Cryptocurrency: Secret currency or taxable property?
Learn about how the IRS treats cryptocurrency transactions. We explain what counts as cryptocurrency, tax rules, and when to check the cryptocurrency box on Form 1040.
Since Bitcoin debuted as the first established cryptocurrency in 2009, many more emerged, including Litecoin, Ethereum, and Ripple. With the rise in cryptocurrency popularity came questions as to how the IRS will deal with these transactions.
What exactly are cryptocurrencies?
Cryptocurrencies track transactions on a log that exists on many different computers all over the world (called the “blockchain”). Cryptocurrencies have no central storage location for all the information stored on the blockchain. Blockchain is the platform underlying cryptocurrencies. A transaction stored on the blockchain is an “on-chain” transaction. A transaction not stored on the blockchain is an “off-chain” transaction.
Virtual currency tax rules apply to cryptocurrency
In 2014, the IRS began releasing guidance on tax rules for virtual currency (which includes cryptocurrency) and how it should be treated for tax purposes. In 2019, the IRS started sending letters to taxpayers about their virtual currency transactions.
Virtual currency, according to the IRS, is a digital representation of value that can act similar to real currency. Like real currency, virtual currency acts like a medium of exchange, unit of account, or store of value. However, unlike real currency, virtual currency is not considered legal tender.
Currencies that are legal tender, like the U.S. dollar, are not subject to the virtual currency rules. This is true even when U.S. dollars are held in an online bank account or are transferred electronically to a third party via a mobile app. Cryptocurrency does not carry the status of legal tender, therefore, it is considered a type of virtual currency.
Tax implications for cryptocurrency transactions can vary
Virtual currency, including cryptocurrency, is property for federal tax purposes. The tax results of a transaction involving cryptocurrency will vary depending on who holds it (a business or an individual) and how the cryptocurrency is held (for personal use, as an investment, or for business use). For example, an individual holding cryptocurrency as an investment would have similar tax results as an individual holding stock as an investment. Taxpayers may have tax consequences when cryptocurrency is acquired, sold, or exchanged. How the transaction is taxed all depends on the type of transaction.
Cryptocurrency basis valuation is important for tax purposes
Cryptocurrency is valued at its fair market value in U.S. dollars for tax purposes. Sometimes value can be easy to determine and sometimes it is not so easy.
Taxpayers who purchase cryptocurrency in an on-chain transaction through an exchange will value their cryptocurrency as of the time and day the transaction takes place in U.S. dollars based on the amount recorded on the blockchain. Taxpayers who purchase cryptocurrency in an off-chain transaction must determine the fair market value of the cryptocurrency at the time and date the transaction occurred as if it were recorded on the blockchain. Taxpayers who engage in a peer to peer transaction may use a cryptocurrency or blockchain explorer to gauge the exact fair market value of a cryptocurrency as of a specific date and time. The IRS accepts evidence of fair market value based on an explorer value.
Taxpayers who own cryptocurrency with no published value must use the fair market value of the property or services exchanged to determine the fair market value of the cryptocurrency received.
Purchasing virtual currency with cash
Taxpayers who purchase cryptocurrency over an exchange or through a special ATM with U.S. dollars will not trigger any immediate tax. However, taxpayers need to keep records on how much the virtual currency costs. This amount is treated as the taxpayer's basis in the cryptocurrency. The taxpayer will have tax consequences when the cryptocurrency is sold or exchanged and will need to know their basis to reduce their tax liability.
For example, Alice pays $10,000 to Crypto Company, a cryptocurrency exchange, for $10,000 worth of cryptocurrency, a virtual currency. This is an on-chain transaction. Alice's basis in the cryptocurrency is $10,000 plus any fees, commissions, or other purchasing costs. Alice will not have any tax consequences until she sells the cryptocurrency. Crypto Company will be taxed on the sale of its inventory, cryptocurrency, and will pay taxes based on its inventory method.
Exchanging property for virtual currency
Taxpayers who exchange property for cryptocurrency will have immediate tax consequences. Taxpayers will have to subtract their basis in the property exchanged from the fair market value of property received to determine the gain they are taxed on.
For example, Alice pays $12,000 worth of cryptocurrency, a virtual currency, to Ivy in exchange for a piece of unimproved land. Alice held the cryptocurrency as an investment for eight months and paid $10,000 in cash for it. Alice will subtract her $10,000 basis in the cryptocurrency from the $12,000 fair market value of the land Alice will receive. Alice's short-term capital gain will be $2,000. Alice will have a short-term capital gain because Alice did not hold the cryptocurrency for more than one year.
Ivy will also have tax consequences. Ivy purchased the unimproved land as an investment five years ago for $9,000. Ivy will subtract her basis in the unimproved land of $9,000 from the $12,000 worth of cryptocurrency received. Ivy held the land for more than one year, so her long-term capital gain will be $3,000.
Notice that both parties have tax consequences in an exchange of property.
Exchanging goods or services for virtual currency
Taxpayers who accept cryptocurrency in exchange for goods or services will be taxed on the fair market value of the full amount of cryptocurrency received as ordinary income. Taxpayers who purchase goods or services for cryptocurrency can be subject to the same capital asset rules discussed above in a property-for-property exchange.
For example, Zach pays Elias to fix a computer for $50 worth of cryptocurrency, a virtual currency. If Elias was not in the business of fixing computers, Elias will recognize $50 of ordinary income for the cryptocurrency he received.
Zach purchased the cryptocurrency he paid to Elias for $20 as an investment four years back. Zach will recognize $30 of long-term capital gain.
Self-employed taxpayers will have to pay self-employment tax on the amount of cryptocurrency received for goods or services in addition to including the amount in income tax.
