The number of people investing in cryptocurrency is increasing as more investors become familiar with how this asset functions, may be acquired, held as an investment asset, or used in purchase transactions. Cryptocurrency, or what the IRS calls Virtual Currency, is a digital representation of value, aside from the U.S. dollar or other foreign currencies. For tax purposes, the IRS views virtual currency as property, which means this currency is treated as property for general tax principles.
The first question, on the 2021 tax Form 1040 asks, “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” The “yes or no” answer depends on what transactions you had in 2021. If a taxpayer simply purchased virtual currency with U.S. currency and had no other virtual transactions throughout 2021, the answer would be “no.” Holding virtual currency in a wallet or account, or a transfer between accounts owned by the taxpayer, would also qualify as a “no.”
When to select “yes” as an option:
• Receipt of virtual currency as payment for goods or services provided, or as income.
• Exchange of virtual currency for other property, including for another virtual currency.
• Exchange of virtual currency for goods or services.
• Receipt or transfer of virtual currency for free (without providing any consideration) that does not qualify as a bona fide gift.
• Receipt of new virtual currency because of mining and staking activities.
• Receipt of virtual currency due to a hard fork (when crypto splits in two).
• Sale of virtual currency, and/or any other disposition of a financial interest in virtual currency.
Any profits earned on virtual currency that is held longer than one year is considered long-term capital gains and, depending on annual income, is normally taxed at a lower rate. If the crypto was held for one year or less, it is considered a short-term capital gains tax and profits will be taxed at the overall ordinary income rate.
Purchases made using virtual currency.
The IRS also expects a report be made on gains and losses attached to crypto investment activity or purchases made using cryptocurrency, such as Bitcoin. Even purchasing a cup of coffee with cryptocurrency has tax implications.
For an example, a crypto investor uses a $10,000 Bitcoin to purchase a new $2,500 computer – an asset that depreciates. The IRS expects a calculation based on the value of the Bitcoin at the time of the transaction and to recognize any capital gains or losses relative to the cost or fair market value.
Crypto used for services.
Many companies in the tech industry have begun paying employees with Bitcoin and other cryptocurrency. While the practice is a bit of a novelty, some firms see this as a means to attract more tech-savvy talent.
Both employee and employer should keep a record of the fair market value of the crypto paid as wages, measured in U.S. dollars at the date of receipt. These wages are subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA), and Federal unemployment taxes. All wages must be reported on Form W-2, Wage and Tax Statement.
On the flip side, employers who pay for services using virtual currency held as an asset must evaluate capital gains or losses for that exchange. The gain or loss is determined by the difference between the fair market value at the time of the exchange for services received and the adjusted basis in the virtual currency exchanged.
Charitable donations and crypto.
Donating to charity through cryptocurrency can reduce tax liability on the investment. According to IRS code Section 170(c), donations made to a charity using virtual currency that results in income or gain is not recognized. The charitable deduction made would be recognized as being equal to the fair market value of the virtual currency at the time of donation, provided the investment has been held over a year. Any deductions made using crypto currency held for a year or less would be based on the lesser of the cost of the virtual currency or the value of the currency at the time of the donation.
Charitable organizations that receive virtual currency should treat the donation as a noncash contribution and can assist a donor by providing the contemporaneous written acknowledgment, something the donor must obtain if claiming a deduction of $250 or more for the virtual currency donation.
It is important to maintain detailed records of all cryptocurrency transactions. This includes receipts and the amount of the purchases or donations, plus the value of the currency on the date of each transaction.
Visit the IRS website for the answers to FAQs on virtual currency. For other questions regarding the tax treatment of virtual currency, refer to Notice 2014-21 and Rev. Rul. 2019-24.
Author, Jeff Spiegel, CPA
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.