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Considering Investing in Cryptocurrency? Know your potential tax implications before going too far.

Posted on 06/28/18

WHAT IS CRYPTOCURRENCY?

Cryptocurrency, or virtual currency, has been in the news a lot lately due to its rapidly increasing popularity as an investment. There are currently more than 1,500 known virtual currencies, with some of the most popular being Bitcoin, Ethereum and Litecoin.

For early investors in Bitcoin, if $100 was purchased in 2010, it would have been worth over $4.3 million dollars in early 2018. In spite of this performance, the Financial Industry Regulatory Authority has deemed cryptocurrency a highly speculative investment. Investors also need to know that earnings and capital gains and losses must be reported by U.S. tax filers. If virtual currency is held in an online exchange outside the U.S., there are also foreign disclosure reporting requirements for U.S. people.

HOW DOES CRYPTOCURRENCY WORK?

Cryptocurrencies like Bitcoin have an equivalent value in real currency. These currencies can be digitally traded between users and exchanged for real currencies. The most common way to obtain Bitcoin or other virtual currencies is through an online exchange.

As the popularity of virtual currency increases, a growing number of businesses are beginning to accept Bitcoin payments. This trend is expected to continue as cryptocurrency becomes more mainstream.

HOW DOES THE IRS VIEW CRYPTOCURRENCY AND HOW IS IT HANDLED FOR TAX PURPOSES?

The IRS does not view virtual currency as real currency; it is treated as property for U.S. federal tax purposes.  (See IRS Virtual Currency Guidance at IRS.gov.) Because it is treated as property, the rules for disposition of capital assets apply. Dispositions include but may not be limited to sales, exchanges, bartering and transfers.

The Tax Cuts and Jobs Act (TCJA) has also caused some changes for cryptocurrency. Previously, there were different thoughts on whether exchanging one virtual currency for another could benefit from the like-kind exchange rules under Section 1031 of the tax code. Under this code, exchanges of certain types of property could be tax-deferred provided the Section 1031 rules were met. Investors hoped Section 1031 rules would be applicable for exchange of virtual currencies. However, many experts disagreed. Going forward the question is moot as the TCJA has now eliminated all tax-deferred like-kind exchanges, except for exchanges of real estate, for 2018 and beyond.

For U.S. tax purposes capital gains and losses are recognized when you exchange cryptocurrency for other virtual currencies or for real currencies, goods or services. If the virtual currency has been held for under a year, the gain is taxed at ordinary income tax rates. Long-term holdings are taxed at capital gains rates. To calculate the gain or loss, investors must use the U.S. dollar equivalents of the price of the cryptocurrency when it was acquired and the price on the date of the exchange. This applies whether the virtual currency is held in the U.S. or outside the U.S. To minimize the gain on the sale, taxpayers should choose an exchange that allows specific identification of which virtual currency “lots” are to be sold.

For example, in 2018 John purchases a television set for $2,000 using Bitcoin. He originally acquired the Bitcoin used in the purchase for $1,200 back in 2016. In this instance, John would report an $800 long-term capital gain on his tax return.

Where things become increasingly more complicated is when the Bitcoin is acquired at different dates and prices. Unlike securities, there is no authority currently tracking cryptocurrency for investors, so it is up to the investor to use software tools to help with tracking, which can become very complicated.

DOES DIGITAL CURRENCY PURCHASED THROUGH A FOREIGN EXCHANGE NEED TO BE REPORTED?

While there has previously been a lack of clarity for U.S. taxpayers about handling taxation and foreign disclosure reporting of cryptocurrency, the IRS Virtual Currency Guidance regarding dispositions now provides clarity about the taxation. Clarity around foreign disclosure reporting potentially comes from The Ninth Circuit Court of Appeals case, HOM, 657 Fed. Appx. 652 (9th Cir. 2016). This case determined that a taxpayer’s account held outside the U.S. that simply served as a money transmitter and cleared transactions for the taxpayer’s online poker games was subject to Foreign Bank Account (FBAR) reporting. Because this is similar to how taxpayers transmit and clear virtual currency transactions, the same conclusion may also be reached for FBAR reporting.

When over $10,000 in any and all financial asset forms including virtual currency is held in a non-U.S. account, an FBAR is required each year. In addition, the Foreign Account Tax Compliance Act (FATCA) requires certain U.S. taxpayers to describe their non-U.S. financial assets on Form 8938 Statement of Foreign Financial Assets when filing their tax return. Failure to file the FBAR and/or Form 8938 can result in stiff penalties and criminal proceedings in some situations.

The guidelines around cryptocurrency are always changing, and it’s important to discuss the latest developments on reporting Bitcoin and other virtual currency exchanges with your KB tax advisor as soon as possible.

IF THERE IS NO TRACKING, WHY DO I NEED TO REPORT?

The IRS has been relatively slow to provide guidance and rules around virtual currency, but due to its rapid rise as an investment tool, it is now being looked at more closely as a potential source of additional tax revenue.

In February 2018, Coinbase, one of the largest cryptocurrency exchanges, announced to its customers that it would be turning over the data of over 13,000 “higher-transacting” users to the IRS as the result of a court order, signaling that the IRS is on the verge of ramping up compliance in this area.

Unfortunately, many taxpayers are unaware of the requirements for reporting virtual currency transactions. Additionally, because cryptocurrency transactions can be difficult to trace, some taxpayers may be tempted to hide this taxable income from the IRS. This is not a good idea.

The penalties for not properly reporting cryptocurrency transactions can be harsh. Taxpayers can be audited for those transactions and subject to penalties and interest.

Regardless of where you purchase your cryptocurrency, it is clear that the IRS has defined Bitcoin and other virtual currencies as property. Contact the tax professionals at Kerkering, Barberio & Co. with your questions and let us assist you with the proper income tax and foreign disclosure reporting.

About the Author

Phoebe Trumpler, CPA

Phoebe Trumpler, CPA joined Kerkering Barberio in 2005 and was admitted as a shareholder in 2016.

Ms. Trumpler’s primary practice is in International Tax, providing consulting, tax planning, and preparation of U.S. tax returns for U.S. citizens and tax residents who have international income and investments. She assists individuals with offshore tax compliance issues related to Foreign Bank Account Reports (FBAR) and the Foreign Account Tax Compliance Act (FATCA) Ms. Trumpler  also works with high net worth individuals who have only US income and accounts and assists them with tax planning and tax preparation needs.

Phone: (941) 365-4617
Email: ptrumpler@kbgrp.com

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