By Anthony Diosdi
Cryptocurrency and blockchain technology have grown in popularity and ubiquity in the past few years. Bitcoin and other forms of cryptocurrency have experienced unprecedented growth in recent years, leaving many investors unexpectedly large tax bills. The Internal Revenue Service defines cryptocurrency as a “type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger such as blockchain.” Virtual currency is a digital asset that is used as a medium of exchange and typically stored electronically in digital wallets. Since the technology, uses and types of blockchain technology and virtual currency are developing so rapidly and growing in number, regulatory agencies are having a hard time keeping up with the developments and legal implications of these developments. This article focuses on how virtual currency is taxed and the wider implications on virtual currency is reporting requirements.
The Technology of Cryptocurrency
Cryptocurrency relies on blockchain technology. Blockchain is a digital form of record keeping. Blockchain is the underlying technology that many cryptocurrencies such as Bitcoin and Ethereum operate on. Typically, database information is stored on tables. Blockchain does not rely on tables. A blockchain organizes information added to ledgers known as blocks or groups of data. Each block can only hold a certain amount of information, so new blocks are continually added to the ledger, forming a chain. The blockchain structure provides an irreversible timeline of data when implemented in a decentralized nature. When a block is filled, it is finalized, and each block in the chain has a precise timestamp that serves as a digital signature. Each block has its own unique identifier known as a “hash.” The hash protects the information in the block and the block’s place along the chain.
The Taxation of Cryptocurrency
Virtual currencies are treated as property and not currency for federal tax purposes in the United States. This is a departure from the rest of the world which treats virtual currency the same as standard fiat currency (fiat money is government issued currency that is not backed by a physical commodity). Internal Revenue Service (“IRS”) Notice 2014-21, provides that taxpayers must recognize gain or loss on the exchange of virtual currency for cash or for other property. Gain or loss is, thus, recognized and taxable, every time that virtual currency is sold or used to purchase goods or services, including other types of virtual currency. To determine the amount of capital gain or loss, a taxpayer must know the basis of the virtual currency and the fair market value of the cryptocurrency when sold or otherwise transferred. In order to determine the proper capital gains rate, a determination must be made how long the cryptocurrency was held before its liquidation. Short-term capital gain is the gain occurring from the sale or exchange of virtual currency when it is held less than one year. Long term capital gain is the gain that occurs from the sale or exchange of virtual currency when it is held for more than one year. Under the current tax rate, the federal rates on long-term capital gains are taxed at rates up to 20 percent, plus 3.8 percent Medicare Tax (in certain cases), plus applicable state and local tax. Under the current tax law, the federal rates on short-term capital gains are taxed at rates up to 37 percent, plus 3.8 percent Medicare Tax (in certain cases), plus applicable state and local tax.
Basis of Cryptocurrencies For Tax Purposes
As discussed above, cryptocurrency is a capital asset for income tax purposes. This means that a trader in cryptocurrency must determine his or her cost basis in the virtual currency when it is sold. The cost basis is the amount an investor spent to acquire an asset. This includes the purpose price, transaction fees, commissions paid, and any other relevant costs. At first glance, calculating the cost or initial basis in virtual currency seems simple. When U.S. dollars are used to acquire cryptocurrency, the basis in the cryptocurrency is the amount of fiat currency used to purchase the virtual currency. This is no different than the rules for determining the basis in any other capital asset. However, determining the basis in cryptocurrency quickly becomes more difficult after this initial stage in basis calculation.
The main reason it can be difficult to determine the basis of cryptocurrency is the method used to acquire the virtual currency. Cryptocurrencies are often acquired through a cryptocurrency trading platform or exchange. In this case, the cost basis of the cryptocurrency is the amount that is recorded by the cryptocurrency exchange for that transaction. However, if the acquisition of the cryptocurrency happens “off-chain,” which means the transaction is not recorded on the distribution ledger, then the basis is the amount the virtual currency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it were on “on-chain” transaction. If cryptocurrency is acquired in a peer-to peer transaction or some other transaction that does not involve a platform or exchange, the basis of the cryptocurrency is determined as of the date and time the transaction is recorded on the distribution ledger or would have been recorded on the ledger if it is an “off-chain” translation.
