Federal Taxation of Bitcoin and Virtual Currencies
In 2014, The IRS issued Notice 2014-21 provides explicit clarification regarding the taxability of cryptocurrency transactions. Virtual currency is considered a capital asset for the majority of taxpayers, thus subjecting transactions involving virtual currency to the same general tax principles that govern property transactions.
- How is virtual currency treated for federal income tax purpose?
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What is virtual currency?
The Internal Revenue Service (IRS) provides a definition for virtual currency as a digital form of value that serves as a means of exchange, a unit of measurement, and a means of storing value.
“Convertible" virtual currency is used to describe virtual currency that holds a comparable value to real currency or functions as a replacement for real currency.
Bitcoin is the most widely used form of convertible virtual currency, facilitating user-to-user exchanges and enabling its acquisition or conversion into various real or virtual currencies, including the US dollar and the euro.
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Virtual currency is property
Virtual currency is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency. In the context of U.S. federal tax regulations, virtual currency is not regarded as a form of currency that has the potential to generate foreign currency gain or loss.
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- The taxation of Bitcoin and Virtual Currencies
The following will use Bitcoin as an example to explain the taxation principles of virtual currency.
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Tax basis
A taxpayer who receives virtual currency as payment for goods or services must include the fair market value (FMV) of the virtual currency in gross income.
FMV is the U.S. dollar (USD) value of the virtual currency on the day of receipt or zero if the currency was obtained through a fork.
Where virtual currencies are received as payment for goods or services, it must be determined that their base is the fair market value in USD as of the day of receipt.
Normal basis rules for capital assets apply to virtual currencies, that is original cost plus acquisition cost (commissions and fees from bitcoin exchange).
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Gross income rules for bitcoin received by airdrop due to hard fork
IRS Revenue Ruling 2019-24 pertains to the tax implications of gross income derived from cryptocurrencies that arise from hard forks and airdrops.
the IRS highlights two key points with regards to gross income associated with hard forks:
(a) According to section 61, if a taxpayer does not receive units of a new cryptocurrency as a result of a hard fork of a cryptocurrency they own, they will not be considered to have gross income.
(b) If a taxpayer receives units of a new cryptocurrency as a result of an airdrop following a hard fork, they will be considered to have gross income of an ordinary nature.
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Selling or exchanging bitcoin
(a) Selling Bitcoins
Bitcoins are usually sold in exchange for real money, or as payment for services. A gain and loss recognition is required when selling. The gain is reportable on Form 8949 and Schedule D.
Short-term capital gains tax applies if you had had your crypto for a year or less when you sold it. The short-term capital gains tax rates range from 10% to 37%, depending on your income tax bracket and filing status.
Long-term capital gains tax applies if you’ve had your crypto for a year or more. The long-term capital gains tax rate ranges from 0% to 10%, depending on your tax bracket and filing status.
Example 1: An individual taxpayer purchases 1 bitcoin for $1,350 on April 15, 20X7. On May 30, 20X7, the taxpayer sells 1 bitcoin for $2,300 cash. The short-term capital gain is $950.
Example 2: An individual taxpayer purchases 1 bitcoin for $250 on March 15, 20X5. On April 15, 20X7, the taxpayer places an order for $1,350 plane tickets on Expedia.com and pays with bitcoin. FMV of 1 bitcoin on April 15, 20X7 is $1350. The long-term capital gain is $1000.
(b) Exchanging bitcoins for another virtual currency
If the fair market value (FMV) of the property acquired through the exchange of virtual currency is higher than the taxpayer’s adjusted basis of the virtual currency, the taxpayer will incur taxable gain. Each transaction gain recognized each time.
Example: An individual taxpayer purchases 1 bitcoin for $2,500. Two months later, FMV is US $3,000. Exchange for 500,000 Dogecoin. Recognize gain of $500 ($3,000 FMV of bitcoin less $2,500 basis). Two months later, sell 500,000 Dogecoin for US$3,100. Recognize gain of $100 ($3,100 proceeds less $3,000 basis in Dogecoin). |
- Possibility of reporting FBAR/FATCA
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Foreign Bank Account Report (FBAR)
As the use of virtual currency becomes more widespread, there is ongoing debate surrounding the inclusion of virtual currencies within the reporting obligations outlined by the Financial Crimes Enforcement Network (FinCEN) in Form 114.
Despite the initial proposal by FinCEN in December 2020 to establish regulations that would encompass virtual currencies as account types subject to reporting, the final regulations have yet to be completed or retracted.
Even though the bitcoin itself may not be subject to reporting, individuals from the United States who engage in the acquisition or exchange of bitcoin on international platforms may still be obligated to file a Report of FBAR.
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Foreign Account Tax Compliance Act (FATCA)
If the parameters of FATCA are met with virtual currencies or otherwise, the taxpayer should file the appropriate paperwork. In the case of FATCA, taxpayers are expected to file Form 8938 alongside their individual income tax return, Form 1040.
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- Wages paid in virtual currency
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Employment taxes
Wages paid in virtual currency by an employer as remuneration for services constitute wages for employment tax purposes. Fair Market Value (FMV) of virtual currency paid as wages is subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA) and must report on Form W-2.
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Self-employment tax
The fair market value (FMV) of virtual currency received in exchange for services rendered as an independent contractor, when converted to U.S. dollars at the time of receipt, constitutes self-employment income and is therefore liable to self-employment tax.
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- Other Issues
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Form 1099 Information reporting applies to virtual currencies
In accordance with current regulations, transactions conducted with virtual currency are subject to the same level of information reporting as any other property-based payment. This reporting requirement is fulfilled by submitting Form 1099-MISC. In the case of payments made with virtual currency, the value of the currency in U.S. dollars at the time of payment should be used for reporting purposes on Form 1099-MISC.
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Backup withholding applies to virtual currencies
In accordance with the regulations, payments conducted through virtual currency are subject to backup withholding, similar to other property-based payments. In cases where payors make reportable payments using virtual currency, they are required to request a taxpayer identification number (TIN) from the payee.
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Penalties
Failure to disclose virtual currency transactions as mandated promptly or accurately may result in not only the payment of outstanding taxes but also the imposition of interest and penalties.
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