Cryptocurrency is an incredible new way to invest. As such, taxes are currently difficult to navigate. This is a collection of advice and information from lawyers and cryptocurrency exchange websites to help guide you into making sure you are reporting your investments correctly.
This post is intended for a layman audience. If you are a tax professional or want a detailed examination of this topic, you may find this post lacking.This post does not address aggressive tax planning strategies. Such strategies are a lot of fun to discuss, but they do not belong in this type of post. If you are interested in such strategies, consult with a tax attorney whom specializes in cryptocurrency or investments.
This post was created for general guidance on matters of interest only, and does not constitute legal advice. You should not act upon the information contained in this publication without obtaining specific advice from a tax professional. No representation or warranty (expressed or implied) is given as to the accuracy or completeness of the information contained in this post, and I do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this post or for any decision based on it.
CIRCULAR 230 DISCLOSURE To ensure compliance with requirements imposed by the IRS, I inform you that any U.S. federal tax advice in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
Is cryptocurrency taxable?
Yes. The gains you make on Bitcoin are taxable. This is one of the only unequivocal answers you’ll find in this post. All income is taxable, regardless of source or form, unless the Internal Revenue Code specifically states otherwise. Bitcoins present a lot of interesting tax questions, but whether gains are taxable is not one of them.
When are my gains on cryptocurrency taxable?
Gains are taxable in the year they are realized. Realization occurs when you exchange cryptocurrency for any type of other property; such as cash, merchandise, or services. This includes everything from haircuts to yachts. Essentially, any transaction involving cryptocurrency is a realization event and triggers taxable gain. Note: IRS Notice 2014-21 expressly confirms this treatment.
Because I’ve seen a lot of misinformation on this point, I want to make myself perfectly clear. If you own cryptocurrencies that have appreciated in value, you cannot use them to purchase goods or services without realizing gain. Such a purchase is an accession to wealth. It puts you in the same position as if you had first sold the cryptocurrencies for cash and then used the proceeds to purchase the goods or services directly. Yet, one would be a taxable transaction while the other would not? The IRS would never tolerate such a blatant loophole, and neither would the courts. In fact, this exact argument has already been rejected for other types of assets. The outcome for cryptocurrencies will be the same.
Unfortunately, this has some serious implications for the future of cryptocurrency. I have to question the effectiveness of cryptocurrency as a medium of exchange when the user has to calculate his or her tax liability on every single transaction. As the saying goes, the power to tax is the power to destroy, and this is no exception.
Note: There is a code section that might provide some relief here, but only if cryptocurrencies are categorized as a foreign currency. Under this code section, the use of cryptocurrency to buy goods and services would be tax free as long as the transaction was personal (i.e. not for business or investment) and did not generate more than $200 of gain. Unfortunately, the IRS ruled in Notice 2014-21 that cryptocurrency is not a currency for tax purposes. So, this code section is inapplicable unless the IRS changes its position sometime in the future.
What if I sell my cryptocurrencies but do not withdraw the proceeds from the exchange?
It doesn’t matter, your gains were realized the moment you sold them. It is irrelevant whether the proceeds from the sale are kept in your bank account or your exchange account, you still have a realized gain for tax purposes.
What if I exchange my cryptocurrencies for different altcoins? Is this a like-kind exchange?
This is a fair question and implicates what is known as a “like-kind exchange.” Under Section 1031 of the tax code, exchanges of like-kind property do not trigger recognition of capital gains, and therefore are tax-free. Whether or not bitcoins/altoins are like-kind is uncertain to say the least. As intangible property, bitcoins/altcoins would qualify as like-kind only if they have the same rights, characteristics, and obligations. This is a very difficult test to apply to virtual currency.
Although nothing is for certain when it comes to cryptocurrency, I’m fairly confident that the IRS would not agree with like-kind treatment and you run the risk of having the unrecognized gains added to your tax return (with penalties and interest added). Thus, I would not suggest that you try to qualify such a transaction as a like kind exchange until further guidance on this issue is given by the IRS or you obtain a tax opinion letter from an attorney concluding that your treatment of bitcoins/altcoins as like-kind appropriate.
Lastly, keep in mind that like-kind exchanges must still be reported on your tax return (using Form 8824).
edit: IRS Notice 2014-21 concluded that bitcoins are not a foreign currency, therefore it is possible that bitcoin can qualify for like-kind treatment if the “rights and characteristics” test is met.
How can I avoid realizing gains on my cryptocurrency?
The only way to avoid realization is to hold your cryptocurrencies without selling or exchanging them. Whether you decide to actually report you realized gains is of course a different matter, but as far as the law is concerned, you have realized gains upon any sale or exchange of your cryptocurrencies.
How does the IRS know about my gains?
