Cryptocurrencies have gone mainstream.
For example, you can use bitcoin to buy far more than you would think. To see, try googling “What can I buy with bitcoin?” You will get more than 350,000 hits.
But using cryptocurrencies has federal income tax implications that may surprise you.
The price of bitcoins soared and declined over the last year. With the increasing acceptance of bitcoins and other cryptocurrencies as forms of payment, the tax implications of using cryptocurrencies are a hot-button issue for the IRS.
What Is Cryptocurrency?
Cryptocurrency is “digital money” usually issued and controlled by software developers and accepted as payment by willing parties.
Also known as virtual currencies, cryptocurrencies can be transferred, stored for future use, held for investment, or traded electronically.
Bitcoin is the most well-known example. Unlike conventional currencies such as the U. S. dollar or the euro, cryptocurrencies are essentially unregulated. The rules are constantly changing as governments worldwide try to deal with this new way of exchange.
The most common way to obtain cryptocurrencies such as bitcoin is through cryptocurrency ATMs or online exchanges, which typically charge nominal transaction fees.
Some businesses happily accept payment in cryptocurrencies to avoid the transaction fees charged by credit card companies and online payment processing services such as PayPal.
Though cryptocurrencies are basically unregulated, every cryptocurrency transaction is digitally recorded in a distributed public ledger, such as a blockchain. Anyone can download a copy of the blockchain to trace the path of cryptocurrency transactions.
Distributed ledger technology uses independent digital systems to record, share, and synchronize transactions, the details of which are recorded in multiple places simultaneously with no central data store or administrative functionality.
IRS Wants to Know About your Cryptocurrency Transactions
The 2020 version of IRS Form 1040 (the form you recently filed or will file soon) asks whether you received, sold, sent, exchanged, or otherwise acquired—at any time during the year—any financial interest in any virtual currency. If you did, you are supposed to check the “Yes” box.
The fact that this question appears on page 1 of Form 1040, right below the lines for supplying taxpayer information such as your name and address, indicates that the IRS is getting serious about enforcing compliance with the applicable tax rules.
The 2020 Form 1040 instructions clarify that virtual currency transactions for which you should check the “Yes” box include but are not limited to
- the receipt or transfer of virtual currency for free (i.e., without having to pay),
- the exchange of virtual currency for goods or services,
- the sale of virtual currency,
- the exchange of virtual currency for other property, and
- the disposition of financial interest in virtual currency.
If you fail to report cryptocurrency transactions on your Form 1040 and get audited, you could face interest and penalties and even criminal prosecution in extreme cases.
How to Report Cryptocurrency Transactions
The IRS takes the position that cryptocurrency is “property” for federal income tax purposes. Because it is property, you recognize and report taxable gain or loss when you exchange cryptocurrency for goods or services, U.S. dollars, euros, different cryptocurrencies, or other currencies.
To calculate your federal income tax from a cryptocurrency transaction,
- you first must calculate the fair market value (FMV), measured in U.S. dollars, of the cryptocurrency on the date you receive it and,
- you need to calculate the FMV again on the date you use it to pay something.
The difference between the FMV on the date of receipt and the payment date is your taxable gain or loss.
When you exchange cryptocurrency for other property, including U.S. dollars, a different cryptocurrency, services, or whatever, you must recognize taxable gain or loss just as you do when you make a stock sale in your taxable brokerage account.
- You’ll have a taxable gain if the FMV of what you receive exceeds your basis in the cryptocurrency exchange.
- You’ll have a taxable loss if the FMV of what you receive is less than your basis in the cryptocurrency.
It is hard to imagine that a cryptocurrency holding will be classified for federal income tax purposes as anything other than a capital asset—even if you use it to conduct business or personal transactions, as opposed to holding it for investment. Therefore, the taxable gain or loss from exchanging a cryptocurrency will be a short-term capital gain or loss or a long-term capital gain or loss, depending on how long you held the cryptocurrency before using it in a transaction.
Example. You use one bitcoin to buy tax-deductible supplies for your sole proprietorship business. On the date of the purchase, bitcoins are worth $55,000 each. So, you have a business deduction of $55,000.
But there’s another piece to this transaction: the tax gain or loss from holding the bitcoin and then spending it.
Say you bought the bitcoin in January of this year for only $31,000. You have a $24,000 taxable gain from appreciation in the value of the bitcoin ($55,000 - $31,000). The $24,000 gain is a short-term capital gain because you did not hold the bitcoin for more than one year.
You Must Keep Detailed Records of Every Transaction
Detailed records are essential for compliance. Your records should include
- the date when you received the cryptocurrency,
- its FMV on the date of receipt,
- the FMV on the date you exchanged it (for U.S. dollars or any other currency),
- the cryptocurrency trading exchange that you used to determine FMV, and
- your purpose for holding the currency (business, investment, or personal use).
Tracking your transactions can be done on a spreadsheet. However, if you do more than dabble in cryptocurrencies, you should consider purchasing or subscribing to software to keep track of your purchases and sales. A quick Internet search will show available products: