According to CoinMarketCap.com, at the start of 2018, virtual currency markets were worth about $560 billion. By the end of the year, that same measure was $130 billion. Most people would characterize this as nothing but bad news. However, CPAs are skilled at finding an upside in a disaster. Now that Bitcoin mania has calmed, is there a tax-saving opportunity buried among the wreckage?
Virtual currency is a term used to describe a medium of exchange that exists solely in digital format. For years, Bitcoin was the standard bearer of virtual currency, but now there are thousands of these currencies in circulation. Given their lack of physical presence, these currencies are stored in digital wallets and transactions are run through a cryptocurrency exchange. Most people purchase and use the cryptocurrencies through contact with an exchange.
It is possible to create your own digital currency, though it is increasingly difficult to do this cost-effectively. The creation of digital currency is referred to as mining. Miners use a computer to solve the mathematical algorithm attached to each virtual coin that authenticates the transaction. The use of encryption to complete every transaction is why the term cryptocurrency is used to describe virtual coin activity. If you do engage in the mining of any type of cryptocurrency, each coin is considered ordinary income the day it is awarded on the blockchain. You can offset that income with deductions for the cost of electricity and equipment used in the mining.
If you get paid in digital currency, it is the same as getting cash in the amount of fiat currency you could get on the day you got paid. Full payroll and income taxes are due on digital currency compensation. The fact that the value of the coins may decline after you get paid will not reduce your tax bill.
Most virtual transactions do not involve ordinary income, but rather capital gains income. The reason for this is the IRS does not recognize virtual currency as currency. In Notice 2014-21, the IRS indicates that transactions using virtual currency will be treated as if they were related to the exchange of property. Unfortunately, this general guidance is missing some key information. For example, assume you have several transactions through the year. Some of them were a gain and others were a loss. When you calculate that loss, what method do you use? It could be first in, first out. It could be last in, first out. Or maybe average cost. Absent further guidance, the basic rules of engagement for working with the IRS apply: practice consistency and be ready to support your assertions with plenty of documentation.
There are software tools available to measure the change in value from when a cryptocurrency was purchased to when it was sold. Coinbase, the largest U.S.-based cryptocurrency exchange, is working with a number of companies to make it easy for taxpayers to transfer transactions to software packages that calculate the value change since initial purchase. It’s worth noting that this issue of having to measure the currency fluctuation occurs not only when you are involved in an investment transaction. Should you use virtual currency to purchase a slice of pizza, that becomes a potentially taxable event. If the value of the currency when first acquired is different than when you bite into the slice of pizza, you may have a bitter aftertaste when it comes to taxes.
Despite the complexity associated with their use, and their declining value, opportunities to use cryptocurrencies are expanding. Fidelity Investments offers custody and trade execution services for virtual currencies through Fidelity Digital Assets. This year, businesses can pay taxes in Ohio using virtual currency. There is no need to worry about running out of opportunities to calculate gain or loss on digital coins.
One important distinction to note (at least for now) is that the measuring of tax implications for cryptocurrency transactions may look like calculating tax for stocks or bonds, but there is one big difference. Virtual currencies are not a security. That means they are not subject to wash sale rules. It is possible to exit a negative virtual currency position, return to it within 30 days, and still recognize the loss.
This is a planning opportunity, but wash sale isn’t the only rule to consider in this situation. The IRS also uses criteria known as the economic substance doctrine to determine if a transaction is eligible for favorable tax treatment. This means if the only purpose of the transaction is to reduce or avoid tax, and it has no other legitimate business purpose, you don’t get the tax break. To reenter the virtual currency market after liquidating a position may be a legitimate investment decision, but if it has a tax advantage, it’s important to be ready to explain why the tax benefit wasn’t the driver of that piece of business.
Another consideration for a taxpayer with large declines in their virtual currency portfolio is the limitation on how those losses can be applied to your tax liability. Cryptocurrency losses can be netted with sales of high-performing stocks to reduce taxable gains from the other investments. If the number at the end of the netting calculation is less than zero, you can claim a capital loss on your tax return. However, the amount is capped at $3,000 per year. The remaining loss can be carried forward for use in future years, but also with the per year limit.
One other interesting area of cryptocurrency and taxes involves the global nature of these transactions. Most virtual currency exchanges are located off shore. If a U.S. taxpayer has a virtual wallet with a non-U.S. exchange, it’s not clear how this relates to requirements about reporting off-shore assets. In 2014, the IRS specifically said that Bitcoin held in foreign accounts would not be subject to a Foreign Bank and Financial Account Report that year. However, the IRS indicated at the time that this policy was subject to change. There has been no clarification since, and no elaboration with regard to possible application of reporting obligations under the Foreign Account Tax Compliance Act of 2009.
Adding to the mix of considerations is the person who transacts through an offshore exchange but holds their virtual currency on a hard drive in the United States. If digital coins are stored on a device in a U.S. residence, does it matter that you conduct transactions through an off-shore exchange? Once again, the best a CPA can offer clients now is a consistent approach backed up with good documentation and research to support the position.
Perhaps the biggest cryptocurrency risk from a tax standpoint lies with those who don’t realize they need to share their virtual coin activity with their CPA. They don’t get a piece of mail from their exchange at year-end labeled “important tax information” with a Form 1099 enclosed. Making sure to ask clients about this topic is a best practice to add to your list. Virtual currencies have real tax consequences, and they are evolving. More tax-planning challenges and opportunities are to be expected from clients who have a virtual financial life in their portfolio.
Judith Herron, CPA, is an accountant for Markovitz Dugan & Associates in Pittsburgh. She can be reached at firstname.lastname@example.org.