As cryptocurrencies such as Bitcoin and Ethereum set new all-time highs, more investors become interested in the financial potential of virtual currencies. With the addition of new investors entering the virtual currency market, it is important for taxpayers to stay up to date with the tax requirements associated with this exciting and new technology.
Traditional capital assets, such as stocks and bonds, have a long established and widely understood procedure in regard to their classification and report of transactions. However, the same process of tax reporting has yet to be adopted by many taxpayers in the virtual currency sphere. For example, virtual asset exchange company, Coinbase, has over 8.5 million users and is present in 190 countries worldwide. Yet, despite the size of Coinbase’s user base, in 2013 only 807 of its users filed an 8949, Sales and other Dispositions of Capital Assets, with the Internal Revenue Service (IRS). The number of Coinbase’s users who filed an 8949 increased to 893 in 2014, before falling to 802 in 2015. In response to the lack of tax filing by many Coinbase users, the IRS has sought to summon all Coinbase users in the United States who transferred virtual currency between 2013-2015. Though the outcome of this case has yet to be decided, taxpayers who fail to accurately report the sale or exchange of capital assets are subject to penalties imposed by the IRS, generally.
To help taxpayers with the report of sale and exchange of virtual currency, the IRS published Notice 2014-21, which explains how current tax principles will be applied to transactions using virtual currency. This notice provides guidance to taxpayers who use virtual currency for everyday use, as well as those who use virtual currency for investment purposes.
A taxpayer will have a gain or loss upon the sale or exchange of the virtual currency, similar to the sale or exchange of other property. When the fair market value of the amount received from the sale or exchange of virtual currency exceeds the taxpayer’s net cost for the virtual currency, the taxpayer has a taxable gain. In contrast, the taxpayer has a loss if the fair market value of the amount received from the sale or exchange of the virtual currency is less than the net cost of the virtual currency.
The classification of the gain or loss from the sale or exchange of virtual currency depends on how the virtual currency was held by the taxpayer. Generally, a taxpayer realizes capital gain or capital loss from the sale or exchange of virtual currencies that were held as capital assets. As mentioned above, traditional capital assets include stocks and bonds, but also include other like property held for investment purposes. Therefore, if the virtual currency is held for investment purposes, it will be classified as a capital asset. Alternatively, a taxpayer will realize ordinary gain or ordinary loss from the sale or exchange of virtual currency when the virtual currency is not held as a capital asset, or used for investment purposes. Property, such as inventory, held mainly to be sold to customers in a trade or business is not classified as a capital asset.
In addition to sales and exchanges, taxpayers who mine virtual currency will need to report their earnings from this activity. Once received, the fair market value of the virtual currency, determined as the date of receipt, shall be included in the reporting of the taxpayer’s gross income. Taxpayers who mine virtual currency as part of their trade or business, independent from activity undertaken by the taxpayer as an employee, shall also report these earnings. The earnings generated from mining as in independent trade or business is classified as self-employment income and is subject to the self-employment income tax.
With the adaptation of cryptocurrencies as capital assets, ordinary property, and virtual currency, taxpayers should stay up to date with tax principles to ensure compliance associated with the developing technology.
The information contained in this post is for general information and educational purposes only. The application and impact of laws can vary widely based on the specific facts involved. Given the changing nature of laws, rules and regulations, and the inherent hazards of electronic communication, there may be delays, omissions or inaccuracies in information contained in this publication. Accordingly, the information on this post is provided with the understanding that the author and publishers are not herein engaged in rendering legal, accounting, tax, or other professional advice and services. As such, it should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisers. Before making any decision or taking any action, you should consult a professional.