In recent years, taxpayers have been investing in virtual currency to exchange monies in the virtual marketplace or hold on to as investment assets. One of the subgroups of virtual currency is cryptocurrency, or a digital form of currency traded or secured using cryptography. The emergence of this digital asset has yet to provide definitive tax guidelines for taxpayers and tax practitioners, particularly for taxpayers who are concerned about their privacy rights in cryptocurrency. However, one thing is clear when it comes to virtual currency: taxpayers must pay their taxes on the gains made from the profits on virtual currency. If not, taxpayers will reap the consequences of enforcement from the IRS.
The IRS has provided some guidance to the virtual currency debacle in the form of Notice 2014-21. The IRS defines virtual currency as a digital representation of value that functions as a medium exchange, a unit of account, and/or a store of value. Virtual currency can act as a substitute for real currency, also known as “convertible” virtual currency, but does not have legal tender status in any jurisdiction. An example of a convertible virtual currency is Bitcoin, which can be digitally traded between users and exchanged into US dollars, Euros, and other real or virtual currencies.
Based on that comprehensive yet confusing definition of virtual currency, taxpayers may wonder how virtual currency might be treated for federal tax purposes. According to the IRS, virtual currency is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency. That means taxpayers who receive virtual currency as payment for goods or services must include the fair market value of the virtual currency, measured in US dollars, the date that the virtual currency was received. If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. The taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency.
The computation of gains and losses for virtual currency seems fairly straightforward as long as taxpayers limit the number of transactions and exchanges that occur in the virtual marketplace. Complications arise when taxpayers “mine” virtual currency or conduct multiple transactions on different cryptocurrency exchanges. Mining virtual currency is when taxpayers use various forms of cryptocurrency to validate transactions and maintain blockchain transaction ledgers. The most common issue in these scenarios is the lack of proper recordkeeping and documentation.
With various transactions happening in different cryptocurrency exchanges, taxpayers tend to lose track of their purchases and sales throughout the taxable year. Furthermore, taxpayers are out of luck if their cryptocurrency exchange shuts down or goes out of business, which limits their access to records and transactions. As for taxpayers reporting these various transactions, the IRS does not look too kindly on homemade transaction lists. The IRS has previously issued summons to obtain records from cryptocurrency exchanges to validate taxpayers’ information and transaction activities, most notably to Coinbase using a John Doe summons.
On a positive note, Treasury regulations do not define virtual currency in an offshore account as a type of reportable account. That means that virtual currency is not reportable on the Treasury’s FinCEN Form 114 (“Report of Foreign Bank and Financial Accounts”), or most commonly known as FBAR, for now. This may change in the future, and taxpayers should be cautious to file if they have U.S. dollars in a foreign third-party exchange in addition to virtual currency.
If you have questions about your cryptocurrency investments or debating whether to invest in cryptocurrency, the Enterprise Consultants Group’s tax advisors are available to assist you. Please contact us today online or at (800) 575-9284 to discuss your case.