by Jamie Hopkins, Forbes Contributor
Cryptocurrencies are all the rage today, but come tax season they might only cause you rage. The reality is that one driving force behind cryptocurrency development was a desire to be outside the view, control, and domain of governments. However, they cannot escape the IRS. Not only do cryptocurrencies not escape the IRS’ tax rules, the tax rules are not that favorable at this time due to a lack of clarity by the IRS around cryptocurrencies and numerous reporting and valuation tracking issues that can be very burdensome come tax time.
The first place to start is that cryptocurrencies, like Bitcoin, Ethereum, and Litecoin, are not considered currencies for federal tax purposes. Back in 2014, the IRS released IRS Notice 2014-21, stating that digital currency might act like the coin and paper money of the United States but it currently does not have “legal tender status in any jurisdiction.” As such, digital currency is treated as property for federal tax purposes. This does raise an interesting issue: if countries start treated digital currencies as legal tender, it could change the nature of its tax treatment. However, the IRS currently does not treat digital currencies as currencies.
Further in the notice, the IRS states that normal tax rules involving property apply to digital currencies. This means that digital currencies could be treated as business, investment or personal property, all impacting taxation. This means that digital currencies are not taxed equally among owners and miners. Some people might be subject to ordinary income taxes and others might be subject to capital gains tax treatment. But, generally speaking, the mining, receipt, sale, use, transfer, or exchange of digital currencies can create an immediate taxable event.
For instance, if you bought Bitcoin for the purpose of buying online goods or services, any gain above your cost basis (essentially what you paid for it) would be subject to taxation. So let’s say you bought $100 of digital currency and exchanged it a month later for some website design services that cost $120. At this time, you would have a $20 gain based on the $120 received in value minus your $100 basis. This would also be the case if you just exchanged one digital currency for another in 2018. (There is some debate as to whether a 1031 exchange was allowed for digital currencies prior to the new tax law changes based on IRS Revenue Ruling 79-143 which implied that like kind-exchanges of gold coins could be accomplished under 1031.) Now, the exact taxation of this gain would depend on if you were holding this asset for investment, business, or personal reasons.
If the digital currency was purchased and held for investment purposes, it is treated as a capital asset, and capital gains tax treatment would be available just like with any other investment or stock. However, if it was held for personal reasons, you might not be as easily able to deduct loses. Furthermore, any exchange of digital currencies for goods or services will result in a taxable event.
If you received a digital currency as payment for goods or services, you need to include it when computing gross income. Furthermore, the digital currency should be valued at its fair market value, in U.S. dollars, on the date when it was received. To figure out the fair market value, one should look at the exchanges and exchange rates that day to convert the digital currency into U.S. dollars. However, this fails to address a few valuation issues. First, digital currencies have seen dramatic swings in price, gaining 100% or losing 40% in a single day. Secondly, finding accurate data from an exchange could also be difficult. Third, exchange rates have varied widely across exchanges during a single day. All of these could create headaches for a taxpayer.
If, instead of receiving digital currencies as a form of payment, you mined the currency, then the tax treatment will depend on whether you were an employee or self-employed. The mining of a digital currency like bitcoin can be treated as a trade or business, subjecting the miner to taxable income and self-employment taxes on the net earnings. Furthermore, if the digital currencies were then sold or exchanged, the transfer, if for a gain, could be subject to ordinary income as inventory or property held as part of a trade or business is not a capital asset, and, therefore subject to ordinary income tax rules.
Further complicating the matter is that cryptocurrencies, because they are taxed as property, can be sold on a First-In-First-Out (FIFO), a Last-In-First-Out (LIFO), average cost, or a “specific share identification” method. Because the IRS does not currently have a stated position on the best method to utilize, taxpayers could presumably pick one that best fits their situation in order to minimize taxes and maximize gains.
The biggest issue with cryptocurrency taxation is not necessarily the tax rules, as they generally follow the same tax treatment rules as stocks and real estate investments, but rather the lack of reporting and tracking. The reality is that the IRS does not require digital currency exchanges like Coinbase to report or track your basis or gains. This means you won’t be getting any annual tax forms in the near future to help you file your taxes. The onus on tracking basis, transactions, and taxation issues falls squarely on the taxpayer here. Coupled with the issues around determining fair market value for digital currency transactions at any given moment, tax filing season could be a huge headache. Hopefully in the future, exchanges are required to do a bit more reporting and tracking, but for now, it is up to the digital currency owner.
Remember, any time you exchange, mine, sell, or use a digital currency it is likely a taxable event. This means you need to track your basis in the currency exchanged at that time and the value you received in return and, if you have a lot of transactions, you should probably be working with an accountant or tax professional that specializes in digital currencies. At a minimum, don’t forget your digital currencies come tax time!
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This article was originally published on Forbes.com