What is cryptocurrency, and are there any tax consequences with using cryptocurrency? The Merriam-Webster dictionary defines cryptocurrency as “any form of currency that only exists digitally, that usually has no central issuing or regulating authority.” The Internal Revenue Service (IRS) does not have the same definition for cryptocurrency. The IRS issued Notice 2014-21, which states cryptocurrency or any virtual currency is considered property.
Therefore, if the IRS considers it property, then when you use cryptocurrency, you generate a taxable event. It should not come as a surprise that when you receive cryptocurrency for payment of goods or services, you will have income to report on the receipt of the cryptocurrency. What might come as a surprise is that when you use that same cryptocurrency to purchase a product/service, you will have another taxable event. You will have a gain or loss depending on the difference in the value of the cryptocurrency between when you acquired it and when you sold or used it. For example, you receive an interest-only loan payment for $1,000. You decide to pay your service provider’s bill with the cryptocurrency. The cryptocurrency is now worth $1,500, which is the same as your invoice. You will have a $500 gain to report on the appreciation of the cryptocurrency.
So the question now is, what type of gain or loss occurs when you sell the cryptocurrency? Is it ordinary income or is it capital? It has the best or worst answer in that “it depends.” It is based on how you hold it. If you hold it for investment purposes, then it will be a capital gain/loss treatment. If you hold it as part of your operating activity, then it will be ordinary income/loss.
As you can see, the taxation of cryptocurrency is not straightforward, and there is not a lot of clear guidance from the IRS since it is still an evolving industry. The real difficulty will be in the recordkeeping of the activity. I know there is someone thinking, “There is no way the IRS is going to find out about the cryptocurrency transactions.” However, the IRS is being aggressive because less than 1,000 taxpayers reported cryptocurrency gains, and the IRS believes there are billions of dollars in underreported income. It knows the number of transactions is much greater than what has been reported. Accordingly, the IRS sued Coinbase, Inc., a cryptocurrency exchange, to share information with the IRS. Coinbase, Inc. lost its case and needs to provide the IRS with the names and tax ID numbers on all transactions over $20,000.
The best plan is to be aware that when you use virtual currency, you are generating taxable transactions, and you will need to keep excellent records so you can inform your tax advisor about these taxable events. We will be happy to help you with the reporting of your activity since the penalties for not reporting could be significant.