no legal tender status in any jurisdiction. Therefore, for US federal income tax purposes, virtual currency is not a “currency” but a capital asset.
In general, the sale or exchange of cryptocurrency, or the use of cryptocurrency to pay for goods or services in a real-world economy transaction, has US tax consequences that may result in tax liability.
Capital Gain Treatment and Holding Period
The general tax principles applicable to property transactions should apply to virtual currency transactions. Accordingly, it follows that the character of the gain or loss from the sale of virtual currency depends on whether the virtual currency is a capital asset in the hands of a taxpayer. For most casual investors, virtual currency will be a capital asset. To determine the gain or loss on a sale, a taxpayer must compare the fair market value of the virtual currency in US dollars on the date of the transaction to the fair market value in US dollars on the date acquired (cost basis). If the fair market value on the date of the transaction is higher than the cost basis, the taxpayer has a capital gain (if the cost basis is higher there is a capital loss). The holding period starts on the date acquired and will determine whether the capital gain or loss is taxed as short-term or long-term. If the virtual currency is held by a taxpayer as a capital asset for more than one year from the date acquired, the gain or loss from the sale will be taxed at preferential long-term capital gain rates.
Cost Basis and Wash Sale Considerations
Since most cryptocurrency exchanges are not designed to track your cost and determine your gain or loss on any sale or exchange, this process will fall upon the taxpayer. The taxpayer will need to implement a cost recovery methodology that is reasonable under potential IRS examination. Since IRS does not currently define cryptocurrency as a security, the default rule is traditionally specific identification. However, this could be burdensome with so many lots purchased over time. The taxpayer will need to document if another method such as (1) first in, first out, (2) last in, first out, or (3) weighted average can be employed and will be an acceptable cost recovery method by the IRS.
Currently, the Securities and Exchange Commission (SEC) treats virtual currency as a security. If the IRS was to adopt this view, the taxpayer would follow that tax lot rules used for determining the cost basis of securities sold.
In a related issue, taxpayers transacting with virtual currency must also consider IRS wash sale rules applicable to the sale of stocks and securities. Under the wash sale rules, the loss on the sale of a security is disallowed when a taxpayer sells or trades a security at a loss and purchases a substantially identical security within 30 days before or after the sale. Since the IRS has not opined whether or not it views virtual currency as a security, it is unclear whether the wash sale rules should apply
Payments for Goods and Services
A taxpayer who receives virtual currency as payment for goods or services must include the fair market value of the virtual currency measured in US dollars, as of the date that it was received. The basis of virtual currency that a taxpayer obtains as payment for goods or services is the fair market value of the virtual currency in US dollars, as of the date of receipt. For US tax purposes, transactions using virtual currency must be reported in US dollars. Therefore, taxpayers will be required to determine the fair market value of virtual currency in US dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange, and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into US dollars (or into another real currency which in turn can be converted into US dollars) at the exchange rate, in a reasonable manner that is consistently applied.
Determining the US tax implications of virtual currency transactions for investors is complicated and, unfortunately, the IRS has so far offered insufficient guidance. Limited legislation has been proposed but to date has not gathered widespread support in Congress. In the absence of precise guidance, each virtual currency transaction should be analysed based on its specific facts and circumstances. Due to the uncertainty regarding the proper tax treatment and reporting of virtual currency transactions, it is important to consult with a US tax specialist who is familiar with these issues.