New on the 2019 individual tax return is the following question: “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
The Internal Revenue Service (IRS) is getting increasingly close to already knowing the answer. As with all questions on a tax return, this must be answered truthfully, as substantial penalties apply to items that are willfully omitted or answered incorrectly.
Virtual currency (VC) is treated as property for tax purposes. Even though “currency” is included in the name, the part of the Internal Revenue Code Section 988, which governs how currencies are treated, does not apply.
The gain or loss on sale is, therefore, capital in nature and reported on Schedule D, the same way as is done for stocks. Profit on VC sold within one year of acquisition are short-term gains (ordinary income tax rates), and selling VC after holding it for more than one year results in preferential long-term capital gains tax rates. Losses can be used to offset profit from other capital transactions. Up to $3,000 of excess losses can offset ordinary income ($1,500 in the case of married filing separately); the unused losses are carried over to subsequent years.
Below are the most common scenarios involving virtual currency:
- Purchase: If paid with regular currency, the cost basis is the amount paid. No income tax reporting is needed.
- Exchange: If the VC was received in exchange for goods or services, the basis is the fair market value of the VC, if traded on an exchange. Otherwise, the basis is the fair market value of the goods or services provided. In an exchange transaction, the receiver of the VC reports it as income in the same manner as if the transaction occurred with regular currency.
- Gift or Inheritance: The same rules apply to VC as they do to receiving a gift or inheritance of any other property, including disclosures if received from a foreign party.
- Hard Fork: As discussed in a previous article, the acquisition of VC in a hard fork results in ordinary taxable income equal to the fair market value of the VC received.
- Mining: Those who provide computing power to the VC network are rewarded via VC payment. Income from mining is ordinary income based on the fair market value of the VC received. This is typically reported on Schedule C (income from self-employment) and deductions are allowed for associated costs such as electricity, hardware, office space, and so on. Such income may also be subject to self-employment tax and, in such a case allow the taxpayer to establish and contribute to a retirement plan based on the net profit from the activity.
- Sale: Gain or loss is recognized in the amount of the difference between the fair market value of the VC sold and its cost basis. Whether sold for dollars or used as payment for goods or services, the transaction is reportable and profits are taxed.
- Donation: If the VC is held for less than one year, the charitable contribution deduction is the smaller of its cost basis or its fair value on the date of donation. If held for more than one year, the deduction is the fair market value on the date of donation. However, unlike stock, which does not require an appraisal, a value of over $5,000 requires an appraisal. There is an effort to specifically exempt virtual currency from the appraisal requirement if the VC is traded on a public exchange. However, this has not been accomplished at this point.
- Gift: Because the VC is property, the same rules apply. The giver does not recognize any gain or loss on disposition but may be required to file a gift tax return.
The importance of proper basis calculation and tracking cannot be overemphasized. So which method will you choose to track currency value? Last-In, First-Out (LIFO)? First-In, First-Out (FIFO)? First-In, Still Here (FISH)? Specific identification? Average cost? The IRS makes it easy by offering two choices:
- Specific identification: Cost basis for each batch of VC is determined upon acquisition, meaning that once disposed of, you will identify the particular batch or batches of VC. The advantage of this method is that you can pick high basis coins that are sold for cash, as well as low basis coins that are donated or gifted.
- FIFO: Dispositions of VC are presumed to be that of the earliest acquisition—first in, first out. Under this method, you have no control over basis and, thus, may be forced to recognize income that could have been avoided or reduced using specific identification.
The holder of VC must maintain a ledger of all VC transactions in order to correctly account for and report VC transactions on the income tax return. For mining activity, additional substantiation for any associated expenses is also required. Should a tax audit occur, the burden of proof is on the taxpayer to demonstrate proper accounting and reporting.
If you engaged in any virtual currency transactions during 2019, now is the time to ensure adequacy of recordkeeping. Waiting to do this until close to the tax filing deadline opens the door for mistakes and omissions.
Virtual currency is a hot issue for the IRS. While all aspects of a tax return filing need to be 100% accurate, this issue in particular deserves an extra level of care to ensure it’s done right.
For questions on virtual currency matters, please contact Larry Rubin, Aronson’s tax controversy practice lead partner, at 301.222.8212.