The method of acquiring cryptocurrency is not the only factor that determines the cost basis of cryptocurrency. The cost basis of an investor’s cryptocurrency depends on his or her method of tax accounting. There are three methods of tax accounting for purposes of cost basis calculation:
1) Determine cryptocurrency taxation under first-in, first-out (“FIFO”). FIFO is an assumption that the first goods acquired or produced should be assigned to the first goods sold.
2) Determine cryptocurrency taxation under last in, first-out (“LIFO”). LIFO is an assumption that the cost of the goods most recently acquired or produced should be assigned to the first goods sold.
3) Determine cryptocurrency taxation under the highest-in, first-out (“HIFO”) method. HIFO is used when inventory with the highest cost of purchase is the first to be used or taken out of stock.
A simple example how a cryptocurrency trader would calculate his or her basis would be as follows; suppose an investor uses FIFO to determine his or her tax basis and the investor acquired one Dogecoin in 2018 and two Dogecoin coins in 2019. If the investor sells two Dogecoins in 2021, the trader would use the cost basis for the one Dogecoin purposed 2018 and the cost basis for the Dogecoin purposed in 2019 to his or her tax basis.
Determining cost basis becomes more complicated if there are multiple coin transactions. For example, assume that a cryptocurrency investor has 10 coins of virtual currency at a cost of $1 per coin acquires additional virtual coins at the following times and costs:
Assuming that 12 coins remain on hand at the end of the year, it is necessary to determine what portion of the $51.50 aggregate cost should be allocated to these 12 virtual coins. Under LIFO, the ending inventory of virtual coins would be deemed to cost $12.04 (consisting of a layer of 10 virtual coins at $1.00 per coin and a layer of 2 coins at $1.02 per coin). The balance of $39.46 would be allocated to the cost basis. Under, FIFO, the ending virtual coin inventory would be deemed to cost $12.68 ((10 x $1.06) + (2 x $1.04)), and the balance of $38.82 would be allocated to the cost basis.
Another challenge in basis calculation is when an investor exchanges one cryptocurrency for another cryptocurrency. In these cases, investors often cannot directly purchase new virtual currency using fiat currency. Instead, the cryptocurrency can only be acquired through major cryptocurrencies such as bitcoin or ethereum. only by exchanging major cryptocurrencies. From a cost basis calculation point of view, the exchange of cryptocurrency is crucial because one capital asset is being liquidated to purchase another capital asset. This type of transaction not only triggers a taxable event from the disposition, but it also requires the basis to be calculated on the newly acquired cryptocurrency.
Prior to the IRS releasing its FAQs on virtual currency, it was thought that since virtual currency is usually held for investment purposes, like stock, it should be subject to the same basis and accounting rules as stock and as such, unless other specific exceptions are made. The “FIFO method should be used in identifying which “coin” is sold or transferred, which determines the gain or loss of the transaction. One of the exceptions to FIFO as it relates to stock as if there can be “adequate identification.” The obvious issue with adequate identification is whether that could ever be applied to virtual currency. With bitcoin, for example, there is no actual “coin;” it is just an entry on a distributed ledger. Fortunately, the IRS did provide guidance in its FAQs that permit investors to choose which units of virtual currency are sold if those units can be “specifically identified.” If the units of virtual currency are not specifically identified then the first in, first out method is to be used. An investor can use specific identification by documenting the specific unit’s unique digital identifier, such as a private key, and address, or by records showing the transaction information for all units of a specific virtual currency held in a single account, wallet, or address.
The ability to use specific identification allows an investor to pick the most advantageous tax treatment and it is further applicable universally across all wallets or virtual currency holdings and not limited to per-wallet application.