The IRS only knows what it is told. This means that it has no knowledge of your cryptocurrency transactions unless someone tells them.
Here are four way that can happen.
First, your cryptocurrency exchange or payment processor may report your transactions to the IRS. This would be done with a Form 1099, which you’ve probably encountered at one time or another in a different context. However, it does not appear that cryptocurrency transactions are currently subject to the 1099 reporting requirements (although that will probably change). Thus, unless they voluntarily file a 1099 against you, it is unlikely that the IRS will receive a report of your cryptocurrency transactions. Note that they would need your social security number to file a 1099 in your name. IRS Notice 2014-21 clarifies that “payment settlors” who convert cryptocurrency payments to cash for merchants will have to file 1099s. IF you are not a merchant, than this does not impact you.
Second, your bank or cryptocurrency exchange might file a Suspicious Activity Report (“SAR”). US banks and cryptocurrency exchanges are required to file SARs for wire transfers that are “suspicious” and larger than $5,000 ($2,000 in the case of cryptocurrency exchanges). The meaning of “suspicious” is very vague and highly discretionary. Out of an abundance of caution, many banks automatically treat all international transfer as “suspicious.” So, if you’ve sent or received a wire transfer of more than $5,000 to/from an international cryptocurrency exchange like Mt. Gox or BTC-e, you can be pretty sure that your bank has already filed a SAR against you (although they are prohibited from telling you if they did, so you’ll never know for sure). The larger and/or more frequent you SAR filings, the more likely they will become a legitimate red flag and trigger an investigation. Although FinCEN is generally concerned with money laundering activities, the IRS does have access to FinCEN filings and it is common for IRS special agents to participate in FinCEN investigations.
Third, someone can rat you out to the IRS, which happens far more often than you might think. The simple fact is that people get jealous, and if they’ve heard that you’ve made lots of tax free money with cryptocurrency, they might get tempted to make sure justice is served. There’s also that nice reward the IRS will pay them for snitching.
Fourth, you voluntarily and accurately report your gains on your tax return. That might sound ridiculous to some people given the inherent anonymity of cryptocurrency, but there are some very rich people in prison right now who used to think the same thing about their Swiss bank accounts. The fact is that penalties for failing to report income are significant. This includes the possibility of criminal prosecution. You can also add to this the additional penalties for failing to report foreign financial accounts (discussed below), which can be even more severe.
How do I calculate my gain or loss?
Gain or loss is calculated first on each cryptocurrency transaction, then on an aggregate basis by combining all your gains and losses to produce a net figure. Your tax preparation software will automatically perform these calculations, so the actual mechanics aren’t really necessary for you to understand. However, you’ll have to know the basics in order to enter the correct information into the software.
Basically, gain or loss is computed by taking the sales price of each cryptocurrency and subtracting its cost. The technical terms are “amount realized” and “basis.” Although simple in concept, determining amount realized and basis can be quite complex, as we’ll see below.
This is especially important even if you are using crypto to make income passively.
What is my Basis?
Generally, basis is equal to cost. So, if you purchase 1 BTC for $500, then your basis is $500. You can also add to this amount any acquisition costs like broker commissions or wire transfer fees. So, let’s assume a 1% fee and a $5 wire transfer fee. This would mean your basis is $500 + $5 + $5 = $510.00. If you later sell that cryptocurrency for $900, your gain would be [$900] – [$510] = [$390].
How do I determine my basis in each cryptocurrency?
If you’ve acquired cryptocurrencies at different times and at different prices, determining basis can be quite complex. This is because cryptocurrencies are fungible. Once a cryptocurrency is purchased, it becomes indistinguishable from the other cryptocurrencies stored in the same wallet or account. In a subsequent sale or exchange, there is no way to trace the cost or acquisition date of the cryptocurrency being transferred out.
Contrary to what you might have heard, it is not acceptable to arbitrarily choose the cryptocurrency with the highest cost or most preferable tax impact. The IRS requires you to use a system with rules that will produce a reasonable and consistent result. The default system (and the one generally preferred by the IRS) is to assume that your cryptocurrencies are sold in the order they were acquired. Thus, the first cryptocurrency you purchase is assumed to be first cryptocurrency you sell. This is called the FIFO method (“First in, First Out”).
There are some other methods available, such as LIFO (“Last In, First Out”) and Average Cost Basis, but it’s not clear if cryptocurrencies are eligible for these alternatives. So, I would caution against using any system other than FIFO without guidance from a tax advisor or instructions from the IRS. Note: If cryptocurrencies are classified as a foreign currency, then it becomes possible to use any method you want, as long as the chosen method is reasonable, you use it year-to-year, and it does not always give you the cryptocurrency with the highest cost available. As discussed below, it is still uncertain whether cryptocurrencies can qualify as a foreign currency, so again I must urge caution in deciding to take this position. Edit: IRS Notice 2014-21 clarified that cryptocurrencies are not a foreign currency for income tax purposes.
