Up to 13 percent of Americans now deal with cryptocurrencies, and that number is expected to grow. Virtual currencies are a popular but volatile alternative to regular banking, and the Internal Revenue Service is working hard to catch up with the technology. These computer-generated currencies are also popular with money launderers and cybercriminals, which is drawing intense interest from law enforcement officials. The IRS considers them to be property and is stepping up scrutiny as crypto becomes more commonplace, so those who deal in it may have some extensive tax reporting to do.
What is cryptocurrency? Money can come in physical form (dollar bills) or digital form (bank accounts), and both are regulated by central banks in the nations where they are distributed. But thanks to a decentralized blockchain technology, new currencies like Bitcoin, Etherium, Dogecoin and others have emerged both as investment vehicles and as methods of transacting value. This also includes works of art that are digitized into NFT’s, or non-fungible tokens. These types of virtual currencies are not regulated by any central banks and can only be accessed using certain platforms and key codes.
On the front page of IRS Form 1040, the main federal income tax form, is now a required check box- “At any time did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” This box must be checked yes or no to electronically file a tax return. Let’s look at each item.
- Receive. Taxable and non-taxable. Crypto received in exchange for work done is treated as self-employment income at the exchange rate when it was received. Mined cryptocurrencies are also considered SE income. Crypto received from customers in the course of business is treated as regular business income. But any crypto received as a gift is non-taxable, though the amount originally paid may be needed at sale. Inherited crypto is also non-taxable, but the value at inheritance must be noted.
- Sell. Taxable. Selling crypto is an investment transaction. Sellers need to track what was originally paid for it, using that amount to calculate any net profit or loss. This is reported just like a stock sale on your tax return.
- Exchange. Taxable. Trading one type of cryptocurrency for another is deemed a sale and purchase and must be reported. Exchanging crypto for other investments such as real estate, stocks, bonds, or collectibles is also treated as a sale.
- Otherwise Dispose. Taxable. Bitcoin, currently the most popular cryptocurrency, is currently accepted as payment in many business settings. Buying a pizza or anything else with crypto, even for a small amount of money, is considered a sale of that virtual currency at the current exchange rate and must be reported as if it were sold. Business purchases with bitcoin are treated as a sale but are also deductible as a business expense.
- Buy and hold- Not taxable. Cryptocurrencies that are purchased and held in an account don’t require any tax reporting, nor does the page 1 box need to be checked. The amount paid does need to be noted and tracked for when items 1-4 take place.
- Lost Crypto. It is estimated that one in five Bitcoin that have ever been mined have been lost forever because the key code is lost. Whether these losses are deductible has been debated, but as long as they are treated as investments, the losses can be claimed as soon as they are deemed lost for certain.
The price of cryptocurrencies can change rapidly. In the past year the value of one Bitcoin has fluctuated between $60,000 and $30,000, though most people deal in small fractions of a Bitcoin. For those who do regular, multiple transactions, keeping track of taxable income or loss can be a daunting task. For instance, if I bought one Bitcoin at a certain price and then started spending it, I would have to keep track of the exchange rate for each purchase and track it back to the fraction of bitcoin that I used up each time. There is now software to help with this tracking, or a good Excel spreadsheet can work as well.
Brokers like Coinbase help track virtual currency purchases and redemptions, which is a big help. The IRS still expects cryptocurrency investors to report taxable events in the proper way, which could include self-employment, investment, or rental income, all of which go on different forms. Starting in 2023 the IRS will require all dealers in cryptocurrency to provide tax information to them and to investors, which will make reporting simpler and more transparent. Until then, the requirement to report all income, even if not reported, on your annual income tax return remains in force. Not checking the box on page 1 could be met with penalties and interest if the IRS catches on to crypto investors. This field of blockchain and virtual currency is rapidly evolving, and laws surrounding it will do doubt evolve as well.