Throughout our three Silver Advantage Alerts on cryptocurrency, we will cover the following topics:
- A beginner’s guide (introduction) that defines and explains how to invest in cryptocurrency (published on May 31, 2022)
- Tax implications of cryptocurrency transactions
- Financial reporting implications of cryptocurrency transactions
In this installment, we will cover the tax implications of cryptocurrency transactions. If you missed our previous Silver Advantage Alert on cryptocurrency be sure to check it out here. It contains some information that we will build upon throughout this article.
Income Tax Implications
As mentioned in the previous article, the IRS has taken the position that convertible virtual currency is treated as property for federal tax purposes. This does not include virtual currency that can only be used in virtual economies, such as virtual currency in video games. Instead, this is for virtual currencies that are convertible to government-issued currencies such as U.S. dollars, euros, pesos, etc. Further, convertible virtual currencies include virtual currencies that can be used to purchase goods and services in the real economy. This includes cryptocurrencies such as bitcoin, Ethereum, Kraken, etc. For simplicity, we will refer to them generally as “Coins.”
Here are some of the general treatments if you or your business transact with cryptocurrency:
- The disposal of a Coin by either selling it or trading it for a different Coin or in exchange for goods or services is a taxable event. The Coin surrendered is considered sold for the value of the property received (Coin, goods, or services). The difference between that value and the acquisition cost of that Coin is the taxable capital gain or loss. The length of time the Coin was held before its disposal determines whether it is a long- or short-term capital gain or loss.
- The creation of a cryptocurrency is called Mining. When Coins are mined, the miner recognizes taxable ordinary income equal to the fair market value (FMV) of the Coin at the time it is mined. This value becomes the Coin’s cost basis for any subsequent transactions. This treatment is similar if Coins are received for payment of goods or services—the recipient has taxable income equal to the FMV of the Coins received. When that Coin is later sold or traded, the latter transaction results in a capital gain or loss computed on the increase or decrease in value from the date received.
- As noted in our first article, new currencies can be “airdropped,” meaning that these Coins are given for free, often to promote the usage and trade of the new Coin. If Coins are received via AirDrop, then the recipient recognizes ordinary income equal to the FMV of the Coins when received and the new owner can transfer, sell, exchange, or otherwise dispose of the Coins.
Therefore, bitcoin and other virtual currencies should be seen as property that can be exchanged for other properties or services. Taxable events occur every time the cryptocurrencies are exchanged for other Coins, goods, or services.
If you take the perspective that virtual currencies are investment property, it is easier to understand that exchanging one type of virtual currency for another (e.g., bitcoin for Ripple) results in a taxable event.
Another item to note is that one might hold virtual currencies in a virtual wallet and transfer it to another wallet. This should NOT result in a taxable event since there was no exchange of the virtual currency for Coin, goods, or services. Instead, it is more like a wire from one bank account to another. This, of course, assumes that the same type of virtual currency was transferred (i.e., bitcoin in Wallet A went to bitcoin in Wallet B).
There are software/services that will prepare transaction reports that may help facilitate preparing your income tax returns. In addition, some crypto exchanges offer this service. However, note that some exchanges do not capture any transactions for goods and services (e.g., paying for something with bitcoin), or do not properly record the cost basis of the Coins if they were originally transferred from another wallet. This often happens because the transaction did not involve cash (government-issued currency) or Coin. Further, some may erroneously capture the transfer of virtual currencies as taxable transactions when they are in fact, not taxable. Often this happens because the software/service will only analyze one wallet.
If you need a deeper review for tax planning and reporting of your “Coin” activity, our team of experts at MichaelSilver is here to help you. We can be reached at 847.982.0333. Please look to your email over the next few months for the third article of this series.
Carlos Salgado, CPA, MSA – Supervisor, Tax, works with mid-size enterprises focusing on flow-through taxation within a variety of industries, including manufacturing and distribution, professional services, real estate, and retail. He has provided accounting and tax services for over six years, including compliance, tax planning, and management consulting. Carlos is a member of the AICPA and ICPAS.
Ryan Lubinski CPA, CVA, Senior Manager, has over ten years of accounting, auditing and business valuation experience working with businesses in a wide range of industries including manufacturing, automobile dealerships, retail, investment companies, holding companies, and employee benefit plans. He has been one of the key leaders of our team of accounting and assurance professionals.