I’ll note that it’s theoretically possible to avoid this problem altogether if you keep each and every cryptocurrency purchase in separate wallets or accounts. This would allow you to trace the actual cost of each cryptocurrency you later sell or exchange, alleviating the need for the FIFO (or alternative) method.
Either way, determining cost will require some detailed record keeping. I will discuss record keeping in more detail below, but remember that the burden to prove basis is on you. The IRS will not give you the benefit of the doubt here. If you cannot prove the cost of each cryptocurrency, they will assume it was $0. Obviously you don’t want that to happen, so keep good records of your cryptocurrency purchases.
I mined my cryptocurrencies, what is my basis then?
IRS Notice 2014-21 clarifies the treatment for cryptocurrency miners. Specifically, miners must recognize income for each cryptocurrency mined during the taxable year. The amount of income is equal to the market price of cryptocurrency on the day it is awarded on the blockchain. This also becomes the miner’s basis in the cryptocurrency going forward and will be used to calculate gain/loss in the future when the cryptocurrency is sold.
For example, assume you mine 1 cryptocurrency in 2013. On the day it was mined, the market price of cryptocurrency was $1,000. You have $1,000 of taxable income in 2013. Going forward, your basis in the cryptocurrency is $1,000. If you later sell the cryptocurrency for $1,200, you have a taxable gain of $1,200 – $1,000 = $200. See below for the character of this gain.
You mining expenses, such as electricity, would not be included into basis. Instead, they would be deductible in the taxable year as an expense. Miners will need to determine if their mining activity rises to the level of a trade or business, which is a highly factual determination.
This is a very difficult question to answer with any degree of certainty. The problem is that cryptocurrency mining is a completely unique activity that yields an even more unique product. To reach an answer, one must resolve some difficult tax issues. Namely, what is cryptocurrency mining and how do we classify the cryptocurrencies it produces?
Unfortunately, addressing these two issues would be a lengthy and detailed post in itself, so I cannot fully address them here. Suffice it to say that cryptocurrency miners will need a very competent tax advisor to make sure their gains are properly reported.
Not to leave you without any guidance whatsoever, the answer will most likely depend on the size and scope of your mining activity. Large scale miners should probably treat themselves as a manufacturing business, and the cryptocurrencies they produce as inventory held for sale to customers. Such cryptocurrency miners would not determine their gains in the same manner as normal investors. They would compute income at the end of the year by figuring their total sales and then subtracting “cost of goods sold.” The latter would take into account the cost of producing cryptocurrencies, such as electricity. Other expenses, like depreciation on the mining rig, would presumably be deductible as an ordinary business expenses. Obviously this implicates some complex accounting rules that are far beyond this post. A tax advisor with some knowledge of these rules would be needed to accurately determine your tax liability.
Smaller mining operations can probably get away with treating their mining as an “activity for the production of income,” as opposed to a manufacturing business. In such a case, they would follow the same rules for determining gain or loss as normal investors. I suspect their basis in this case would be determined by allocating their mining costs on a pro rata basis, assuming they can reasonably track and allocate such expenses (like electricity). The safest and most conservative approach, on the other hand, would be to use a basis of zero. Depreciation and other indirect expenses would likely be deductible as an itemized expense, similar to a general investor (see below).
I must emphasize that neither of these treatments is a perfect fit. I expect different tax advisors to reach different conclusions on the correct treatment. The goal in any case is to use the best method of matching income to expenses, whatever that is. Presumably the IRS will respect your chosen method as long as you can convincingly argue that it is the best at accomplishing this goal.
I received my cryptocurrencies as payment, what is my basis then?
If you sell goods or services and accept cryptocurrency as payment, your basis in those cryptocurrencies is equal their fair market value at the time they were received. Generally, this is determined by reference to the average market price on that day. Thus, if you wrote a software program for someone and received 1 BTC as payment on November 1st, your basis in those cryptocurrencies is equal to the average price of 1 BTC on that day.
The choice of which exchange to use for this purpose (e.g. Mt. Gox, Bitstamp, etc.) is up to you. Whichever exchange you choose, you should have a reasonable explanation for your choice. You should also stick with that choice when computing your gains in the future. Arbitrarily picking exchange prices that best suit your tax interests will not be acceptable to the IRS in a subsequent audit.
I received my cryptocurrencies as a gift, what is my basis then?
It depends. Generally, you inherit the basis of anything given to you as a gift. This means you would take the same basis as the friend who gave you the cryptocurrencies. However, an important exception applies if the friend’s basis was more than the market value of the cryptocurrencies at the time of the gift (i.e. the cryptocurrencies had a built in loss).
