Cryptocurrency has been around since January 2009 but has become increasingly popular over the past couple of years. For some, cryptocurrency is thought to be the currency of the future, resulting in an urgency to buy it now before the value increases. For others, it is the technological aspect, particularly the idea that transactions are more secure through a decentralized processing system, that is the driving force for the increased interest. Then there are those who, quite frankly, do not have any interest in cryptocurrency. Their interest is tied solely to the virtual currency’s growing value. Regardless of one’s reasons for investing in cryptocurrency, it is important to understand what events generate income or gain/loss recognition, and therefore require reporting on Form 1040: U.S. Individual Income Tax Return.
The Internal Revenue Service (IRS) highlighted the expectation of reporting any gain or loss generated from cryptocurrency in 2019. At the time, the agency added a question to Schedule 1 of Form 1040 asking the taxpayer if he or she had any financial interest in cryptocurrency during 2019. In 2020, the IRS moved the question from Schedule 1 to page 1 of Form 1040, thereby requiring everyone who filed an individual tax return to answer the question, not just those who filed Schedule 1. This was a significant indicator the IRS is now paying close attention to the compliance of reporting any gain/loss derived from a virtual currency event.
Below are some terms commonly used when talking about cryptocurrency.
- Blockchain: A digital ledger that records transactions.
- Crypto Assets: Digital assets that use a cryptographic approach to generate financial transactions.
- Cryptocurrency: An electronic form of money that is created and exchanged on blockchains.
- Virtual Currency: This term is often used when referring to all cryptocurrencies. It is also important to know that the IRS has broadened this term to refer to all crypto assets.
- Legacy Cryptocurrency: The original cryptocurrency prior to a hard fork (refer to hard fork explanation in “Taxable Events” below).
- New Cryptocurrency: The cryptocurrency created after a hard fork has occurred.
To fully comply with reporting requirements, it is critical that taxpayers can identify cryptocurrency transactions that would result in reportable income or a gain/loss. Below are some common transactions to consider.
Exchange for Services – A taxable transaction has occurred when a taxpayer uses cryptocurrency to pay someone else for services, or the taxpayer is the individual receiving cryptocurrency for services they provided. The difference between being the payer or the payee matters when considering how to report the income or gain/loss. If the taxpayer is receiving the cryptocurrency as a form of payment for services, then the cryptocurrency should be reported as ordinary income. However, if the taxpayer is paying someone else in the form of cryptocurrency for services, then the taxpayer will recognize a capital gain or loss on the exchange.
Exchange for Other Property or Goods – Whether a taxpayer exchanges cryptocurrency for other property, or exchanges other property for cryptocurrency, a taxable transaction has occurred. If a taxpayer exchanges cryptocurrency for other property or goods, the taxpayer will recognize a capital gain or loss. On the flip side, if a taxpayer exchanges capital asset property for cryptocurrency, the transaction will be reported as a capital gain or loss on his or her personal tax return. If a taxpayer exchanges non-capital asset property for cryptocurrency, the transaction will be reported as an ordinary gain or loss on his or her personal tax return.
Sale of Cryptocurrency – Another common transaction is the sale of cryptocurrency for real currency. A taxpayer is required to report any capital gain or loss incurred in such a sale.
Hard Fork – Revenue Ruling 2019-24 explains that when a cryptocurrency experiences a protocol change resulting in a permanent deviation from the existing or “legacy” distributed ledger, a “hard fork” has occurred. As a result of the hard fork, a new cryptocurrency on a new distributed ledger may be created. The new cryptocurrency transactions are recorded on the new distributed ledger, and any legacy transactions carry on reporting on the legacy distributed ledger.
If a new cryptocurrency is created because of a hard fork, an “airdrop” may occur. An airdrop is simply a way of distributing the new cryptocurrency to taxpayers that own any of the legacy cryptocurrency. A taxpayer has reportable ordinary income equal to the fair market value of the new cryptocurrency when it is received. A taxpayer is considered to have received the cryptocurrency when he or she can transfer, sell, exchange, or otherwise dispose of the cryptocurrency.
It is imperative that taxpayers correctly report income or gains/losses generated from a cryptocurrency transaction or event to avoid incurring an IRS penalty assessment.
If you have questions about the taxation of cryptocurrency or would like assistance with tax planning and compliance, business management, or audit and assurance services, contact a PYA executive below at (800) 270-9629.