Ten years ago, cryptocurrency was the new buzzword, and we were asking: What is it and what do we do with it? In simple terms, cryptocurrency is a global digital asset, or currency, which is an alternative form of payment created using encryption algorithms. The technology and architecture decentralize existing monetary systems and make it possible for transacting parties to exchange value and money independently of intermediary institutions such as banks. Cryptocurrency was initially intended for use in day-to-day transactions, from a cup of coffee to computers, luxury items, and cars. While it hasn’t yet achieved such daily usage, it is tendered by numerous e-commerce retailers and tech companies.
How does cryptocurrency work?
The first and most recognized cryptocurrency is Bitcoin, now one of thousands of different types (platforms) of virtual currency. Bitcoin and most other cryptocurrencies are supported by a technology known as blockchain, which maintains a tamper-resistant record of transactions and keeps track of who owns what. Individual units of cryptocurrencies can be referred to as coins or tokens, depending on how they are used, and they are stored in digital wallets. Cryptocurrency payments exist purely as digital entries known as a public ledger.
Units of cryptocurrency are created through a process called mining, which involves using computer power to solve complicated mathematical problems that generate coins. Within the mining process, you will run into “proof of work” and “proof of stake.” These are both algorithms to keep the blockchain secure, so users can add new cryptocurrency transactions.
Taxation of cryptocurrency
One might refer to cryptocurrency as a virtual currency, but it is not a true currency in the eyes of the IRS. Cryptocurrency is considered property, and the associated capital gains and losses need to be reported in the same method as you would report stock portfolio transactions. The bad news is that treatment makes cryptocurrency more difficult to use and cumbersome to report. Unlike your brokerage account, where you receive Form 1099-B, the same level of reporting is not yet available for cryptocurrency. Looking ahead, a law passed in November 2021 will require greater tax reporting starting January 1, 2023. The law requires brokers—including, controversially, anyone who moves digital assets for another—to report that information to the IRS on a 1099 or similar form.
When is cryptocurrency considered income?
You might think that if you only use—but do not trade—cryptocurrency, you are not liable for taxes. Not true! Any time you receive or exchange virtual currency for real currency, goods, or services, you may create a tax liability. You will create a liability if the price you realize for your cryptocurrency—the value of the good or real currency you receive—is greater than your cost basis in the cryptocurrency. If you get more value than you put into the cryptocurrency, you have taxable gain. Of course, you could just as well have a tax loss. In either case, you will need to know your cost basis to make the calculation.
Tracking capital gains and losses with cryptocurrencies
As previously stated, if you are going to buy, sell, or exchange virtual currency, you must keep track of several elements, including basis. Within the tracking, you need to monitor the transaction method, as not all movement is taxable. If you maintain your virtual currency in one account on one exchange, it will be much easier to track. If you transfer currency between platforms, wallets, and different types of cryptocurrencies, your reporting will require more diligence. Basis does not transfer with the asset. Fortunately, there are software programs available that can aid in tracking and reporting cryptocurrency.
The IRS has not provided guidance at this time as to whether a taxpayer holding cryptocurrencies on a foreign cryptocurrency exchange or in a foreign virtual wallet will be required to report the accounts on an FBAR (Foreign Bank Account Report); however, the language contained in IRS Letter 6173 (July 2019) provides that the obligation to report all sales, exchanges, and other dispositions of virtual currency “applies regardless of whether the account is held in the U.S. or abroad.” Additionally, Form 8938, Statement of Specified Foreign Financial Assets, must be provided annually with one’s individual income tax return. The financial assets reported on Form 8938 are broader than those required to be reported on the FBAR.
Tax strategies—legal and tax issues
Cryptocurrency is a new paradigm for money and has evolved faster than the legislation to regulate it. The IRS’s “wake-up call” to enforce the administration of taxation of virtual currencies has just begun. Legislators have introduced proposed legislation—the Responsible Financial Innovation Act—that will set new tax rules for virtual currencies and shift much of the oversight to the Commodity Futures Trading Commission. Perhaps the single largest risk facing cryptocurrency is the threat of tighter regulation.
We hope this Insight has given you a better understanding of cryptocurrency. View additional thought leadership on this subject here.
If you have any questions related to the taxation of cryptocurrency, tax planning and compliance, business management, or audit and assurance services, contact a PYA executive below at (800) 270-9629.