In that case, you would wait to determine your basis until you sell or exchange the gifted cryptocurrencies in the future. When the time comes, you would use the following rules:
First, calculate your gain/loss using your friend’s basis.
If this results in a gain, then the default rule applies and nothing changes.
If this results in a loss, however, then you do not inherit your friend’s basis. Instead, you must use the market value of the cryptocurrencies on the date of the gift and recalculate your gains/loss.
After recalculating, you must check if you still have a loss. If yes, then proceed with using the market value as your basis. However, if the recalculation results in a gain, then the tax law says to ignore the gain and report nothing. To be clear, you have no gain or loss in this situation.
Now that last point might confuse many readers, so here is an example to demonstrate. Assume you received cryptocurrencies worth $750 at the time of the gift. Your friend’s basis was $1000. This triggers the exception discussed above and you have to wait until you sell the cryptocurrencies in the future to determine your basis. Consider three alternative sale prices:
Sale Price = $1200. Using your friend’s basis of $1000, this creates a gain of $200. Therefore, you inherit your friend’s basis and have a realized gain of $200. No problem.
Sales Price = $600. Using your friend’s basis of $1000, this creates a loss of $400. Therefore, you cannot inherit your friend’s basis. Instead, you must use the value of the cryptocurrencies on the date of the gift, which was $750. Therefore, you have a loss of $150. No Problem.
Sales Price of $900. Using your friend’s basis of $1000, this creates a loss of $100. Therefore, you cannot use your friend’s basis. Instead, you must recalculate your gain/loss using the value of cryptocurrency on the date of the gift. Now you have a gain of $150. Therefore, you disregard the sale and have no gain or loss to report.
This is a perplexing tax treatment. It might help to think of this rule as preventing your friend from shifting cryptocurrency losses to your tax return. This is why you get to inherit his basis only if it would create a gain on the subsequent sale. If not, then the amount of his loss is extinguished and you get to recognize only the amount of loss that accrued after the gift occurred. This also explains why you would have no gain or loss if the market price of cryptocurrency has increased since the time of the gift but is still less than your friend’s original basis.
In any case, when receiving cryptocurrencies as a gift, make sure to ask the person what his or her basis was in the cryptocurrency, as well as their acquisition date (which you always inherit). Lastly, write down the date of the gift and the market price of cryptocurrencies on that day.
How do I determine Amount Realized (i.e. Sales Price)?
This depends on the transaction and if you sold cryptocurrencies for cash or exchanged them for goods/services.
In the case of a sale, amount realized is equal to sales price, less any selling costs you incur in the transaction (like commissions or wire transfer fees). So, if you sell a cryptocurrency for $900 and incur a 1% transaction fee, your amount realized is $900 – $9 = $891.00.
If you exchanged cryptocurrencies for goods or services (instead of selling them), then amount realized is more complicated. This is essentially a barter transaction, where the default rule is to use the fair market value of the goods or services received in the exchange. For example, if you purchased a laptop on November 29th with cryptocurrencies, your amount realized would be equal to the Fair Market Value of the laptop on that date. The easiest way to determine Fair Market Value is by reference to the sales price, although an alternative method can be used if yields a more accurate value.
Presumably, the sales price of most goods or services will be denominated in dollars (even though payment is made in cryptocurrency). Thus, if the laptop’s price was $1,500, you can safely assume that it’s FMV was also $1,500. If the sales price is denominated in cryptocurrency (instead of dollars), you’ll have to convert it into dollars using the average exchange price on that day. As mentioned above, the choice of which exchange to use for this purpose (e.g. Mt. Gox, Bitstamp, etc.) is up to you. The most conservative option would be to use the price from the exchange that you purchased the cryptocurrency in the first place. Whichever exchange you choose, you should have a reasonable explanation for your choice. You should also stick with that choice when computing your gains in the future. Arbitrarily picking exchange prices that best suit your tax interests will not be acceptable to the IRS in a subsequent audit.
Gain is determined by subtracting basis from amount realized. Basis is generally equal to cost, but special rules must be followed (such as FIFO) if your cryptocurrencies are mixed together. Amount realized is generally equal to sales price. If goods or property were received instead of cash, then amount realized is equal to the FMV of the property received.
Are my gains “capital gains?”
Probably. The first hurdle to clear is the classification of cryptocurrencies as a capital asset, because capital gains treatment applies only to capital assets. This is actually a pretty easy hurdle to clear because the definition of a capital asset includes all forms of property by default, unless specifically excluded. So, if you look at the list of excluded property under § 1221(a) of the code, you’ll see that cryptocurrencies are not excluded by name, nor would they fall within any of the excluded categories. (keep in mind that this is not true if cryptocurrencies are held as inventory in a trade or business, which might be the case if you mine cryptocurrencies, nor is it true if cryptocurrencies are classified as a self-created intangible asset like a copyright or artistic composition, which is unlikely but possible).