For example, Ivy pays Elias $4,000 in cryptocurrency, a virtual currency, for his cybersecurity services to help her business website. Elias is in the business of providing cybersecurity services, so he is an independent contractor. Elias will have $4,000 worth of income subject to both income tax and self-employment tax. Elias will report the fair market value of the cryptocurrency he received on his Schedule C and Schedule SE. His basis in the cryptocurrency is its fair market value on the date he received it.
Ivy will have two sets of tax consequences. First, Ivy will have to give Elias a Form 1099-NEC (or a Form 1099-MISC if the transaction is in 2019 or earlier). Assuming the cybersecurity services Elias provided were an ordinary and necessary business expense for Ivy, she would be able to deduct the fair market value of the cryptocurrency she paid to Elias. Second, Ivy will also have tax consequences for exchanging the cryptocurrency for services. If Ivy held the cryptocurrency, with a basis of $2,500, for three years as a business investment before paying Elias, she will have a long-term capital gain of $1,500.
Paying virtual currency to employees
Taxpayers who receive cryptocurrency as wages from an employer will treat the fair market value of the cryptocurrency received as subject to social security tax, Medicare tax, Federal Unemployment Tax Act (or FUTA) tax, and federal income tax withholding. Depending on the state of the employee, the amount can be subject to state tax rules as well.
Ivy hired Zach as an employee. Zach lives in a state with no income tax. Ivy pays Zach $1,000 of cryptocurrency, a virtual currency, per week as compensation. Ivy pays Zach’s federal income tax withholdings, social security tax, Medicare tax, and FUTA tax in U.S. dollars. Zach will receive paystubs and his Form W-2 showing his compensation. The amount shown on each document will include the fair market value of the cryptocurrency Zach received on the date he received it plus enough to pay Zach’s employment taxes (i.e. a “gross-up”). Zach will include the amount listed on his Form W-2 as wage income when filing his Form 1040.
Assuming Zach’s salary is reasonable, Ivy will be able to deduct the amount of Zach’s salary (including the gross-up) as a business expense. Ivy will pay Zach’s federal income tax withholdings, social security tax, Medicare tax, and FUTA tax in U.S. dollars just like she would for any of her other employees. Ivy will file Form 941 and all other required employment forms.
Gifting virtual currency
Taxpayers who receive virtual currency as a gift will not have any immediate income tax consequences and may have the same basis and holding period as the donor. Gifts of virtual currency can be subject to gift tax and generation skipping tax if the value of the cryptocurrency is above the annual and lifetime exclusion amounts.
Zach gives $20,000 worth of cryptocurrency, a virtual currency, to his sister Alice. Alice will need to know Zach’s basis, Zach’s holding period, and the fair market value of the cryptocurrency at the time of the gift. Alice decides to hold onto the cryptocurrency as an investment.
Alice may use Zach’s basis of $25,000 and his holding period of two years if she sells or exchanges of the cryptocurrency for a gain. If, however, Alice sells the cryptocurrency one year later when it is worth $23,000, she will have no gain and no loss on the transaction.
Zach will not have any income tax consequences associated with the gift to his sister. However, he may have gift tax consequences because the amount of the gift is over the annual exclusion amount. He will have to file a gift tax return.
When to check the box on Schedule 1 (Form 1040)
Form 1040 contains a checkbox to report virtual currency transactions: “At any time during [the tax year], did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
Taxpayers who engage in one of the following transactions must check “Yes” to the virtual currency question:
- Sell virtual currency during the tax year;
- Exchange virtual currency during the tax year for either other property or virtual currency;
- Exchange virtual currency for goods or services; or
- Receive virtual currency for free because of an airdrop, hard fork, or any other type of transaction along those lines. For more information on hard forks and airdrops, see TAX in the News article “New checkbox for virtual currency”
The IRS has defined a “hard fork” as when a cryptocurrency divides into two separate cryptocurrencies: an old legacy cryptocurrency and a new cryptocurrency. Each will have its own blockchain or distributive ledger going forward. The IRS does not consider this a taxable event so long as taxpayers do not receive new units of the cryptocurrency.
The IRS has defined an “airdrop” as issuing new cryptocurrency to the owners listed on the blockchain or distributive ledger. An airdrop is recorded on the blockchain. When an airdrop follows a hard fork, taxpayers will have ordinary income on the fair market value of the units of new cryptocurrency received from the airdrop.
For 2019, taxpayers were required to file Schedule 1 (Form 1040) to answer “Yes” to the virtual currency checkbox. Taxpayers who have not engaged in a virtual currency transaction during the 2019 tax year don’t need to file Schedule 1 (Form 1040) just to report no virtual currency transactions (i.e. to check “No” on the virtual currency checkbox), but taxpayers who must file Schedule 1 (Form 1040) for other reasons will need to mark “No” if they did not engage in any transactions involving virtual currency.
For 2020, the virtual currency checkbox will be located on the first page of Form 1040. Additionally, the IRS clarified its stance on virtual currency transactions. Taxpayers engaged in either of the following transactions are not engaging in a virtual currency transaction:
- holding a virtual currency during the entire tax year, or
- transferring a virtual currency between two accounts or wallets the taxpayer owns or controls.
In addition to reporting virtual currency transactions with the virtual currency checkbox, taxpayers will need to report the virtual currency transactions in the other appropriate places throughout their tax return.
Recordkeeping is key
Remember to keep records, including but not limited to, documents showing sales, exchanges, and other dispositions; documents showing the fair market value of any virtual currency; and any receipts.
Using cryptocurrency adds a layer of complexity to any existing tax transaction, but it does not change the fundamental nature of the transaction taking place. All of the normal rules about income and gift tax apply to virtual currency transactions.
For more information on Roblox and V-bucks see the Insights article, "In-game currencies Roblox and V-bucks are not reportable"