The ever-changing market of cryptocurrencies presents an array of new tax challenges and the IRS has been urgently training its examiners to handle them. As quickly as miners create cryptocurrencies and investors buy and sell them all over the world, taxable events can occur every step of the way. Users of “virtual currencies”, the IRS’s term for cryptocurrencies, should be aware of the tax implications early on in order to comply with federal and state tax law to avoid potentially significant penalties.
What do cryptocurrency users need to keep in mind when making transactions?
Although substantial media attention and frequent discussions have centered on cryptocurrency for some time, the IRS still hasn’t provided guidance on every type of transaction relating to this new commodity. Although the word “currency” is in the name, virtual currencies are not treated as a form of currency for federal tax purposes. Instead, they are treated as property and must be accounted for and tracked similarly to any other capital asset. However, there are numerous types of cryptocurrency transactions and they don’t always follow the same guidelines.
As virtual currencies are purchased and sold, created by miners, exchanged for goods and services, and in some cases used as compensation through wages, users must maintain proper recordkeeping practices as transactions occur. Waiting until year-end to determine revenues, gains, and losses could be extremely burdensome, if not nearly impossible.
When goods and services are exchanged for virtual currency, taxpayers in receipt of virtual currency must include the fair market value (FMV) in US dollars on the day of the transaction in their gross income. On the other hand, those paying with virtual currency must recognize either a gain or loss at the time of the exchange depending on whether the FMV of property received is greater or less than their adjusted basis in the virtual currency. In fact, any time a virtual currency is exchanged for actual currency, other property, or services, a gain or loss should be recognized. However, the gains or losses may be either capital or ordinary, depending on whether the virtual currency is considered inventory or property held mainly for sale to customers in trade or business. Miners must recognize income at the FMV of the virtual currency received on the day it is mined. It is best to stay ahead of these tracking issues, and when in doubt, taking a conservative approach is best until further guidance has been issued by the IRS.
What about virtual currency held in foreign bank accounts?
Taxpayers may choose to keep their virtual currency in a foreign account. At this time, it is not explicitly required by the Financial Crimes Enforcement Network (FinCEN) to report virtual currency on a Foreign Bank Account Report (FBAR) filing. However, the penalties for not properly filing an FBAR are significant enough that taxpayers should still consider the reporting implications of virtual currency held in foreign accounts. Non-willful violations can result in penalties of $10,000 per year, and willful violations can result in penalties of 50% of account balances or $100,000 for every year, whichever is more. Taxpayers can take a more conservative approach by reporting virtual currency in foreign accounts when the aggregate high balance in all foreign accounts of the taxpayer is above $10,000.
DiSanto, Priest & Co. continues to stay up-to-date on the tax implications of virtual currencies as guidance is released by the IRS. If you have questions regarding your virtual currency and the effects it may have on your tax return, please contact our Tax Department.
Want to read more about Blockchain and Cryptocurrency?
Don’t miss Part 1: The New Technology Quickly Changing our World and Part 2: The Coin Behind the Technology.