Thus, cryptocurrencies are a capital asset in the hands of most taxpayers and qualify for capital gains treatment. If you were lucky enough to buy your cryptocurrencies more than a year ago, then your gains would qualify for the lower preferential tax rate given to long term capital gains (probably 15%, but it depends on your income level).
If you held you cryptocurrencies for one year or less, then the gains are characterized as short term capital gains, which are taxed at ordinary income tax rates (i.e. the same rate as your paycheck).
IRS Notice 2014-21 concluded that cryptocurrencies are not foreign currency.
What if I mined my cryptocurrencies?
IRS Notice 2014-21 clarified that cryptocurrency miners have income in the year the cryptocurrency is mined. The notice is silent as to the character of this income, but it is probably ordinary.
When the miner later sells the cryptocurrency, the gain is also taxable. The character of that gain is probably capital for the reasons discussed above. However, if your mining activity rises to the level of a “trade or business” and you cryptocurrencies can be considered as “inventory held for sale to customers,” than the gain is ordinary income.
Whether your cryptocurrencies are “inventory” depends on the facts and circumstances of your particular situation. Generally, if you sell cryptocurrencies to an exchange, your cryptocurrencies are probably not inventory. If you sell them to a specific person or list of persons/companies, then it’s possible they are inventory. I suggest consulting with a competent tax advisor to determine whether your activity is a “trade or business” and whether your cryptocurrencies are “inventory held for sale to customers.”
What if I’m a “day trader?”
Generally, the tax treatment for day traders is the same as a regular investor. Of course there are exceptions to this rule, such as the mark-to-market regime, but they would not apply to cryptocurrencies without some affirmative directive by the IRS.
There is also the possibility of your day-trading activities rising to the level of an actual business (which would make your gains and losses “ordinary.”) The IRS is extremely stingy when it comes to classifying day-traders in this manner, though, so it’s unlikely you have anything to worry about here. However, you should consult with a tax advisor to be sure about your status.
What if cryptocurrencies are classified as a collectible?
As a collectible, the gains would still be “capital gains,” but the lower tax rate given to long term capital gains would be fixed at 28% (instead of the 15% most taxpayers would use). However, it’s pretty unlikely at this point that cryptocurrencies would be classified as a collectible. First, cryptocurrencies are not specifically named in the code section that defines “collectibles.” Second, collectibles are traditionally limited to tangible assets, whereas cryptocurrencies are intangible assets. (Note: there might be an argument that physical cryptocurrencies, such as those made by Casacius, are “collectibles.” However, that would still require some declaration by the IRS or Congres to make certain). Thus, for now, it’s safe to conclude that cryptocurrencies are not a collectible and regular long-term capital gains treatment applies. Note: IRS Notice 2014-21 is silent as to this issue.
Are cryptocurrencies treated as a foreign currency?
IRS Notice 2014-21 clarifies that cryptocurrencies are not a foreign currency.
As a foreign currency, cryptocurrencies would be disqualified from capital gains treatment (even though still technically a capital asset). In other words, all cryptocurrency gains would be taxable at ordinary income tax rates regardless of holding period. Although this sounds like bad news for cryptocurrency investors, there are some caveats that arguably outweigh the negatives of this outcome .
The biggest is the exception under the foreign currency rules for “personal transactions.” Under this exception, gains of less than $200 are tax free as long as the transaction is not for investment or business purposes. Remember that without this exception, every exchange of cryptocurrencies for goods or services would trigger taxable gain, which creates a significant burden on the use of cryptocurrency for day-to-day transactions. Thus, this exception is a potential game changer for the future of cryptocurrency. Assuming that most consumer transactions would generate less than $200 of gain, there would be no tax consequences to the use of cryptocurrency for personal spending. The implications of this outcome cannot be overstated.
If the gains are greater than $200 (on personal transactions), they are no longer tax free. However, instead of being taxed as ordinary income, the code allows them to be treated as capital gains instead. Thus, the gains would be eligible for the lower tax rate given to long-term capital gains . Although not as significant as the $200 exemption mentioned above, this still offers a benefit to consumers who use cryptocurrency for day-to-day personal transactions.
Just to be clear, any gains on non-personal transactions would be ordinary income. So, investors would lose the lower tax rate given to long-term capital gains. However, this isn’t as bad as it sounds. First, many investors – particularly day traders – do not hold cryptocurrency for longer than one-year anyways, so their tax rate is effectively unchanged. Second, because they are no longer “capital,” cryptocurrency losses would be fully deductible (i.e. not subject to the $3,000 limitation discussed below). Finally, investors stand to benefit indirectly from the $200 exemption mentioned above. That is because this exemption should help propel the wide spread use of cryptocurrency, is likely to be the greatest catalyst for future market appreciation.
