Virtual currencies, also known as cryptocurrencies, have gone mainstream. For example, you can use Bitcoin to buy a Tesla, or you can use a Bitcoin wallet on your smartphone to make everyday purchases. However, using virtual currency has federal income tax implications that may surprise you.
The IRS takes the position that virtual currency acts as property for federal income tax purposes. That means you have to recognize and report taxable gain, income, or loss every time you exchange virtual currency for goods, services, U.S. dollars, or for a different virtual currency.
Depending on the circumstances, a virtual currency holding can be classified as business property, investment property, or personal-use property. If you fail to report virtual currency transactions on your tax return and get audited, you could face interest, penalties, and even criminal prosecution in extreme cases.
Detailed records are essential for compliance with the federal income tax rules. Your records should note:
• When you received the virtual currency,
• The currency’s fair market value (FMV) on the date you received it,
• The currency’s FMV on the date you exchanged it,
• The virtual currency trading exchange that you used to determine FMV, and
• Your purpose for holding the currency (business, investment, or personal use).
This information determines the federal income tax consequences of your virtual currency transactions.
Reporting Virtual Currency Transactions
The 2020 version of IRS Form 1040 asks if, at any time during the year, you received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency. The fact that the IRS prominently displays this question on the first page of your return indicates the level of seriousness the IRS has about enforcing compliance with the applicable tax rules.
IRS instructions clarify that reportable virtual currency transactions include:
• The receipt or transfer of virtual currency for free (without having to pay),
• The exchange of virtual currency for goods or services,
• The sale of virtual currency,
• The exchange of virtual currency for other property, and
• The disposition of a financial interest in virtual currency.
To arrive at the federal income tax results of a virtual currency transaction, calculate the FMV, measured in U.S. dollars, of the virtual currency on the date you receive it or pay it. Exchanges list the values of the most-popular virtual currencies. For example, The Coinbase exchange lists Bitcoin and three other virtual currencies.
When you exchange virtual currency for other property, including U.S. dollars or a different virtual currency, you must recognize either:
• A taxable gain if the FMV of the property you receive exceeds your basis in the virtual currency that you exchanged, or
• A loss for tax purposes if the FMV of the property you receive is less than your basis in the virtual currency. However, various tax-law limitations may apply to virtual currency losses.
If you held the virtual currency for investment purposes for more than one year, any gain will qualify as lower-taxed long-term capital gain.
For example, say you use one Bitcoin to buy tax-deductible supplies for your business. On the date of the purchase, Bitcoin is worth $60,000 each. So, you have a business deduction of $60,000. But another piece to this transaction exists: the tax gain or loss from holding the Bitcoin and then spending it.
Suppose you bought the Bitcoin in January 2021 for only $31,000. So, you have a $29,000 taxable gain from the appreciation in value of the Bitcoin ($60,000 – $31,000) that you exchanged for the $60,000 worth of supplies. Assuming you do not operate in the trade or business of buying and selling virtual currencies, the $29,000 gain becomes a short-term capital gain, because you held the Bitcoin for less than a year.
Virtual Currency Payments to Employees and Independent Contractors
If you use virtual currency to pay employee wages, the FMV of the currency counts as wages subject to federal income tax withholding, FICA tax, and FUTA tax. Like any other wages paid to employees, you must report wages paid with virtual currencies on Form W-2.
If you use virtual currency to pay an independent contractor for performing services for your business, the FMV of the virtual currency paid is subject to self-employment tax for the contractor. You must report the payment on Form 1099-NEC if payments to that contractor during the year amount to $600 or more.
You may also have a tax gain or loss due to appreciation or decline in the value of the virtual currency during the time you held it before paying it to the employee or independent contractor. Assuming you do not operate in the trade or business of buying and selling virtual currencies, the gain and loss will be a capital gain or capital loss (short-term or long-term depending on how long you held the virtual currency).
Virtual Currency Receipts
If you accept virtual currency for goods or services, you must determine the FMV of the currency on the transaction date to convert the deal into U.S. dollars. Then you can calculate your taxable income or gain.
To illustrate, say you sell a valuable vintage auto that you bought and restored for two Bitcoin. On the date of sale, each Bitcoin is worth $55,000. Your tax basis in the vintage auto is $57,000. How would you report this transaction on your tax return?
First, you would convert the two Bitcoins into U.S. dollars ($55,000 × 2 = $110,000). Second, you would calculate your taxable gain on the sale ($110,000 – $57,000 = $53,000). You would report this amount as income or gain on your Form 1040.
Now, test your understanding with this example: Arnie works as a self-employed IT professional who operates as a sole proprietorship for tax purposes. He accepts two Bitcoin as payment for a major project. On the date of receipt, each Bitcoin is worth $60,000 each according to the Coinbase exchange. How much income should Arnie report?
The answer is surprisingly simple: Arnie must recognize $120,000 of taxable income ($60,000 × 2) for services rendered. Because of his roles as a self-employed independent contractor, the $120,000 is also subject to self-employment tax. His tax basis in the two Bitcoin will be $120,000 when he uses it in a future transaction.
Many taxpayers may be unaware of all the federal income tax implications of virtual currency transactions. But the IRS doesn’t accept ignorance as an excuse for failure to comply with tax rules. There may be state income tax consequences, too. If you have questions or want more information, contact a Hantzmon Weibel tax expert.
© Copyright 2021 Thomson Reuters.
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