The Taxation of Mining Cryptocurrency
We often hear of mining cryptocurrency currency. Cryptocurrency mining is the process in which transactions between users are verified and added to the blockchain public ledger. The process of mining is also responsible for introducing new coins into the existing circulating supply. The IRS has not provided a large amount of guidance regarding the taxation of mining virtual currency. The primary source of discussion is found in Notice 2014-21, which states the following:
Q-8: Does a taxpayer who “mines” virtual currency (for example, uses computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger) realize gross income upon receipt of the virtual currency resulting from those activities?
A-8: Yes, when a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income. See Publication 525, Taxable and Nontaxable Income.
Pursuant to IRS Notice 2014-21, the mined virtual currency has a fair market value, and is included as gross income, as of the date of receipt. The fair market value of the cryptocurrency is determined as of the date and time the transaction is recorded on the distributed ledger. The income from mined virtual currency may also be subject to self-employment tax. See IRS Notice 2014-21, Q-9.
The Tax Controversy of Hard Forks
In 2018, the IRS launched a virtual currency taxation awareness campaign that evolved into a targeted compliance effort in 2019 aimed at taxpayers with virtual currency transactions who failed to report the resulting income and pay the associated taxes. In 2019, the IRS also issued Revenue Ruling 2019-24 which provides guidance regarding the taxation of “hard forks” and “air drops.” For the most part, a hard fork is a blockchain software update used to correct security flaws that adds new functions or reverses transactions. Hard forks do not undo a network’s transaction history, hard forks do create a permanent divergence from the previous blockchain that may require the forced exchange of the old network’s virtual currency for the virtual currency of a new network. A hard fork also results when there is a split in a cryptocurrency’s blockchain.
In brief, a hard fork represents a permanent change to the coding of a virtual currency’s underlying blockchain that necessitates the creation of a separate and distinct cryptocurrency. A hard fork will impact the basis and taxation of cryptocurrency. However, the IRS and the Department of Treasury have yet to issue comprehensive guidance in this area.
There are currently three theories as to how a hard fork will impact the basis and taxation of cryptocurrency. Some view a hard fork as the receipt of a new asset. Under this view, the investor would recognize ordinary income on the opening market value of the new cryptocurrency against the cost basis of the ordinary acquired cryptocurrency. A second view is to treat a hard fork as a spinoff or stock split in which the existing cryptocurrency splits into two. Under this theory, the virtual currency trader would immediately recognize income on the new cryptocurrency received and would split with the cost basis tacked on the original cryptocurrency between the two using the respective market values following the split using the best available data. Anyone considering taking this position should understand that the IRS would likely challenge it. This is because this theory does not fit well into the existing provisions allowing for nonrecognition treatment. A third approach and final approach is to apply a zero basis to the new cryptocurrency. The rationale behind this approach is that although the new cryptocurrency may be a new asset, the validity of the cryptocurrency market makes assigning a market value immediate to it difficult. Anyone virtual currency transfer involved in a “hard fork” transaction, should seek professional advice as to how to report the transaction.
Finally, another transaction unique to cryptocurrency is the airdrop. IRS Rev. Rul. 2019-24 explains that investors who receive an “airdrop” of units of new virtual currency to their digital wallet after a hard fork realize ordinary gross income on the date the new currency is received regardless of whether that currency is converted into U.S. dollars.
The challenge with this treatment is taxpayers may not be aware that an airdrop has occurred.
Virtual Currency Received for Services
If an investor receives virtual currency in exchange for services, the income is the fair market value of the virtual currency on the date acquired and is possibly subject to self-employment tax. The foundation for this can be found in Internal Revenue Code Section 83. Under Section 83, which deals with property transferred in connection with performance of services, property transferred in exchange for services is immediately taxable at the time the property is transferable or there is not a substantial risk of forfeiture. In the virtual currency context, this would occur when the cryptocurrency is credited and available for transfer in exchange for the service.