Are cryptocurrencies foreign currency?
IRS Notice 2014-21 clarifies that cryptocurrencies are not a foreign currency.
It is impossible to say at this point whether cryptocurrencies are a foreign currency for purposes of income taxation. No US court has directly addressed this issue, nor has the IRS published any guidance . The closest we’ve come is an obscure federal court decision written by a Magistrate judge involving bank fraud chargers (which has nothing to do with taxation) and a ruling by FinCen that cryptocurrency is not a currency. However, the FinCen ruling uses an extremely narrow definition of currency that has no application whatsoever to the issue of taxation.
Thus, cryptocurrency users and tax professionals are left to guess as to it’s proper classification. The conservative approach is to treat cryptocurrency as a normal capital asset until some further guidance is issued by the IRS. This is consistent with the general attitude towards cryptocurrency expressed by the IRS, as well as some notable legal scholarship on the issue. When dealing with uncertainties such as this, it is generally advisable to proceed with the most cautious option available, which would be treating cryptocurrency as a capital asset (not a foreign currency).
This is not to say that you would be without a basis for treating cryptocurrency as a foreign currency. Indeed, cryptocurrencies are intended to serve as a medium exchange and lack any other functional purpose. Unlike gold, silver or other commodities that have served as currency in the past, cryptocurrencies do not have any industrial or commercial usefulness aside from exchange. This arguably makes them much more similar to a currency than a commodity or other capital asset.
Of course, the fact that cryptocurrencies are not minted by any foreign government or bank casts some doubt as to whether they are truly foreign. However, the internal revenue code does not employ the term foreign currency. It distinguishes currency as being functional or nonfunctional. Further, it declares that only the US dollar can be a functional currency. Thus, the fact that cryptocurrency is not produced by a foreign government is not actually relevant, because any currency that is not the US dollar is automatically a non-functional currency and therefore subject to the foreign currency rules.
In the end, the decision of whether to treat cryptocurrencies as a foreign currency is up to you (and your tax advisor). The trouble is that the IRS could subsequently try to undo your elected treatment and assess the additional tax that would result. Of course, it’s possible that the IRS will ultimately agree with your treatment of cryptocurrency as a foreign currency, in which case you would not be at any risk by adopting the treatment early. I wish I could provide a more concrete recommendation here, but at this point it’s just too uncertain.
Your gains are most likely characterized as “capital gains.” If cryptocurrencies are determined to be a foreign currency, the characterization would be different. Additionally, there are other exceptions that might apply (particularly if you are a cryptocurrency miner or a very active day trader).
What happens if end up with an overall loss (instead of a gain) from my cryptocurrencies?
Remember that gains and losses are combined at the end of the year to reach the amount of your “net gain.” If you had more losses than gains, however, then you will end up with a “net loss.” It’s possible that some of you will find yourself in this position. Net losses are deductible on your tax return, but there are some important limitations depending on whether they are characterized as “capital” or “ordinary” (character is discussed above).
Can I deduct my net losses if they are “capital?”
Yes, but subject to a $3,000 maximum per year. This limitation is painfully low if you have substantial losses. Fortunately, any losses in excess of that amount can be carried forward and deducted in subsequent tax years (still subject to the $3,000 maximum each year). There is no limit to how long you carry your capital losses.
Can I deduct my net losses if they are “ordinary?”
Yes. Ordinary losses are fully deductible and not subject to the $3,000 limitation mentioned above. If your net losses are so big that they offset all of your other taxable income, you get to carry the unused losses back two -years (by amending your prior tax returns) as a Net Operating Loss. Any remaining NOL can then be carried forward for an additional twenty years.
Keep in mind that most cryptocurrency holders will not have “ordinary losses.” The only time your losses will be characterized as ordinary is if (1) you are in engaged in a trade or business with cryptocurrencies as inventory (which is possible in the case of cryptocurrency miners, although it is still unresolved), or (2) cryptocurrencies are categorized as a foreign currency and your losses did not arise from a “personal transaction.”
Note: this answer ignores the possibility of passive activity or at-risk limitations, which may be applicable and need to be addressed on a case-by-case basis with a tax professional.
What kind of expenses can I deduct as an investor?
