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Things to Know About Cryptocurrency and Your Taxes

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Steven E Miller, CPA PC

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The speculative market called CRYPTOCURRENCY is attractive to new investments.  So, what is Cryptocurrency?

WHAT IS CRYPTOCURRENCY

Let's start with a simple definition. Cryptocurrency is also known as Virtual Currency or Digital Currency. That tells us Cryptocurrency is not something that can be felt or touched. Cryptocurrency is a medium created to be moved from one trader to another by digital tracking on ledgers called "Blockchains."

These ledgers are connected worldwide through the Internet. Within the system, the individual accounts are called "Wallets," and you trade from your wallet to someone else's wallet.

Early thinking could be a market for someone to have a value system between two or more people, which could be traded among each other for goods or services and without government oversight - "a barter system".

These blockchains then began to gain a tradeable value among those connected to each other by highly encrypted computer systems. The key was to continue attracting more real currency to the system to create a trading market value.

The nature of Cryptocurrency is that any government standard does not back this digital commodity, nor is it supported by any value system such as the value of gold or minerals, or cotton.  

The value to the owner is whatever another trader is willing to accept. 

As such, there is no protection from hacking or other intrusions or even abandonment of value. That is if nobody wants what you have – you have no value.

That also means new virtual currencies are being created as two or more decide they will begin to trade their new system. The most popular Cryptocurrency system is Bitcoin. There are others known as Ethereum, Litecoin, EOS, Binance, and some 1,200 different traded digital currencies. 

The new phenomenon is some of these Crypto Currencies have started what is known as a "Hard Fork," where they will spin-off some of their values to create another new virtual currency. Much like a company may cut out a subsidiary and the newly created stand-alone company stock is traded, these new currencies are called "Air Drops."

HOW DOES IT AFFECT YOUR FEDERAL INCOME TAX

The Internal Revenue Service began attempting to regulate Crypto Currencies' taxation as early as 2014 when they ruled virtual currencies, even though unregulated in the world-wide-web when traded were "property."  

As such, they are treated like a stock is traded. If you make a buy, you own a capital asset, and when you make a sale, the difference in gain or loss is taxable and should be listed on Form 8949 and Schedule D of an individual tax return.

The Hard Forks and Air Drops mentioned above also create a taxable event when the value is booked on the new ledgers and the new wallet is made. You may see that Bitcoin has spun-off "Bitcoin Cash" or Ethereum creating "Ethereum Classic" or Binance creating "Binance Cash" and on and on.

There is a pretty significant market for trading the major virtual currencies for goods. Some of the larger international companies will accept Cryptocurrencies for the purchase of products. Amazon, for instance, will accept virtual currency in payment of purchases. Office Depot and some automobile dealers will sell their products and take digital currency as payment.  

Guess what –this creates a taxable event as the Cryptocurrency has now taken a value of what you bought and is therefore taxable. 

The Tax Cuts and Jobs Act of 2017 eliminated any attempt to claim a tax-free exchange of virtual currency for other things of value.

As these trades occur, of course, you have seen and read of the enormous increase in trading up, and the plummet downward as perceptions and attraction of the "greater fool" may rise and fall from investment.  

Another issue has risen as the trades are difficult to document. You generally will not get a brokerage statement that details purchases and sales. Some services have risen to the challenge and, therefore, will provide trading detail for you at a cost. As more documentation is uncovered, more regulation is taking place.

One of the U. S. based Crypto-Currencies, Coinbase, became the target of a review. Its investors became known. Several hundred thousand investors began to receive letters that as account owners, they should report their Cryptocurrency transactions for prior years and the current tax year if they had not done so.

In a 2018 and 2019 mailing, what has become known as the "Coinbase Letters" (6173 and 6174), investors realized their investment was not as cryptic as they once may have been thought.  

FOREIGN BANK ACCOUNT REPORTING

Many investors have been unaware or who may have thought they are not subject to Foreign Bank Account Reporting.

To maintain an awareness of U. S. citizens and those in the U. S. who are treated as U. S. citizens and have money on deposit in foreign countries, there is a regulation that they must report by the depository, location, account number, and the value in U. S. Dollars of these foreign accounts each year.  

This Form 114 FBAR must be filed by the due date of an individual tax return, and it must be filed electronically. The report is mandatory if your total value of all foreign accounts is $10,000.00 or more. Once more for emphasis – the TOTAL value of all foreign accounts is $10,000.00 or more.  

The reason for the extra emphasis is that the fine for not reporting is $10,000.00 for each year unreported.  

As you see, there are many potholes and pitfalls in Cryptocurrency dealings. 

  • You must report transactions as trades on your Federal Income Tax Return. These trades are subject to Short-Term or Long-Term Capital Gains taxation.
  • You must file FBAR reports annually to admit foreign accounts, or you could face severe monetary penalties.

There is much uncertainty about how the Internal Revenue Service treats disasters in dealing with Cryptocurrency. One which comes to mind is what happens if you are hacked – and that is happening at an alarming rate. The hackers take your wallets, and you end up with no value in an account that once had many thousand dollars in value. What happens if someone gets your encryption key and scoops your accounts. There is no FDIC coverage for this event.  

Once there were theft and casualty write-offs, but no longer would these deductions be available in the event of intrusion to your account.

Finally, be aware that the trading community's lack of regulation leaves the door cracked for significant abuse of the system and the bad guys. The uncertainty of a value basis makes the economics of Cryptocurrency trading hard to determine a future safety of principal, and there is no income determination.

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