Cryptocurrency is a form of virtual currency that has risen in popularity over the last decade and has prompted the Internal Revenue Service (IRS) to provide guidance as to the reporting requirements for such transactions.  There are a growing number of cryptocurrencies and vendors that are accepting these currencies as payment.  As the landscape continues to evolve, the IRS is doing its best to keep up with the constantly changing environment surrounding cryptocurrency and questions from taxpayers and preparers alike.  The draft instructions for the 2020 Form 1040 seek to clarify the transactions for which reporting is required.

Virtual Currency – In General

Virtual currency, or cryptocurrency, is a digital form of currency that can be bought and sold as an investment or used as currency for purchasing goods or services.  Bitcoin is likely the currency that most are familiar with, but as of today, there are over 300 different virtual currencies that are currently available.  Virtual currency relies on blockchain technology and a public ledger maintained by a community, rather than utilizing a central bank.  When used correctly, proponents of the digital currencies argue that transactions with cryptocurrency are more secure and provide a level of anonymity. 

Virtual currency was initially created to be used in the same manner as fiat currencies (the US Dollar or Foreign Currency) but the extreme volatility of price swings had made the practical applications less attractive than the opportunities to hold these currencies as an investment.

 With more recent increase in popularity of using the currency in the ordinary course of business has prompted the IRS to release guidelines as to what transactions and holdings need be reported to the IRS.  Though called “virtual currency,” the IRS has generally taken the position that these are assets either held for investment, sale, or as inventory. 

Virtual Currency Transaction Question – Form 1040

The virtual currency question on page one states that, “At any time during 2020, did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?” This question first appeared on the 2019 tax return on Schedule 1 to Form 1040.  This question has been moved to the top of page 1 of Form 1040 and the instructions have been expanded to include the following additional language. 

According to the draft instructions, a transaction involving virtual currency includes:

  • The receipt or transfer of virtual currency for free (without providing any consideration), including from an airdrop or hard fork
  • An exchange of virtual currency for goods or services
  • A sale of virtual currency
  • An exchange of virtual currency for other property, including for another virtual currency

Airdrops and Hard Forks

An airdrop is a marketing tool in which coins or tokens are added to wallets to promote awareness of a new virtual currency.  Typically, airdropping of these currencies is advertised on the cryptocurrency’s website.  Members of the cryptocurrency community are tasked with promoting the new form of digital currency via social media or other venues in exchange for the airdrop of the new currency.

A hard fork is a radical change in a network’s protocol that makes previously invalid blocks and transactions valid, or vice-versa.  A hard fork is essentially the splitting of one form of virtual currency into two separate currencies.  Upon the hard fork, for example, when Bitcoin split into Bitcoin and Bitcoin Cash, the owner of Bitcoin prior to the split received the same amount in Bitcoin Cash for what they held in Bitcoin.  Per the IRS instructions, the receipt of these new coins result in taxable income to the receiver of the new coins.  Taxable income is based on the fair market value at the date of the fork. 

Taxation of hard forks have created some controversy in the cryptocurrency community.  Holders of a virtual currency prior to a hard fork involuntarily receive the new coins as the result of the fork.  The newly created coins typically lose value immediately after the fork due to owners selling their new holdings shortly after receiving it.  In these cases, taxpayers are required to claim income at a higher valuation than the coin retains after the split.  Nevertheless, the IRS’s position is that these coins are taxable upon receipt at their fair market value on the date of the hard fork.

Exchange of Virtual Currency for Goods and Services

Virtual currency received as payment for goods or services is included in gross income at the fair market value of the currency on the date it is received.  The nature of this income is reflected in the same manner had they received fiat currency for the same goods or services.  For example, virtual currency received for purchase of goods is included at fair market value in the seller’s gross ordinary income.

Concurrently, when virtual currency is exchanged for goods and services, the taxpayer exchanging the virtual currency records a gain or loss on their tax return.  Gain or loss is calculated by subtracting the adjusted basis of the virtual currency from the fair market value of the goods or services received.  The character of the gain or loss is dependent on whether the virtual currency is a capital asset in the hands of the purchaser and their holding period in the virtual currency.  Typically, a taxpayer exchanging virtual currency for goods and services will recognize gain or loss of a capital nature.  There are instances that may occur where a taxpayer utilizes virtual currency held as inventory or property held for sale, and in that case, the gain would be ordinary in nature.

Sale of Virtual Currency

A sale of virtual currency is treated, for tax purposes, nearly the same as an exchange for goods and services.  The main difference is that in a sale, the taxpayer receives money instead of goods or services.  The same applies as it does above, and the nature of the holdings in virtual currency and holding period determine the type of gain, while the adjusted basis and sales price are used to arrive at the amount of gain or loss reported.

Exchange of Virtual Currency for Other Property, Including Other Virtual Currency

The exchange of virtual currency for other property is again alike the exchange for goods and services.  Gain or loss is reported by subtracting the adjusted basis of the virtual currency exchanged from the fair market value of the assets or other virtual currency received.  The character of the gain or loss is dependent on whether the virtual currency is a capital asset in the hands of the purchaser and the holding period in the virtual currency.  Like-kind exchanges are expressly disallowed for the exchange of one type of virtual currency for another.

Additional Guidance Provided

Previously, CPAs were unclear if the mere holding of virtual currency constituted a “yes” response to the virtual currency question.  The instructions certify that this is not a reportable transaction and will not require the taxpayer to answer the question with a “yes” response.  Other non-reportable transactions include the moving of virtual currency from one wallet to another, the purchase of virtual currency with fiat currency (i.e. USD, CAD, EUR, etc.), and donation of virtual currency to a tax-exempt organization. 

Sources have also included gifts as non-taxable transactions.  This is the case in the instance where gifts of virtual currency are below the annual gifting exclusion, and therefore by nature, are not required to be reported on a gift tax return.  Some consideration may be necessary when gifting cryptocurrency and this should be discussed with your tax professional.  As with any other gift, the taxability of the gift is based on the fair market value at the date of the gift and the individual receiving the gift will retain the donor’s adjusted basis in the asset. 

Reporting requirements for such transactions are also discussed in the draft instructions.  A disposal of “virtual currency that was held as a capital asset through a sale, exchange, or transfer” must be reported on Form 8949 and on Schedule D, as is the case of sales of any other type of capital asset.  If the virtual currency is received as compensation or held for sale to customers in a trade or business, the transactions must be reported in the same matter that other income of the same type would be reported.  For instance, virtual currency received as compensation would be reported as wages for Federal income tax purposes.

Virtual currency is still a relatively new concept and continues to develop and grow.  As developments in the field continue to evolve, the tax code will be sure to adjust along with the market.  Additional guidance provided by the IRS should provide investors, currency holders, and tax preparers with some well needed clarity.  Please consult your tax advisor when conducting transactions or investing in virtual currency.