5 Tax Rules to Know About Cryptocurrency

Bitcoin, Ethereum, and other cryptocurrencies are mainstream. Whether you call cryptocurrency by another name—virtual currency, digital assets—you can now use them to pay for various consumer products. You can also view valuations as easily as you can stocks and bonds. From a tax perspective, the treatment of cryptocurrency is not easy to handle. Here are 5 things to know.

1.      Cryptocurrency is treated as property

A number of years ago, when cryptocurrency was relatively new, the IRS concluded that it should be treated like property and not like currency. As a result, when you hold cryptocurrency for investment purposes, it is a capital asset and when you use cryptocurrency to pay for things, you have to figure capital gain or loss as you would with the exchange of any other type of investment property. If you exchange your virtual currency for other property, including other virtual currency, your gain or loss is the difference between the fair market value of the property you received and your adjusted basis in the virtual currency you exchanged.

Similarly, if someone provides you with a service and you pay them with virtual currency, your capital gain or loss is the difference between the fair market value of the services you received and your adjusted basis in the virtual currency exchanged. Your capital gain or loss is long-term or short-term, depending on your holding period for the cryptocurrency.

If you receive cryptocurrency as payment for services you provide, you report the payments as ordinary income by determining the fair market value of the cryptocurrency when received; if you are self-employed, the income is subject to self-employment tax.

The IRS has extensive FAQs on virtual currency transactions for individuals who are not engaged in the business of selling cryptocurrency.

2.      There’s a box on the income tax return to denote you’ve made cryptocurrency transactions

Below your name and address on Form 1040 and 1040-SR, there’s a question you must answer: “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” Check the appropriate box for yes or no.

3.      Not all cryptocurrency transactions are taxable

In order for cryptocurrency transactions to be taxable, you need a taxable event. The IRS has considered various scenarios in which transactions are not taxable. For example, a hard fork of cryptocurrency that does not result in the receipt of units of new cryptocurrency is not a taxable transaction. But an airdrop of a new cryptocurrency following a hard fork where the individual receives units of new cryptocurrency is a taxable transaction.

4.      Wash sale rules may apply to cryptocurrency sales

At present, it is unclear whether the wash sale rule applies to sales of cryptocurrency. The wash sale rule bars you from taking a loss if you acquire substantially identical securities within 30 days before or after a sale. The Build Back Better Act, which passed the House on November 19, 2021, would make it clear that the wash sale rule applies to sales of cryptocurrency.

5.      Reporting for digital asset transfers is coming

The Infrastructure Investment and Jobs Act of 2021 introduced a new information reporting requirement. Brokers—anyone who for consideration effectuates transfers of digital assets on behalf of another person—is the party doing the reporting to the IRS. Digital assets are defined as “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology.” The reporting is set to commence for transactions in 2023, so there is time for the IRS to provide guidance and/or Congress to clarify some of the confusion about this reporting rule.

Conclusion

With the ability to use cryptocurrency to pay for airline tickets, buy a car, or build up wealth, accompanied by the government’s desire for revenue, the tax aspects of cryptocurrency cannot be ignored. More to come…

Resources: Notice 2014-21; Rev. Rul. 2019-24