Revenue Rule 80-52 provides additional guidance for virtual currency exchanged for services. Revenue Rule 80-52 discusses a barter club that uses “credit units” as a medium of exchange. The club debited or credited members’ accounts for goods or services received or rendered to other members. The ruling stated as follows:
In this case, A, B, and C received income in the form of a valuable right represented by credit units that can be used immediately to purchase goods or services offered by other members of the barter club. There are no restrictions on their use of the credit units because A, B, and C are free to use the credit units to produce goods or services when the credit units are credited to their accounts.
Consequently, according to Revenue Ruling 80-52, members receiving credit to their barter club were required to recognize income pursuant to Section 83 of the Internal Revenue Code.
The Reporting of Cryptocurrency on an Individual Income Tax Return
The IRS is starting to track and enforce cryptocurrency compliance regarding virtual currency transactions. The individual 1040 tax returns require taxpayers to answer a yes or no questions regarding whether the taxpayer was involved in the transfer of virtual currencies. Capital gains and losses are reported on Form 8949 and on Schedule D of the Form 1040 for individual taxpayers. Ordinary income received from cryptocurrency is reported on Schedule 1 of Form 1040 for individuals. It should be noted if an individual is in the trade or business of acquiring and selling cryptocurrency, than he or she may have additional filing requirements.
Foreign Informational Return Reporting Consideration
It has been somewhat ambiguous whether virtual currency transactions are required to be reported on Form 8938 or FinCen Form 114 (also known as “FBAR”). These forms are required for the disclosure of foreign bank accounts or assets.
Taxpayers with specified foreign assets that exceed certain thresholds must report those assets to the IRS on Form 8938, Statement of Specified Foreign Financial Assets, which is filed with an income tax return. A specified foreign financial asset includes financial accounts maintained by a foreign financial institution or the following foreign financial assets if they are held for investment and not held in an account maintained by a financial institution: 1) stock or securities issued by someone that is not a U.S. person (including stock or securities issued by a person organized under the laws of a U.S. possession); 2) any interest in a foreign entity; and 3) any financial instrument or contract that has an issuer or counterparty that is not a U.S. person. Cryptocurrency cannot be considered stock, security, or an interest in a foreign corporation. However, cryptocurrency may be considered a “financial instrument or contract that has an issuer or counterparty that is not a U.S. person.” Virtual currencies like Bitcoin and Ethereum only exist as digital representations of value. However, cryptocurrency has also been referred to as “smart contracts.” This is because virtual currencies are legally enforceable contracts which translate programming code into written blockchain for autonomous execution and enforcement. Under this broad and expanding definition of cryptocurrency, many U.S. cypocurreny will likely have an 8938 filing requirement.
FBARs are used to report a U.S. person’s financial accounts in a foreign country. Under the current FBAR regulations, a U.S. person is not required to report cryptocurrency on an FBAR. However, on December 30, 2020, the Financial Crimes Enforcement Network (“FinCEN”) published the following guidance:
“Currency, the Report of Foreign Bank and Financial Accounts (FBAR) regulations do not define a foreign account holding virtual currency as a type of reportable account. (See 31 C.F.R. 1010.350(c)). For that reason, at this time, a foreign account holding virtual currency is not reportable on the FBAR (unless it is a reportable account under 31 C.F.R. 1010.350 because it holds reportable assets besides virtual currency). However, FinCEN intends to propose to amend the regulations implementing the Bank Secrecy Act (BSA) regarding reports of foreign financial accounts (FBAR) to include virtual currency as a type of reportable account under 31 C.F.R. 1010.350.” See FinCEN Notice 2020-2.
With FinCEN providing notice that cryptocurrency reporting change is coming for purposes of the FBAR, virtual currency holders must understand that their filing requirements with the IRS will likely increase in the very near future.
Overall, cryptocurrency is still an emerging asset class with a largely undefined tax framework. As a result, little authoritative guidance is available for investors with respect to basis tracking. Thus, cryptocurrency investors should adopt a method that is both thorough and consistent on what is known about the current law, until further guidance becomes available. Investors should seek guidance from an experienced tax professional.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.