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Income Taxation of Virtual Currency: It's Complex

First Republic Private Weath Management , First Republic Bank
September 23, 2021

  • Greater IRS scrutiny: The IRS has provided reporting and compliance guidance to ensure taxpayers report income and pay the resulting tax.
  • Gains are taxed: Income taxes must be paid on any appreciation when virtual currency is sold as an investment or exchanged or received for a product or service.
  • Professional advice: Taxpayers should seek the advice of a tax professional who specializes in virtual currency before engaging in a transaction.

In the early days of virtual currency, there was no standard for exchanges to report virtual currency transactions,1 and as a result, many taxpayers did not even know they owed taxes. That is starting to change with the IRS enhancing the monitoring of virtual currency as well as providing additional guidance as more taxpayers use virtual currency for financial transactions.

Taxation of Virtual Currency

Sale of Virtual Currency Held as an Investment

When a taxpayer sells virtual currency, capital gain or loss must be recognized on the sale. Short-term capital gain or loss applies to virtual currency held for one year or less, and long-term capital gain or loss applies to virtual currency held for more than one year with the holding period starting the day after the currency was purchased or received. Capital losses may be used to offset capital gains from the sale of other property, and up to $3,000 of unused losses may be used to reduce ordinary income. Any remaining losses may be carried forward and used in future years.2

Capital gain or loss from the sale of virtual currency is calculated by subtracting the adjusted basis in the virtual currency from the net proceeds received from the sale. The adjusted basis is the amount spent in U.S. dollar terms to acquire the virtual currency, including any acquisition costs such as fees and commissions, and is adjusted higher or lower by expenditures, deductions or credits.

When different units of virtual currency are sold, the default method for identifying the liquidated units is first-in, first-out. The specific identification method is also allowed and may be a better method because it may substantially reduce the recognized gain. In order to utilize the specific identification method, the taxpayer must be able to specifically identify the units and substantiate the basis in those units. A specific unit of virtual currency may be identified by documenting the unit’s unique digital identifier, such as a private key, a public key and an address.

Another way is to document the transactions for all units of a specific virtual currency held in a single wallet, account or address. The documentation must include the:

  • Date and time each unit was acquired
  • Basis and fair market value when each unit was acquired
  • Date and time each unit was sold (or exchanged)
  • Fair market value of each unit when sold (or exchanged)
  • Amount of money or value of property received for each unit

Exchange of Virtual Currency for Other Property

When a taxpayer receives virtual currency in exchange for other tangible or intangible property, such as stock, real estate or another virtual currency, capital gain or loss must be recognized. The taxpayer must recognize ordinary gain or loss if the property exchanged is not a capital asset (e.g., inventory used for sale to customers in a trade or business). The gain or loss is the difference between the fair market value of the virtual currency received3 and the adjusted basis in the property. The basis in the virtual currency is its fair market value in U.S. dollars.

Capital gain or loss must also be recognized when the taxpayer receives tangible or intangible property in exchange for virtual currency and the gain or loss is the difference between the fair market value of the property received and the adjusted basis in the virtual currency. The basis in the property is its fair market value.

Example

A taxpayer purchased one bitcoin in January 2020 for $7,000. In June 2021, the taxpayer used the same bitcoin toward the purchase of a new Tesla. Assuming the bitcoin is worth $37,000 on the purchase date (same as the price paid for the car), the taxpayer will realize a long-term capital gain of $30,000, which is taxed at the taxpayer’s long-term capital gains tax rate, the highest rate being 20%. If the Tesla was purchased within 12 months of when the bitcoin was purchased, the taxpayer would realize a short-term capital gain, which is taxed at the taxpayer’s ordinary tax rate, the highest rate being 37%.4

Virtual Currency Received for Services

If a taxpayer receives virtual currency in exchange for performing services, the taxpayer must recognize ordinary income where the income is equal to the fair market value of the virtual currency received in U.S. dollars. If the taxpayer is an employee, the income is subject to federal, state (if applicable), FICA and Medicare taxes. If the taxpayer is an independent contractor, the income is also subject to self-employment tax.5

If a taxpayer pays for services with virtual currency, the payment is considered an exchange and capital gain or loss must be recognized. The gain or loss is the difference between the fair market value of the services received and the adjusted basis in the virtual currency.

Example

The same example as above, except the taxpayer used the bitcoin to pay a self-employed travel agent $37,000 to plan a vacation and include the cost of airfare, hotel accommodations, sightseeing, entertainment, meals and gratuity. The taxpayer will realize $30,000 of long-term capital gain. The travel agent will recognize $37,000 of ordinary income, which is also subject to self-employment tax.

