Crypto currency is on the decline which means that many Americans may have experienced losses with their virtual currency transactions. According to CCN the valuation of the crypto market fell by $4 billion from $130 billion to $126 billion, dropping to the $120 billion region for the first time since mid-February. One must remember, that US taxes are involved with virtual currency and to date, it is still a very confusing area of tax practice. To compound matters, the Internal Revenue Service is targeting virtual currency transactions.
With income tax returns due right around the corner (April 15), today’s post gives a brief overview of some of the US tax issues.
Americans living and working abroad may find it difficult to maintain a bank account in their country of residence due to the infamous “Foreign Account Tax Compliance Act”, often called FATCA (or “FACTA” by those not in-the-know). These individuals may more frequently turn to crypto-currency to handle payments as more and more goods and service providers are becoming happy to accept it.
Tax Implications of Bitcoin/Virtual Currency
In 2014, the US Internal Revenue Service (IRS) announced in Notice 2014-21 that virtual currency is to be treated as “property” and not “currency” for US federal tax purposes. Even though virtual currency operates like “real” currency — i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance — it did not have legal tender status in any jurisdiction until April 1, 2017 when Japan declared Bitcoin as a legal tender or payment method. The IRS Notice issued in 2014 relied on the fact that virtual currency was not regarded as legal tender in any jurisdiction. That has now changed with the aforementioned Japanese pronouncement. Whether the IRS may view Bitcoin differently (especially when used in transactions with Japan where it is legal tender) is an open question. Evidently, the tax law cannot keep up with technological changes, putting taxpayers at great risk for simply not knowing how transactions should be treated for tax purposes.
According to the IRS Notice, virtual currencies that can be converted into traditional currency are “property” for US income tax purposes. This means a taxpayer can have a gain or loss (typically, a capital gain or loss) on the sale or exchange of a virtual currency. The gain or loss is determined by subtracting from the sales proceeds (i.e., what was received in the sale or exchange), the taxpayer’s cost to purchase the virtual currency (the so-called tax “basis” in the property).
Aside from Notice 2014-21, there is no other specific tax guidance at the moment. More is needed on how to treat virtual currency transactions, especially since some US courts have held that “bitcoin” is money for other regulatory purposes, in complete divergence from the IRS tax position. See e.g., US v. Faiella 39 F. Supp.3d 544 (2014) and U.S. v Murgio et al, U.S. District Court, Southern District of New York, No. 15-cr-00769 (2016).
Typical Tax Events
Tax events associated with virtual currency include:
- Selling on an exchange,
- Selling to another person, or
- Buying goods or services with virtual currency
Since each of these events will have US tax implications, you will need to know the date, cost basis, sale amount and any related fees.
Calculating the capital gains and losses for virtual currency transactions may become a daunting task. Do you know the cost basis of every coin you own? Are you tracking the profits (or losses) and keeping records of the new cost basis when you spend the virtual currency or when you sell it?
Virtual currency users may think that a tax event takes place only when they transfer US dollars into or out of an exchange. This is not correct. For example, simply buying goods with virtual currency carries tax implications. When you use your Bitcoins to make a direct purchase of goods or services, this is a barter transaction or an “exchange” and will have US tax consequences. In calculating the gain or loss, you use the fair market value of the goods or services you are acquiring as the sale proceeds received in exchange for your virtual currency. From this, you will subtract your basis in the virtual currency you used to purchase those goods or services. The resulting number will be your taxable gain or loss.
Here’s a simplified example:
Rosetta purchased 1 Bitcoin in May 2012 for $300. In order to keep it simple, assume no fees were associated with the purchase. In 2017, Rosetta buys cable TV services for 3 months from the cable provider and pays the charges in Bitcoin. The vendor charges $100 for the 3 months of cable service and Rosetta pays 0.20 BTC when the rate is $500/BTC.
Rosetta has a taxable gain in 2017 as a result of this transaction. From a tax standpoint, Rosetta will be viewed as having “sold/exchanged” her 0.20 Bitcoin for $100.00 (the fair market value of the cable service). Her cost basis in the .20 Bitcoin she is treated as having “exchanged” for the cable service is $60 (calculated as .20 x $300). Her capital gain on the transaction is $40 ($100 value of the cable service she received minus her $60 basis in the Bitcoin).
Because Rosetta held her Bitcoin for over 1 year, her capital gain will be taxed at the favorable long-term capital gain rate (maximum 20%). More on this below.
As you can tell from this example, detailed records will be required to be maintained – initial cost of the virtual currency, associated fees at purchase, all trades, exchanges and sale amounts. If you have many trades, this kind of record-keeping can become very complex and difficult.
“Basis” and the “Standing Instruction”
As can be seen from the above example, “basis” is a critical part of calculating gain or loss on a virtual currency transaction. Some accountants use what is called a “standing instruction” so that any virtual currency that is sold will be the most costly or highest coin. With the proper standing instuction in place, the first thing you sell will always be the most costly coin, and therefore this strategy may allow you to minimize gain or maximize your losses, as the case may be.
It is not clear that the IRS will accept this position, but the “standing instruction” strategy is applied to sales of stocks and bonds. Thus, it is possible that the rule can apply to virtual currency.
Having a standing instruction helps you keep track of what was paid for the currency. Your standing instruction must be able to verify that you said any currency you sell shall be from the lot with the highest cost basis. When you sell the currency, you may sell it at a price of say $6,000; but with the standing instruction, the sale will be based on coins you bought at say, $10,000. This may permit you to maximize the loss of $4,000 for tax purposes.
Gains and Losses on Virtual Currency Transactions
The total gains and losses from all of your Bitcoin transactions during the calendar year will be aggregated yielding your net capital gain or loss. This is then taxed according to special rules detailed below.
Gains earned on virtual currency held as a capital asset for over one year are considered long term capital gains. Long term capital gains are taxed at a rate dependent upon your particular income tax rate. The tax rate for long-term capital gains range from 0-20% (e.g., low bracket taxpayers will pay 0% on such gains; whereas if you are in the top income tax-bracket, the rate will be 20%). By contrast, gains earned on assets held for one year or less are considered short term capital gains, and are taxed at ordinary income tax rates (which can go as high as 37%). Since the long-term rates are more favorable than the ordinary income tax rates, keeping your virtual currency for longer than one year prior to its disposition can be more tax efficient. You can learn more about capital gains and losses here.
Currently, it seems that virtual currency transactions are not being properly reported on US income tax returns by such currency users. IRS is clearly on the case; closer examination by the taxman is inevitable as the potential for virtual currency continues to increase exponentially.
Regardless of what you do with your Bitcoins (save them, spend them on goods or services, sell them) you should maintain detailed records including date of purchase, cost at purchase, fees associated with purchase, date of sale or exchange, sales proceeds or the fair value of goods/services purchased. In the event of an IRS audit your ability to produce information justifying your treatment of the items and your calculations may mean the difference between the IRS respecting capital gain treatment or rejecting it entirely and treating your Bitcoins as income with a zero cost basis (this can happen for example, if you cannot show what you paid for the Bitcoins and when you bought them). Filing a tax return in good faith along with Form 8949, which is attached to Schedule D of Form 1040 to report capital gains on property transactions (including virtual currency) are all-important steps.
As a further reminder, filing of an FBAR may be required with regard to some virtual currency accounts. More on this topic at my blog post here.
Posted March 10, 2019
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