Sometimes what’s in a name really does matter. It creates expectations.
Take bitcoin. You can buy something with bitcoins. You can choose to accept payments using bitcoins. They’re even called coins, right there in the name.
But in spite of all that, the IRS doesn’t consider them coins — or any type of currency for that matter. Instead, it considers bitcoins and other cryptocurrencies to be property. Cryptocurrency substitutes for a real currency and has an equivalent value in real currency, but isn’t actually currency — and therein lies the problem.
With its 2014 announcement about the tax rules for cryptocurrencies, the IRS dramatically complicated their use by individuals and businesses. Cryptocurrency transactions have tax consequences that recognized currencies like dollars and pesos and euros and yen do not.
It’s worth noting that the U.S. isn’t the only country to consider cryptocurrency to be property. In fact, for most countries it’s property. But for others it’s currency and for a few, it’s banned altogether. Then there are those countries that have launched their own cryptocurrencies. If you’re using a cryptocurrency internationally, it’s important to know that the rules may, and generally do, differ.
U.S. Financial and Tax Consequences of Owning and Using Cryptocurrency
Because the IRS considers cryptocurrency to be property, the financial consequences are less like earning or paying with the dollars in your bank account and more like investing in a precious metal – think gold or silver.
You are only subject to tax when you sell or otherwise use or dispose of your cryptocurrency. Examples include a sale of the cryptocurrency or exchange for a different cryptocurrency; use of the cryptocurrency to make a purchase; or use of the cryptocurrency to pay employees, contractors or creditors.
To establish the value of your cryptocurrency when you sell or otherwise dispose of it, you can use either the FIFO (first-in-first-out) or the specific identification inventory method. Again like gold or silver.
Note: Under the Tax Cuts and Jobs Act, after 2017 you can’t swap bitcoins for other cryptocurrency in a tax-deferred 1031 exchange.
As a consequence of being considered property for tax purposes, there is generally more record-keeping required for bitcoins and other cryptocurrencies.
Because of its inherent volatility, if you own cryptocurrency for any length of time you’ll need to maintain detailed records. For tax reporting, they include the exchange and resulting fair market value in dollars at various transaction dates.
Cryptocurrency transactions must be reported in U.S. dollars for tax purposes, so you’ll need to know the relevant exchange rate at the time of each purchase, sale, use or other disposal transaction.
You can find current values and exchange rates for a number of cryptocurrencies online. For example, you can find historical data for bitcoin in dollars at coinmarketcap.com. Exchange rates can vary among the various exchanges.
Fair Market Value at Relevant Dates
You’ll need to document the fair market value of your cryptocurrency — based on the applicable exchange rate — on the date(s) you acquire it and the date(s) you sell, use or otherwise dispose of it.
Tax Rules and Consequences for Investors
If you invest in cryptocurrency, your basis for tax purposes is generally the fair market value at the time you acquired it. If you acquired it at more than one time, you must track each purchase and its related exchange rate/fair market value separately.
The difference in value between the time you acquire the cryptocurrency and the time you dispose of it is taxable as a realized gain (if the value increase) or a realized loss (if the value decreased). Changes in value while you continue to hold the cryptocurrency are not subject to tax.
Any realized gain or loss that results from the sale or other disposition of your cryptocurrency, because its considered property, is generally a capital gain or loss and not ordinary income.
Net long-term capital gains (for property held more than one year) are subject to tax at preferential rates. However if you’ve held the cryptocurrency for one year or less, the gain is taxed as ordinary income.
If your capital losses exceed your capital gains, you have a net capital loss and you’re limited in the amount you can deduct for the year (generally $3,000). The rest carries over to offset future gains. Again like gold or silver.
There is an exception if your cryptocurrency is essentially inventory for your business, or is other business property held for sale to your customers. In this case, any gain or loss is ordinary income.
Sales transactions conducted using cryptocurrency are subject to sales tax.
Tax Rules and Consequences for Miners and Employees/Contractors Paid in Cryptocurrency
If you mine bitcoins or other cryptocurrencies, the cryptocurrency you earn as a result is income to you, subject to federal income and self-employment taxes. If you’re self-employed, the income is not subject to tax withholding.
Likewise, cryptocurrency earned for work performed as an employee or independent contractor is considered income subject to federal income and employment or self-employment taxes and applicable tax withholding.
The amount of income you report on your tax return is equal to the fair market value of the cryptocurrency at the time you earned it.
Cryptocurrency payments made to employees or contractors for services are subject to applicable federal information reporting requirements, such as W-2s and 1099s. These information reporting requirements are complicated by the fact that one or both parties to a cryptocurrency transaction may be anonymous.
Tax Rules and Consequences for Buyers Who Pay with Cryptocurrency
If you use cryptocurrency to make a purchase or a payment, you have a taxable capital gain or loss. The character (long- or short-term) and amount of the gain or loss is determined by your holding period and the change in fair market value between the time you acquired the cryptocurrency and the time of the purchase or payment.
Cryptocurrency payments may also subject you to backup withholding if the business you’re paying doesn’t have your taxpayer identification number.
Tax Rules and Consequences for Sellers Who Receive Cryptocurrency Payments for Goods or Services
When you acquire cryptocurrency as a result of a sale — either a personal or a business transaction — both the payment amount and your tax basis in the cryptocurrency is equal to its fair market value at the time the transaction was completed.
If you continue to hold the cryptocurrency and its fair market value changes, you won’t have a gain or loss until you dispose of it. To avoid a future gain or loss, many digital wallets and other merchant tools can determine the exchange rate at the time of the payment and immediately convert that payment amount into dollars.
The backup withholding requirements mentioned above also apply, where appropriate, when you don’t have the payer’s tax identification number.
The tax consequences of the IRS’ rules for cryptocurrency