Tax Implications of Cryptocurrency
Welcome to our 3-part Cryptocurrency articles series where we break down 1) what cryptocurrency (we’ll call it crypto for short) is like you’re 10 years old, 2) how to analyze crypto, and, more importantly, 3) what you need to think about come tax time if you invest in crypto. This is part 3 of the series where our featured guest, Joseph R Buoscio, takes you through the tax implications you should consider when investing in cryptocurrency. Here is Part 1 and Part 2 of the series incase you haven’t gone through it yet.
Uncle Sam and Cryptocurrency
Cryptocurrency has become a pretty hot topic in 2017, with the advent of very explosive, record setting gains. Gains of well over 1,000% have become the norm with investors in cryptocurrency. With all these gains, the cryptocurrency market is beginning to find its way into the vernacular of more traditional investor households. As an example, many people who bought and held large amounts of Bitcoin only several years ago are now sitting on well over a million dollars.
Because of all these jaw dropping gains, it is important to go over some commonly asked issues regarding federal taxation. As a general rule, whenever money is made, Uncle Sam is legally entitled to take his share. This section is a high level overview of some of the many considerations a young investor must take into account before, during, and after taking the plunge into the world of cryptocurrency. Before we dive in, let’s do a quick recap.
Cryptocurrency is a digital currency which utilizes encryption techniques to regulate the generation of units of currency, verifies the transfer of funds, and operates independently of a central bank. The exact cryptography of the coins and their structure is beyond the scope of this article. However, it is important to know that you can exchange dollars for various “coins” on exchanges like Coinbase. You can also hold an account of these coins, called a “wallet.” Furthermore, you can transfer coins to other users as a form of payment or hold and sell them. Just like you would buy and sell stock in a brokerage account. In this regard, coins are like a mixture of fiat currency and equity investments. They can store value like investments but they can also be wired to anyone as a form of payment.
All cryptocurrencies have an equivalent value in fiat currency. In this regard, they act as a substitute for fiat currency. Bitcoin is the most prominent example of a cryptocurrency. Bitcoin can be digitally traded between users and can be purchased for, or exchanged into real or crypto-currencies.
IRS’s general position on Cryptocurreny
The Internal Revenue Service (“IRS”) issued guidance to taxpayers in 2014. IRS Notice 2014-21 says that Bitcoin and other crypto-currencies (Ethereum, Litecoin, XRP, etc.) are to be treated as property, not currency. Therefore, in the eyes of the IRS, cryptocurrencies are not currency, but property. As a result, for federal tax purposes, cryptocurrency is treated just as other property as treated.
Using Cryptocurrency as a Bartering tool
Using crypto as a “currency” (a medium of exchange) is really just a property-for-property exchange, that is taxable. For example, if I acquire one unit of cryptocurrency for 5 dollars, then the value rises to 6 dollars, I have a realized gain of one dollar. If I take that appreciated property and exchange it for a cup of coffee (presumable worth 6 dollars), I owe taxes on that $1 gain. Now let’s say I purchase a 1966 Ford Mustang for $10,000 and its value rises over time to $15,000. If I exchange the Mustang for a boat, the boat’s value, assuming a fair, arm’s length transaction, is $15,000.
I received the boat but I will owe taxes on the $5,000 gain that originated from the car. Unfortunately, the IRS has not made a specific tax form for cryptocurrency transactions. The car-for-boat exchange above, assuming it was a like-kind exchange, is reported via Form 8824. If treated the same way as a like-kind exchange the taxpayer is obligated to keep track of everything. That means his or her basis, quantities, and price appreciations of every class of crypto-coin he or she owns. The coins are still so young that many of these logistical kinks still have to be worked out.
Used as an Investment
For investment purposes, the same concept holds true. Most people are familiar with the whole “buy low, sell high” idea of traditional investing. In other words, most investors know that selling property at a gain results in income, subject to taxation. If a person buys 1 bitcoin for $1,000, that $1,000 price paid is the tax basis of the property. If the value doubles, and that bitcoin is now worth $2,000, the taxpayer has a realized gain of $1,000. This gain is not taxable until the taxpayer sells the bitcoin. If they sell at $2,000, they will disclose the $1,000 gain on their tax return.
The character of this gain depends upon whether the cryptocurrency is a capital asset in the hands of the taxpayer. The sale of property held by an investor is usually capital in nature and assuming this is the case, our hypothetical gain of $1,000 is categorized as a capital gain.
“So what does this mean?”
Capital gains are taxed at a different rate than ordinary income. Ordinary income is taxable at rates ranging from 0% to 39.6%. A good example of ordinary income is your salary, wages, and bonus payments from work. Capital gains and losses are reported on the taxpayer’s Schedule D, which is a component of Form 1040. Generally speaking, capital gain tax rates are lower than ordinary income rates, with a maximum of 20% for top earners. Just remember that these favorable rates are only applicable to investments held for more than a year. If an investor sells his or her coins within a year, it’s taxed at ordinary income tax rates.
Cryptocurrency is taxed like property, not currency…
Because of the IRS’s categorization of cryptocurrency as property, it is important to track one’s basis in every coin a taxpayer buys, sells, or uses. For those buying and selling cryptocurrency as an investment, calculating gains and losses are done the exact same way as buying and selling stock. In a stock transaction, this is pretty simple because when a taxpayer buys stocks, bonds, or funds from a licensed broker, the broker has a legal duty to track the cost and tax basis of the asset acquired.
At the end of the year, the broker sends the investor a Form 1099-B which outlines the assets acquired and the basis and any gain or loss. Because cryptocurrency exchanges are so new, it is entirely possible that they will not send a 1099-B to the investor; as I stated earlier, the details and logistics are still being worked out. For this reason, it is advisable that any crypto-investor or user keep detailed records and tracks his or her cost basis in any coin acquired, sold, or used.
Now you are ready to invest!
And there you have it folks! 3 articles giving you the tools and insight to invest in cryptocurrency. If you’ve only read the 3rd part of our article series, check out part 1 and 2 here. If you loved the content you are reading join the Young Wealth Builders Facebook Group as we strive to be the most engaging personal finance group on FB! Follow us on Twitter and like our Facebook page. We’ve dedicated ourselves to adding value in everyone’s life through multiple channels!
Joseph R Buoscio is a tax attorney and consultant. He believes the best way to give back to his community is to provide people with the tools and insight to shape their own financial goals. Joseph believes strongly in the power of compounded interest and dividends, as well as the virtue of saving and preparing for the future. His accolades include receiving a Bachelor of Arts from Loyola University Chicago, a Masters of Business Administration in Accountancy from DePaul University, as well as a Juris Doctor from DePaul University. He is also a member of the Illinois State Bar. When time permits, he is an avid outdoor enthusiast.