You are permitted to deduct investment related expenses as an “itemized deduction.” However, this deduction is fairly meaningless for most investors. This is because you must actually itemize your deductions instead of taking the standard deduction, which many taxpayers do not. Additionally, such expenses fall within the category of “miscellaneous itemized deduction,” which are only deductible to the extent they exceed 2% of your Adjusted Gross Income. The 2% floor is particularly troublesome because most “miscellaneous itemized deductions” are pretty insignificant, particularly investment related expenses. Recall that you’ve already accounted for commissions and wire transfer fees in determining “amount realized” and “basis.” Your remaining expenses might include:
- Interest paid on funds that you borrowed in order to invest (limited to the amount of your net gains),
- Rent expense for a safety deposit box (this could arguably be extended to include the cost USB drives for cold storage),
- Consulting fees for the tax treatment of cryptocurrency,
- Depreciation on equipment used in the production of income, such as your computer (however, you’ll have to allocate the cost of the equipment between personal use and investment use, which is likely to reduce this deduction substantially in most cases).
In most cases, these deductions will be quite small. Other expenses may or may not be available to you, depending on your specific situation, though. You should consult with your tax advisor to be certain of your deductible expenses. There are also a myriad of resources online if you have questions about what kinds of expenses are deductible by investors.
What kind of expenses can I deduct as a miner?
If your mining operation is substantial and continuous enough to be considered an actual business, then you can deduct all of your ordinary and necessary expenses. This would include the cost of electricity and depreciation on your mining rig, among others. If your mining operation is not substantial or continuous, you would deduct expenses like an ordinary investor.
As mentioned above, the tax treatment of cryptocurrency miners is exceptionally uncertain. So, its important that you obtain the advice of a tax professional with regards to whether or not your activity rises to the level of a trade or business.
What kinds of records should I keep?
You are required to maintain records sufficient for determining the amount of your gain or loss, as well as the holding period of your cryptocurrencies. This is a flexible standard and depends on the circumstances. Ideally, you should maintain a log of all your cryptocurrency acquisitions and dispositions, including the price, date, and related address of each transaction. Many exchanges make this information available to you in the form of a downloadable spreadsheet.
How long should I keep my records?
The IRS can generally go back and audit your tax returns for a period of 3 years. That period is extended to 6 years if your tax return omitted more than 25% of your income. Finally, there is no time limit if you are charged with civil fraud or never filed your tax returns. Thus, it is advisable that you save your records for at least three years after filing your tax return, although you might consider keeping them at least six years to be safe.
What if I don’t maintain records?
You are required by law to maintain records, so failing to do so will result in civil penalties if you are subsequently audited and owe additional tax. This means that if you have no records of your cryptocurrency purchases/acquisitions, you might consider claiming a zero basis and characterize your gains as short-term if you want to avoid penalties. This makes sure you’ve paid the maximum amount of tax possible on your gains, and hence there cannot be any additional tax to which a penalty can attach.
Penalties aside, it is in your best interest to maintain records because the burden is on you to prove your basis. Thus, if you cannot reasonably establish your purchase price, the IRS will assume it is zero. The same goes for holding period (which would cause you to lose the benefit of the lower long term capital gains rate).
This assumption can be disastrous if you engage in a lot of cryptocurrency transactions. For example, consider a day trader who buys $2,000 worth of cryptocurrencies after seeing a specific market signal, which he then sells shortly after for a small profit of $100. He does this once per day. If he is subsequently audited and lacks the necessary documentation to prove his basis, the IRS will assume it was zero. Thus, he would be taxable on $2,100 of gain every single day, instead of just $100. That is a total taxable gain of $766,500 for the year, compared to $36,500if he had kept adequate records. In addition, he would be subject to penalties on top of the additional tax.
The requirements to report foreign accounts are complex and convoluted, such that many taxpayers and tax preparers overlook them entirely. However, the penalties for doing so are severe – even criminal in some cases. Therefore, I feel compelled to address the reporting requirements for foreign accounts even though I rarely see any questions on this issue.
What are the foreign account reporting requirements?
There are two separate reporting requirements under federal law, each created by a different statute (The Bank Secrecy Act and the Foreign Account Tax Compliance Act). Although the exact wording is different between the two statutes, they generally require reporting of financial accounts held at foreign financial institutions. Whether cryptocurrency wallets and exchange accounts fall meet the definitions for these terms is debatable.
Do the reporting requirements apply to cryptocurrencies kept in paper wallets?
Probably not. It’s pretty difficult to imagine that a paper wallet containing your cryptocurrencies would qualify as a “financial account” held at “foreign financial institution”. Thus, it’s fairly safe to assume that paper wallets are not subject to the reporting requirements.
What about accounts at a foreign cryptocurrency exchanges (such as Bitfinex or Cryptopia)?
These are probably subject to the reporting requirements. The answer basically depends on whether foreign cryptocurrency exchanges are “foreign financial institutions,” and whether an account with one of them is indeed a “financial account.”
Unfortunately, an analysis of the specific meanings of these terms and the myriad of regulations that apply is too large of a task for this post. However, I will say that the definitions for these terms are exceptionally broad and you would have a hard time arguing that foreign cryptocurrency exchange accounts are not covered by the reporting requirements. After all, they accept deposits of fiat and provide brokerage services, which are traditional characteristics of a financial accounts and financial institutions.