Summary Chart: Taxation of Virtual Currency Ordinary Income  Capital Gain or Loss
Sale of virtual currency held as an investment  No Yes
Virtual currency received in exchange for property (e.g., capital assets) No Yes
Virtual currency received in exchange for property
that is not a capital asset (e.g., inventory
Yes No
Virtual currency paid for property No Yes
Virtual currency received for services Yes No
Virtual currency paid for services No Yes

Air Drops, Forks, Mining and Multiple Wallets

Air drops, forks, mining and having multiple wallets may also present various tax implications or challenges when calculating your overall tax liability. Below is a chart that summarizes what these items are and if they are subject to income tax.

  Air Drops Hard Forks Soft Forks Mining Multiple Wallets
What is it?
When a
company
distributes
its coins to
the wallets of
certain users.
Usually issued
for marketing
purposes.
A software
upgrade that is not compatible
with earlier
versions. Users
must update
to participate
in new
transactions.
New
cryptocurrency
is received.
A software
upgrade that is
compatible with
earlier versions.
It does not
create new
cryptocurrency
as hard forks
do.
When
taxpayers earn
cryptocurrency
by using a
computer
to validate
transactions.
When
cryptocurrency
is moved
between
wallets.
Taxable Income? Yes Yes No Yes No

Gifting Virtual Currency

The fair market value of gifting virtual currency is not taxable income to the taxpayer who made the gift or the recipient of the gift. The taxable event occurs when the virtual currency is sold or exchanged by the recipient. The recipient’s basis is equal to the taxpayer’s basis unless the recipient sells or exchanges the virtual currency at a loss, in which case the basis is equal to the lesser of the taxpayer’s basis or the fair market value of the virtual currency at the time the gift was received. If there is no documentation to substantiate the taxpayer’s basis, the recipient’s basis is zero.

The recipient’s holding period includes the taxpayer’s holding period. If there is no documentation to substantiate the taxpayer’s holding period, the recipient’s holding period starts the day after the gift was received.6

A taxpayer purchased one bitcoin on January 5, 2020, for $7,000. On June 10, 2021, when the same bitcoin was worth $37,000, the taxpayer gifted it to Sam. On June 13, 2021, Sam sold the bitcoin for $38,000. Sam’s basis was $7,000, and the holding period started on January 6, 2020. Sam realized a long-term capital gain of $31,000 that will be taxed at Sam’s long-term capital gain tax rate. There was no taxable income to the taxpayer or Sam when the gift was made.

If the value of the bitcoin on the date of the gift was $6,000 and Sam sold the bitcoin for $5,000, Sam’s basis will be the fair market value of the bitcoin on the date of the gift. Accordingly, Sam will realize a long-term capital loss of $1,000.

Determining the Fair Market Value of Cryptocurrency When Exchanged or Received for Property or Services7

Type of exchange
Cryptocurrency
exchanged
for property or
services.
Cryptocurrency
received in
exchange for
property or
services.
Cryptocurrency
received in a
transaction
facilitated by a
cryptocurrency
exchange.
Cryptocurrency
exchanged in
peer-to-peer
transactions.
Fair market value
of cryptocurrency
As published on
the exchange.
If the value is
not published
or cannot be
determined,
the fair market
value is equal
to the value of
the property
or services
received when
the transaction
occurred.
As published on
the exchange
and included in
income when the
cryptocurrency
was received.
If the value is
not published
or cannot be
determined,
the fair market
value is equal
to the value of
the property
or services
exchanged when
the transaction
occurred.
The amount that
is recorded by
the exchange. If
not recorded on
the distributed
ledger, the fair
market value is
the amount the
cryptocurrency
was trading for at
the date and time
the transaction
would have been
recorded.
Determined as of
the date and time
the transaction
is recorded or
would have been
recorded on
the distributed
ledger.

The type of exchange will determine the fair market value of cryptocurrency. Below is a chart that summarizes the type of exchange and how the fair market value of cryptocurrency is determined.

IRS Involvement in Virtual Currency

The IRS has addressed the taxation of virtual currency in Notice 2014-21, which stated that virtual currency is treated as property for federal tax purposes. Accordingly, tax principles applicable to property transactions apply to virtual currency transactions. Additionally, the IRS has answered questions regarding the tax treatment of virtual currency transactions in Revenue Ruling 2019-24 and a frequently asked questions article. In 2018, it announced a compliance campaign to address tax noncompliance related to the use of virtual currency. A year later the IRS sent letters to more than 10,000 taxpayers who may have failed to report income and pay the resulting tax from virtual currency transactions or did not report their transactions properly. For the 2019 tax year, the IRS asked taxpayers on Schedule 1 of Form 1040 to acknowledge any virtual currency transactions. In 2020, that question was moved to the first page of Form 1040, immediately under the taxpayer’s name and address. Suffice to say that it is now highly unlikely that a taxpayer can claim ignorance for failing to report a virtual currency transaction on their tax return.

