You Can’t Hide from Cryptocurrency Taxes

If you invested in cryptocurrency thinking it wasn’t taxable, you may be in for a big surprise.

Cryptocurrency can be traced as far back as 2009, but you may not have heard of it until the investment boom of 2017. The growing volume of cryptocurrency transactions in 2014 drew the attention of the IRS and other regulatory agencies. Since then, the IRS has been working to provide guidance as to how it defines and taxes cryptocurrency, and it released the latest guidance in October 2019. Here’s what we know: transacting in cryptocurrency may carry costly tax implications.

For federal income tax purposes, cryptocurrency is generally treated as property (think real estate) and thus “the character of the gain or loss generally depends on whether or not the cryptocurrency is a capital asset in the hands of the taxpayer,” per the IRS. Therefore, the sale or exchange of cryptocurrency could be taxed at capital gains rates if held as an investment, or at ordinary income tax rates if held as inventory. In addition, how you use your cryptocurrency will determine what needs to be disclosed to the IRS and whether any tax is due. Activities such as sales, exchanges, conversions, transfers and rollovers should be recorded and shared with your tax advisor to assess your liability.

For example, if you’ve made payments for goods or services using cryptocurrency, as a payer you must issue a Form 1099-MISC – Miscellaneous Income, or a Form W-2, to the IRS and to the payee. If you want to gift cryptocurrency or include it in your estate, you should consult your estate and trust advisors and discuss potential tax implications.

Here are five things to keep in mind as tax season approaches.

1. Gain or loss may result from the purchase, sale, or exchange of tokens.

If you or your business experienced gain or loss from the purchase, sale, or exchange of tokens, this information needs to be disclosed to the IRS. If you had a loss, the cryptocurrency had to be converted to dollars prior to December 31, 2019, to report the loss. Depending on how long you’ve held a token, it may be taxed as long-term capital gain or loss. The holding period begins the day after the cryptocurrency is received.

2. Mining is considered ordinary income for tax purposes.

Cryptocurrencies can be acquired through “mining,” a process that involves verifying transactions and adding them to the blockchain ledger using specialized computer hardware. If you mine tokens or are paid in tokens for your work, these funds may be taxed as business, wage, or self-employment income. As such, it must be reported on Form W-2, Wage and Tax Statement.

3. Forks and airdrops are special cases and require individual review.

A fork, in terms on blockchain technology, is a split from the main ledger that often results in new coins being created. If an individual holds tokens in a certain chain prior to the fork, he or she will own a proportionate ratio of the new token. Sometimes an investor does not receive the newly generated token right away; instead, they are awarded, or “airdropped,” down the road. If a taxpayer receives and has dominion over a new token after a fork, this is a taxable event.

4. Be prepared to show your work.

Your tax preparer will want to see all records pertaining to your dealings in cryptocurrency. Some virtual wallets may provide you with tax forms, or transcripts of transactions. If you do not receive any formal documents, as the taxpayer it is your responsibility to keep sufficient backup of your transactions and the fair market value of your tokens at the time of the transaction to be able to provide this information when filing your return.

5. The IRS has ramped up enforcement efforts.

The IRS mailed over 10,000 letters to crypto account owners asking them to review their returns and make sure they’ve reported income correctly, or amend their returns. Whether you’ve received one of these warning letters, it’s prudent to review your accounts and returns, and verify that all income deriving from cryptocurrency transactions has been properly recorded and reported.

Cryptocurrencies taxes are not black and white. IRS Notice 2014-21, IRS Virtual Currency Guidance, notes: “the sale or other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences that could result in tax liability. This guidance applies to individuals and businesses that use virtual currencies.”

At Kaufman Rossin, we are advising our tax clients to be proactive in seeking counsel when transacting in cryptocurrency to comply with IRS guidance and determine their tax liability before a deal. If you are unsure whether you should disclose any individual or business activity involving cryptocurrency, contact me or another tax professional for further assistance.