What is virtual currency?
Virtual currency is a digital representation of value other than a representation of the U.S. dollar or a foreign currency (“real currency”). Virtual currency is used as a unit of account, a store of value, or a medium of exchange. TAS wants to help you understand the tax treatment of virtual currency that can be converted into, or exchanged for, real currency.
Bitcoin is one example of a convertible virtual currency. Bitcoin is a cryptocurrency, which is a specific type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. A transaction involving cryptocurrency that is recorded on a distributed ledger is referred to as an “on-chain” transaction. A transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction, where individuals can engage directly with each other without necessarily using a trusted third party like a cryptocurrency exchange.
Why are virtual currency transactions taxable?
Income is generally taxable regardless of the source it comes from. As such, virtual currency transactions are taxable just like ‘traditional’ transactions involving money for goods or services, or an exchange of property for other property or services. Virtual currency is treated as property by the IRS and general tax principles that apply to property transactions apply if you sell, exchange, or otherwise transact using virtual currency.
How are virtual currency transactions taxed?
In general, individuals who transact with virtual currency, including buying and selling virtual currency or exchanging virtual currency, hold the virtual currency as a capital asset and the transactions result in capital gain or capital loss. Since virtual currency is considered property, the same general principles apply. However, virtual currency received as compensation for services is treated the same as wages and results in ordinary income to the recipient who then holds the virtual currency as a capital asset.
The following examples illustrate several common transactions involving virtual currency:
- Sales: When you sell virtual currency, it is generally a capital asset and you must report the transaction along with any capital gain or loss on the sale.
- Example: If Mary purchased 5 Bitcoins for $50,000 in April and sold all of her Bitcoins in July for $52,000, she would have short-term capital gain of $2,000 (the sales price less the purchase price). If Mary sold the Bitcoins for $48,000, she would have a short-term capital loss on the sale, that must be reported too, but it would be subject to any limitations on capital loss deductions.
- Exchanges: If you exchange virtual currency held as a capital asset for services or other property, including goods or another virtual currency, you must report the transaction and any capital gain or loss resulting from the exchange.
- Example: If Bill buys 5 Bitcoins for $50,000 in April and exchanges them for another virtual currency in June worth $40,000 at the date and time of the exchange, Bill would report a $10,000 short-term capital loss on the transaction. In this case, Bill would have to look at his other capital losses and could potentially be limited in how much he could deduct in the current year. Likewise, if the exchanged virtual currency was worth $60,000 instead of $40,000, Bill would report a $10,000 short-term capital gain on the transaction.
- Earnings: When you receive property, including virtual currency, in exchange for performing services, whether or not you perform the services as an employee, you must report the earnings as ordinary income. Compensation for services are reported and taxed the same regardless of how the compensation is received (dollars, virtual currencies, property, or other services).If you receive virtual currency in return for providing services as an employee, it’s considered wages and is subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported by your employer on Form W-2, Wage and Tax Statement, like traditional wages paid in U.S. dollars. If you receive virtual currency in return for providing services and are not an employee of the payor, you are self-employed, and may be considered an independent contractor. Income from self-employment is often reported on Form 1099-MISC, Miscellaneous Income.
- Example: If Deng receives $100,000 for providing services as an employee, he should report this as “wages” on his income tax return. If Deng is not an employee, the compensation is reported on Schedule 1 or Schedule C. Deng must report this income on his income tax return regardless of whether he receives a W-2, 1099-MISC, or other information return.
- Hard forks: A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger. This may result in the creation of a new cryptocurrency in addition to the legacy cryptocurrency. If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency you don’t have taxable income.
- Example: Maria holds 10 units of cryptocurrency A that has a hard fork after which she also has 10 units of cryptocurrency B. Regardless of how she receives the new cryptocurrency B, she has income. If the 10 units of cryptocurrency B are worth $50 at the date and time she receives them, Maria will have taxable income of $50 that she must report in the year she receives the cryptocurrency B.
- Unreported transactions: You must report income, gain, or loss from all taxable transactions involving virtual currency on your Federal income tax return for the year of the transaction, regardless of the amount or whether you receive a payee statement (like a Form W-2) or information return (like a Form 1099-MISC).
For more information on the tax treatment of property transactions, see Publication 544, Sales and Other Dispositions of Assets.
What virtual currency transactions are not taxable?
Generally, the same rules that apply to other property apply to virtual currency. Not all property transactions are taxable. For example, the following transactions are not taxable:
- Transactions with yourself. If you transfer virtual currency from a wallet, address, or account belonging to you, to another wallet, address, or account that also belongs to you, the transfer is a non-taxable event, even if you receive an information return reporting the transfer.
- Bona fide gifts. If you receive virtual currency as a bona fide gift, the gift is not taxable. You will report any income or loss when you sell, exchange, or otherwise dispose of the virtual currency.
- Charitable donations. If you donate virtual currency to a charitable organization described in Internal Revenue Code Section 170(c), you will not report income, gain, or loss from the donation.
- Soft forks. A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and thus does not result in the creation of a new cryptocurrency. Because soft forks do not result in you receiving new cryptocurrency, you will be in the same position you were in prior to the soft fork, meaning that the soft fork will not result in any income to you.
Where Are Virtual Currency Transactions Reported?
Transactions conducted in virtual currency are generally reported on the same tax forms as transactions in other property. They are also reported on a new checkbox on Form 1040. Virtual currency transactions must be reported on:
- Checkbox on page 1 of Form 1040, U.S. Individual Income Tax Return, or Form 1040-SR, U.S. Tax Return for Seniors. Beginning in 2020, if you engage in any transaction involving virtual currency, check the “Yes” box next to the question on virtual currency on page 1 of Form 1040 or Form 1040-SR, even if you received virtual currency for free, including from an air-drop or hard fork. Do not check this box if you only engaged in transactions with yourself.
- Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D (Form 1040 or 1040-SR), Capital Gains and Losses. You must report most sales and other capital transactions and calculate the capital gain or loss in accordance with IRS forms and instructions, including on Form 8949, and then summarize capital gains and deductible capital losses on Schedule D.
- Form 1040 series or Form 1040 Schedule 1, Additional Income and Adjustments to Income. You must report ordinary income from virtual currency on Form 1040, U.S. Individual Tax Return, Form 1040-SS. U.S. Self-Employment Tax Return (Including the Additional Child Tax Credit for Bone Fide Residents of Puerto Rico), Form 1040-NR, U.S. Nonresident Alien Income Tax Return, or Form 1040, Schedule 1, Additional Income and Adjustments to Income, as applicable.
What records do I need to maintain regarding my transactions using virtual currency?
The Internal Revenue Code and regulations require taxpayers to maintain records that are sufficient to establish the positions taken on tax returns. You should therefore maintain records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the virtual currency for at least three years after reporting any taxable event or have other reporting requirements even if they’re not immediately taxable.
If you have any questions regarding accounting, domestic taxation, essential business accounting, international taxation, IRS representation, U.S. tax implications of Real Estate transactions or financial statements, please give us a call at 305-274-5811.