In any case, it’s advisable to err on the side of caution here. As you’ll see below, the penalties for failing to file foreign account disclosures are tremendously harsh, so it’s likely that you’re better off assuming that you should report such accounts (subject to the minimum balance requirements) until told otherwise. At the very least, you should consult with a tax attorney if you have a foreign cryptocurrency account with a balance higher than the minimum thresholds discussed below. There are many complex strategy considerations here that an attorney can help you navigate.
What about e-wallet accounts (such as blockchain.info)?
These are probably not subject to the reporting requirements, although it depends on the nature of your account. The most important factor is whether you give custody of your cryptocurrencies to the e-wallet provider. If you do, then your e-wallet probably qualifies as a “deposit account,” which would bring it within the reporting requirements. Of course, there is still the question of whether the e-wallet provider is a “financial institution,” but given the extremely broad definitions used by the BSA and FACTA, it’s probably fair to assume that any business accepting deposits on behalf of customers is a “financial institution” – even deposits of cryptocurrencies. Therefore, e-wallet accounts that take custody of your cryptocurrencies are likely subject to the reporting requirements.
On the other hand, if you maintain control of the e-wallet and the provider has no access to your cryptocurrencies, then it’s unlikely your e-wallet is a “financial account.” Without a financial account, you cannot be subject to the reporting requirements.
A good test for whether your account is custodial or noncustodial is to check if you are given a personal key for the wallet. Most custodial e-wallets do not provide you with a personal key, meaning that you must request a transfer of your cryptocurrency, which they then execute. A noncustodial e-wallet, on the other hand, gives you the personal key and you can transfer cryptocurrencies out of the wallet without any interaction with the e-wallet provider. They have no access to your cryptocurrencies and essentially just generate a valid wallet address for you without keeping any control over your account. Therefore, it would be unlikely that they are maintaining an account on your behalf.
Again, though, I must emphasize an abundance of caution here. If your e-wallet account is greater than the minimum thresholds, you should consider talking with a knowledgeable attorney to make sure you are not subject to the reporting requirements.
What is the minimum account balance for reporting the reporting requirements?
Remember there are two separate reporting requirements. The first arises under the Bank Secrecy Act and has a minimum account threshold of $10,000. The test if whether the total aggregate value of all your foreign accounts exceeds $10,000 at any point during the year. If so, you must report the highest balance for each account by filing an FBAR with the IRS. This form is filed separate from your income tax return and must be received by June 30th of each year.
The second filing requirement arises under the Foreign Account Tax Compliance Act (FACTA). This requirement has a minimum threshold of $75,000 during the year, except for the last day of the year when it is lowered to $50,000. Thus, if the aggregate value of your accounts is less than $75,000 during the year, you will still have to report them if their value is greater than $50,000 on December 31st. The reporting is done by filing a Form 8928 with your income tax return. This form reports the highest balance of each account during the year. Note: this is in addition to the FBAR filing.
What is the penalty for failing to file an FBAR?
The penalty for failure to file an FBAR under the BSA varies depending on “willfulness.” If your failure to file was not willful, the penalty is capped $10,000. If your failure was willful, the penalty is the greater of $100,000 or 50% of the highest account balance for each account. Criminal penalties can also apply.
Willfulness is defined generally as the intentional disregard of a known legal duty. The IRS will typically asserts willfulness if you fail to file FBARs in multiple years. Otherwise, the determination will depend on your knowledge, sophistication, and experience as an investor.
What is the penalty for failing to file a Form 8938?
The penalty for failing to file a Form 8938 with your tax return is an automatic $10,000.00, increased up to $60,000 if you fail to file after receiving notice from the IRS. Criminal penalties may also apply.
At the end of the day, the penalties for both the FBAR and Form 8938 are severe. It is not worth the risk of failing to file these forms, just as it is not worth the risk of failing to report your gains.
United States IRS on Taxes via Notice 2014-21
The Internal Revenue Service today issued a notice providing answers to frequently asked questions on virtual currency, such as bitcoin. These FAQs provide basic information on the U.S. federal tax implications of transactions in, or transactions that use, virtual currency.
In some environments, virtual currency operates like “real” currency — i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance — but it does not have legal tender status in any jurisdiction.
Read the full notice here.
Cryptocurrency Exchanges and Taxes
Currently no internal information.
For U.S. users only, Coinbase provides Forms 1099-K to certain business users and GDAX users that have received at least $20,000 cash for sales of cryptocurrency related to at least 200 transactions in a calendar year.
Coinbase also provides a Cost Basis for Taxes report (in beta) which will help with filing your taxes.
Login to your Coinbase account, select Reports from your Accounts page, and generate a Cost Basis for Taxes.