Article contributed by Mark DiMichael, Citrin Cooperman
The IRS has stated that only 800 to 900 taxpayers reported gains on cryptocurrency each year between 2013 and 2015. As a result, the IRS has pursued litigation with Coinbase, Inc. (“Coinbase”), a digital currency wallet and platform, for access to customer records. On November 29, 2017, a federal court judge ordered Coinbase to comply with a summons that requires it to identify 14,355 accounts, all of which performed transactions exceeding $20,000 between 2013 and 2015. Coinbase has stated that it intends to further challenge the court order. However, the IRS has its sight set on cryptocurrency and those early adopters who have profited from it. Furthermore, the IRS has been utilizing bitcoin transaction tracing tools developed by a startup, Chainalysis, Inc., since 2015.
If the IRS’s claims are accurate, thousands of individuals have failed to report cryptocurrency related gains and should have cause for concern. If caught, those individuals subject themselves to interest and accuracy related penalties. Individuals could even be subject to fraud related penalties and jail time if the IRS can prove that 1) an unpaid tax liability exists 2) there was an affirmative act by the defendant to evade or attempt to evade and 3) the defendant had a specific intent to evade a known legal duty to pay.
Cryptocurrencies are a relatively new invention, and misinformation on the topic is rampant. The IRS has issued a brief six-page memo entitled IRS Notice 2014-21, which arguably raises as many questions as it answers. However, if the taxpayer has made money (or lost money) on cryptocurrency, there is information they need to know.
If a Taxpayer Purchased and Sold Cryptocurrency for Investment Purposes
As per the IRS, for federal tax purposes, virtual currency is considered property. Purchasing cryptocurrency is not a taxable event. Instead, the taxable event occurs upon the disposition of that cryptocurrency.
If an individual taxpayer sells cryptocurrency for a gain, that gain is taxable and should be reported in the year of the sale. That gain can be considered a short-term gain, if the cryptocurrency is held under a year, or a long-term gain if it is held over a year. Short term gains are taxed at the ordinary income rate, whereas long term gains can receive a reduced “capital gains” tax rate (so long as that individual is not in the business of buying and selling cryptocurrencies).
If a taxpayer sells cryptocurrency for a loss, that loss is deductible. (That is assuming the taxpayer has other capital gains to offset the losses. If they do not, the yearly limit on capital losses that an individual can deduct is $3,000, or $1,500 if filing as married filing separately.)
Exchanging One Cryptocurrency for Another
There is a fair argument that trading one cryptocurrency for another cryptocurrency qualifies for a deferral of gain, under IRS Section 1031. The intricate rules behind a 1031 Exchange and whether a cryptocurrency exchange would qualify has been debated by Forbes and other blogs/articles. If one were to attempt to utilize the 1031 Exchange position with the IRS, they would have to file a form 8824 with their tax return to identify that exchange. However, the 1031 Exchange could very well be challenged by the IRS. Tax courts have historically held that gold and silver, although both precious metals, are not like-kind assets that can qualify for a 1031 Exchange. Tax Courts may feel the same about two different cryptocurrencies (particularly trading a pure cryptocurrency like bitcoin with a utility token). A taxpayer attempting to use a 1031 Exchange might end up in tax court with a questionable position.
However, going forward, Section 1031 Exchanges apply to only real estate assets as a result of the Tax Cuts and Jobs Act. So, this particular position may never have its day in court and is no longer a usable position in 2018 and beyond.
If the Taxpayer Spends Cryptocurrency
As mentioned previously, the IRS considers cryptocurrency to be property, not currency. The result of this is an unusually burdensome tax reporting requirement. If a taxpayer spends cryptocurrency on goods or services, the IRS considers it a sale of that cryptocurrency and a taxable event.
For example, consider an individual that purchased one bitcoin for $10,000 and then spent 0.1BTC on goods or services when bitcoin was trading at $11,000. The gain computation is as follows:
Value at Disposition $11,000 X 0.1BTC = $1,100
Less: Basis $10,000 X 0.1BTC = ($1,000)
Taxable Capital Gain $100
In the case of a loss, losses on property held for personal use are not deductible, except in the case of a casualty or theft. As a result, taxpayers who utilize cryptocurrency for purchases have the disadvantage of having to pay taxes on their gains, combined with an inability to deduct their losses. As a result, there is currently a bill introduced in the House of Representatives by Rep. Jared Polis (D-CO) and Rep. David Schweikert (R-AZ), which stipulates that transactions under $600 be considered tax-exempt. This legislation, if it passes, could go a long way towards allowing the utilization of cryptocurrency on a day to day basis, without unusually burdensome tax reporting requirements.
If the Taxpayer Receives Cryptocurrency as Payment for Goods or Services
A taxpayer who receives cryptocurrency in return for goods or services must pay income taxes on the fair market value of the cryptocurrency, measured in US dollars, as of the date that the cryptocurrency was received. This payment is normally reported on a 1099 (where the 1099 should reflect the fair market value of the cryptocurrency as of the date(s) it was paid).
Individuals and businesses that “mine” cryptocurrency are also required to value and report that income as of the date it was received. That value of the cryptocurrency, as of the date it is received, is then considered the taxpayer’s “basis” in the cryptocurrency, which is utilized in future gain or loss calculations.
What to do
If a taxpayer has gains from cryptocurrency, the IRS does not plan to drop this issue. In the event the IRS can prove tax fraud, there is no statute of limitations. The safest option for the taxpayers is to amend their historical tax returns and pay any taxes, interest, and penalties due. The IRS looks favorably on self-reporting and will often take information at face value. On the flip side, once an audit has commenced, the IRS will be less lenient, and will likely be looking to make examples of the first few individuals they catch.
Mark DiMichael is a director in Citrin Cooperman’s valuation and forensic services department, specializes in litigation support and valuation services. He can be reached at firstname.lastname@example.org.
Citrin Cooperman is among the largest, full-service assurance, tax, and business advisory firms in the United States, having steadily built its business serving a diverse and loyal clientele since 1979. Rooted in our core values, we provide a comprehensive, integrated business approach to traditional services, which includes proactive insights throughout the lifecycle of our clients wherever they do business, across the globe.