Finding yourself confused about the tax treatment of virtual currency? You’re not alone. The perplexing and often onerous tax rules have not been simplified (or clarified), even as the numbers of investors and available virtual currencies have exploded. The last time that the Internal Revenue Service (IRS) issued specific guidance on the tax treatment of virtual currency to taxpayers was on March 25, 2014, at a time when about $14,020,100 worth of Bitcoin was trading at around $585. As of this writing, volume share is approximately $4,631,500,000 trading at around $7,500 a pop. And that’s just bitcoin (BTC). It doesn’t include other virtual currencies like Ripple or Ethereum.
(You can download the official 2014 IRS guidance as a pdf here.)
The guidance made it clear that, for tax purposes, virtual currency is treated as a capital asset, provided that it is convertible into cash. In simple terms, this means that capital gains rules apply to any gains or losses. But taxes are never quite that simple, and more guidance is needed, not only to clarify questions from the initial notice but also to address unexpected events like forks and splits.
(You can read more about the tax treatment of virtual currencies, including cryptocurrency, here.)
The clamor for more guidance comes at a crucial moment. The IRS is demanding more compliance after alleging that some users have been using virtual currency to avoid tax-reporting requirements. To prove their point, the IRS demanded that Coinbase, a company which facilitates transactions of digital currencies like Bitcoin and Ethereum, turn over customer data. After a lengthy court battle, Coinbase eventually notified a subset of its customers that it would comply with a court order regarding the release of specific data. As part of its press, the IRS had argued that “only 800 to 900 taxpayers reported gains related to bitcoin in each of the relevant years” while “more than 14,000 Coinbase users have either bought, sold, sent or received at least $20,000 worth of bitcoin in a given year.” That, the court wrote in its order, “suggests that many Coinbase users may not be reporting their bitcoin gains.”
While the question of whether willful avoidance or confusion has resulted in below-expected reporting numbers remains, many tax professionals believe that further guidance would benefit taxpayers. One group, the American Institute of Certified Public Accountants (AICPA), recently sent a letter to the IRS requesting that the agency issue additional and “immediate” guidance.
Annette Nellen, CPA, CGMA, Esq., chair of the AICPA Tax Executive Committee, penned the letter to the IRS, emphasizing that “[t]he rapid emergence of virtual currency has generated several new questions on how the tax rules apply to various transactions involving virtual currency and activities and assets related to it.” Additionally, Nellen said, “the development in the number of types of virtual currencies and the value of these currencies make these questions both timely and relevant to a growing number of taxpayers and tax practitioners.”
The letter went on to recommend that the IRS specifically address issues in 12 areas:
- Expenses of Obtaining Virtual Currency
- Acceptable Valuation and Documentation
- Computation of Gains and Losses
- Need for a De Minimis Election
- Valuation for Charitable Contribution Purposes
- Virtual Currency Events
- Virtual Currency Held and Used by a Dealer
- Traders and Dealers of Virtual Currency
- Treatment under §1031 (like-kind exchanges)
- Treatment under §453 (installment sales)
- Holding Virtual Currency in a Retirement Account
- Foreign Reporting Requirements for Virtual Currency (FBAR and FATCA)
The AICPA recommended that the IRS consider frequently asked questions (FAQs), including how to calculate expenses (including depreciation) and whether taxpayers may use averages of different exchanges when calculating values.
The FAQs also note the need for a de minimis election. The Latin phrase de minimis translates roughly to “of little importance.” You may recall that in the tax world, the phrase is used to indicate when IRS considers items “so small as to make accounting for it unreasonable or impractical.” Since tracking the basis and value of virtual currency for small purchases—like shopping on Overstock—can be time consuming and burdensome for what is, in most cases, a small amount of taxable gain or loss, the AICPA recommends that there be an exclusion similar to the one which exists for foreign currency for personal transactions (up to $200 per transaction).
The FAQs also address issues which had not been contemplated in the original guidance: virtual currency events like chain splits, airdrops and giveaways. Notably, the AICPA recommends that the IRS clarify tax treatment following the Bitcoin split of 2017. The AICPA suggests that the IRS should take the position that “[t]axpayers have the option to report events as they deem appropriate.” However, as part of reporting, if the taxpayer chooses to make an “Election to Include a Virtual Currency Event as Ordinary Income in Year of Transfer,” the IRS should not challenge that method of treatment for 2017. Specifically, the AICPA writes, “a taxpayer makes the election that states they received Bitcoin Cash in the August 2017 split event and the currency has zero basis.”
(You can read more about headaches resulting from the 2017 shift here.)
Another popular topic that was not considered under the prior guidance is how to report virtual currency held in retirement funds—and what’s permissible. The AICPA writes that IRS should clarify that since virtual currency is treated as property (remember that it’s a capital asset), it would be permissible in an IRA. However, the AICPA notes that “[t]axpayers need guidance on whether other types of retirement accounts, if any, can hold virtual currencies. The IRS should also provide guidance on what special documentation rules or requirements apply given the decentralized nature of virtual currencies and the various ways these currencies are held and transferred.”
And what about those FBARs? In 2014, I reported that, in response to my query, the IRS issued a statement:
The Financial Crimes Enforcement Network, which issues regulatory guidance pertaining to Reports of Foreign Bank and Financial Accounts (FBARs), is not requiring that digital (or virtual) currency accounts be reported on an FBAR at this time but may consider requiring such accounts to be reported in the future. No additional guidance is available at this time.
Since that time, I’ve been asked many times for an update. The IRS has not issued an update, nor formal guidance. I suggested, and the AICPA seems to agree, that individually held currencies, such as those in wallets, should not be subject to FBAR reporting. However, neither IRS nor Treasury has provided guidance on whether virtual currency accounts may become reportable. The AICPA also asked for formal direction on whether additional reporting obligations might exist under the Foreign Account Tax Compliance Act (FATCA).
The IRS has not responded publicly to the AICPA. You can read the 21-page letter, which downloads as a pdf, here.
So what should you do in the meantime?
- If anything, I think the AICPA letter emphasizes the need for taxpayers to remain a part of the conversation. Stay informed and be heard. How virtual currency is being traded and used, as a practical matter, should drive how the IRS chooses to treat it for tax purposes.
- Also, keep excellent records. One of the problematic issues I’ve seen from taxpayers is a lack of tracking when it comes to trading one cryptocurrency for another. Cashing cryptocurrency out of an exchange or similar platform may be treated as a sale—even if you’re forced to withdraw it. You’ll want to be able to track your basis, costs, and gains as you go, not as the IRS may see it. (Again, you’ll find more on basis and tax treatment of trades and withdrawals here.)
- And, of course, make friends with a good tax professional. There’s a lot to see here, and you’re going to want someone who is knowledgeable to stay on top of things.
- Above all, be patient. As Nellen writes, “The issuance of clear guidance in this area will provide confidence and clarity to preparers and taxpayers on application of the tax law to virtual currency transactions.”