Tax strategies for virtual currency

Virtual currency (also known as cryptocurrency), such as bitcoin, has been increasing in popularity. Virtual currency may be used to pay for goods or services or held for investment. Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments, it operates like “real” currency, but it does not have legal tender status in any jurisdiction.

Observation:Bitcoin futures can now be traded on futures exchanges. Guidance is provided by the Commodity Futures Trading Commission.

For federal tax purposes, virtual currency is treated as property (Notice 2014-21). As such, it can be classified as business property, investment property, or personal property. General tax principles for property transactions apply to transactions using virtual currency. The IRS recently issued a revenue ruling (Rev. Rul. 2019-24) and posted FAQs on its website (available at www.irs.gov providing additional guidance on the tax treatment of virtual currency transactions.

Basis in virtual currency is the fair market value (FMV) of the currency on the date the currency is received. If received as payment for services, it is considered taxable income and will be subject to both income and Social Security taxes.

Using the virtual currency to obtain cash or purchase goods is a recognizable transaction. If the FMV of property received for the virtual currency exceeds the taxpayer’s adjusted basis in the currency, the taxpayer has a taxable gain. A loss will occur if the FMV is less than the taxpayer’s basis. The character of the gain or loss depends on whether the virtual currency is a capital asset for that particular taxpayer.

IRS enforcement efforts

The IRS is attempting to crack down on unreported income from virtual currency transactions. Starting with the 2019 Form 1040, Schedule 1, Additional Income and Adjustments to Income, the IRS is asking taxpayers for the first time if they had a financial interest in any virtual currency during the tax year. The IRS’s FAQs remind taxpayers that they must report income, gain, or loss from virtual currency transactions on their federal income tax return for the tax year of the transaction regardless of the amount or whether they received a payee statement or information return.

The IRS is also pursuing providers to produce information regarding account holders. In one case, a federal district court granted the IRS the right to request the following information from a provider with at least the equivalent of $20,000 in any one transaction between 2013-2015 (Coinbase, Inc., No. 17-cv-01431-JSC (N.D. Cal. 11/28/17)):

• Taxpayer identification number;
• Name;
• Birthdate;
• Address;
• Records of account activity including transaction logs or other records identifying the date, amount, and type of transaction (purchase/sale/exchange), the post-transaction balance, and the names of counterparties to the transaction; and
• All periodic statements of account or invoices (or the equivalent).

Examples of virtual currency use

Example 1. Use of virtual currency in business: A, a sole proprietor, accepts 10 bitcoins from F in payment for services. At the time the services were performed, bitcoins were worth $400 each. Therefore, A recognizes $4,000 ($400 × 10) of business income. A month later when bitcoins are worth $425 each, she uses two bitcoins to purchase supplies for her business. At that time, she will recognize $850 in business expense ($425 × 2) and $50 of gain on the bitcoins [($425 – $400) × 2]. Since A is not in the trade or business of selling bitcoins, the $50 gain is capital.

Variation 1: The bitcoins are worth $380 each at the time the supplies are purchased. A will now have $760 in business expense ($380 × 2) and $40 of loss on the bitcoins [($380 – $400) × 2]. The loss is a business capital loss.

Variation 2:A uses the two bitcoins worth $380 each to purchase a new TV for her personal use. Since the bitcoins were not used in her trade or business and were not held for investment purposes, the loss is considered a personal loss and is not eligible for deduction.

Observation:If F was using A’s services in his trade or business, he is subject to the Form 1099-MISC, Miscellaneous Income, reporting requirements since the value of the bitcoins is $600 or more.

Note:The market values in these examples do not reflect current prices.

Observation:Security tokens represent real-world assets, usually anticipated profits of a blockchain-based business. The SEC has oversight of these security tokens. Additional cryptoassets include utility tokens, which entitle their owners to future access to a service or product, and digital asset tokens, which signify that an asset exists off the blockchain.

Example 2. Use of virtual currency for investments: B believes the bitcoin will increase in value. He purchases 15 bitcoins on March 15, 20X1, for $400 each, and 20 bitcoins on May 19, 20X1, for $460 each. On April 3, 20X2, he sells 10 bitcoins for $425 each.

Since B held the bitcoins for investment purposes, any gain or loss will be capital in nature. If he sells 10 bitcoins from his March 15 batch, he will recognize a $250 [($425 – $400) × 10] long-term capital gain. If he sells 10 bitcoins from the May 19 batch, he will recognize a $350 [($425 – $460) × 10] short-term capital loss. Since the bitcoins were held for investment purposes, the short-term capital loss may be included on B’s Form 8949, Sales and Other Dispositions of Capital Assets, for 20X2.

Observation:When bitcoins are purchased, they are placed in the taxpayer’s virtual “wallet.” For purposes of tracking basis and identifying which bitcoins were sold, it is best that wallets be kept separately and not combined.

Unresolved issues

Practitioners should be aware of various unresolved issues related to virtual currency, including the following:

• Since virtual currency is considered property, is it eligible for a valuation discount or premium in estate or gift tax situations?
• Should the costs to mine and acquire virtual currency be capitalized?
• Are retirement accounts permitted to hold virtual currency?
• The IRS has not provided guidance on whether virtual currency is a security and thus subject to the dealer rules of Sec. 475 and the wash-sale rules.
• Uncertain exchange rates make it difficult to determine FMV.
• It is difficult to obtain appraisals for charitable contribution deductions.
• While it is essential to track basis in virtual currency transactions, the IRS has not provided guidance on which accounting method to use (e.g., LIFO, FIFO, or some other method).

This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 20th edition (March 2019), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters, Carrollton, Texas, 2019 (800-431-9025; tax.thomsonreuters.com).