Bringing It All Together

Due to the increased popularity of virtual currency, many exchanges now provide the ability to view trading data that can be used to calculate the tax on a transaction. In addition, software and applications are available to monitor transactions and complete the tax forms required to file a tax return. Regardless of the tools utilized to keep track of gains or losses, taxes associated with virtual currency transactions must be paid and they can become quite complex, especially since the laws are constantly evolving. Taxpayers who engage in virtual currency transactions should seek the advice of a tax professional who specializes in cryptocurrency transactions.

Digital and Virtual Currency: What Is It, and How Does It Work?
 
Digital currency is any intangible currency that is only available in electronic form. It is primarily managed, stored or exchanged on digital computer systems, especially over the internet. Virtual currency is a form of digital currency, which is controlled by private issuers and used among the members of a specific virtual community.8
 
Additionally, virtual currency can operate like real currency (e.g., U.S. dollars and euros), but it does not have legal tender status.9,10 It functions as a medium of exchange to pay for goods and services or may be held as an investment. Some virtual currencies have an equivalent value in real currency or act as a substitute for real currency and are referred to as “convertible” virtual currency. The sale or exchange of convertible virtual currency, or the use of such currency to pay for goods or services, may result in federal tax liability.11
 
Unlike regulated currencies that are backed by government-issued currency (e.g., U.S. dollars) or a commodity such as gold, virtual currency is currently an unregulated currency that is not issued or controlled by a central bank.12 The value of virtual currency is mainly moved by the sentiment of traders, often driven by the perceived likelihood of widespread adoption, and most virtual currencies can experience considerable price fluctuations.
 

 

Authored by Paul K. Mutch, Advanced Planner, in June 2021.


1.) Exchanges are still not required to send taxpayers a 1099-B. Some exchanges provide taxpayers with Form 1099-K if during the calendar year gross payments exceeded $20,000 AND there were more than 200 transactions. The American Families Plan would require virtual currency transactions greater than $10,000 to be reported to the IRS. In addition, businesses that receive cryptocurrency with a fair market value of more than $10,000 would also have to report the assets to the IRS. The Build America Act of 2021, also known as the infrastructure bill, has additional reporting requirements for cryptocurrency transactions and cryptocurrency brokers.

2.) Given that cryptocurrency is classified as a commodity by the SEC and property by the IRS, it is not a security and therefore not subject to the wash-sale rules. Under the wash-sale rules, you may not take a deduction for a realized loss upon the sale of stock or securities if, within a period beginning 30 days before the date of the sale and ending 30 days after that date, you have acquired the same or substantially identical stock or securities. Accordingly, taxpayers may sell cryptocurrency at a loss and use that loss to mitigate or even eliminate their overall capital gains tax burden. Secondly, they can immediately buy back into the cryptocurrency they sold to recapture future appreciation.

3.) Fair market value is determined when the transaction is recorded on the distributed ledger.

4.) This does not account for the 3.8% surtax.

5.) Companies also have responsibilities. For example, virtual currency paid to an employee must be included in the employee’s W-2. A 1099 should be issued to an independent contractor who received virtual currency payments of at least $600.

6.) A taxpayer should also be aware of the potential gift tax consequences of making a gift of virtual currency. The gift tax rules go beyond the scope of this article and are not discussed.

7.) Fair market value is determined in U.S. dollars.

8.) There are two types of virtual currency: centralized and decentralized. Centralized virtual currency uses a central administrator to control the system. Decentralized virtual currency uses a distributed system to authenticate transactions. Many decentralized currencies are cryptocurrencies, such as bitcoin, and are based on blockchain networks. A blockchain network links a list of records (known as blocks) with cryptography to control the creation of monetary units and verify the transfer of funds.

9.) Legal tender is anything recognized by law to settle a public or private debt or meet a financial obligation. In the United States, currency that is produced and issued by the U.S. Treasury is legal tender.

10.) On June 9, 2021, El Salvador became the first country to adopt bitcoin as legal tender.

11.) This article does not address state tax consequences.

12.) A central bank digital currency (CBDC) utilizes an electronic record or a digital token to represent a country’s currency in digital form. Several countries are looking into creating CBDCs, although as of the writing of this article, none have. The Federal Reserve plans to publish a paper in the summer of 2021 that will consider the implications of creating and distributing a CBDC.

First Republic Private Wealth Management encompasses First Republic Investment Management, Inc., an SEC-registered Investment Advisor, First Republic Securities Company, LLC, Member FINRA/SIPC, First Republic Trust Company, First Republic Trust Company of Delaware LLC and First Republic Trust Company of Wyoming LLC.
 
The strategies mentioned in this document will often have tax and legal consequences; therefore, it is important to bear in mind that First Republic does not provide tax or legal advice. This information is provided to you “as is,” does not constitute legal advice and is governed by our Terms and Conditions of Use, and we are not acting as your attorney. We make no claims, promises or guarantees about the accuracy, completeness or adequacy of the information contained here. Clients’ tax and legal affairs are their own responsibility. Clients should consult their own attorneys or other tax advisors in order to understand the tax and legal consequences of any strategies mentioned in this document.
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