Cryptocurrencies are all the rage today, but come tax season they might only cause you rage. The reality is that one driving force behind cryptocurrency development was a desire to be outside the view, control, and domain of governments. However, they cannot escape the IRS. Not only do cryptocurrencies not escape the IRS’ tax rules, the tax rules are not that favorable at this time due to a lack of clarity by the IRS around cryptocurrencies and numerous reporting and valuation tracking issues that can be very burdensome come tax time.
The first place to start is that cryptocurrencies, like Bitcoin, Ethereum, and Litecoin, are not considered currencies for federal tax purposes. Back in 2014, the IRS released IRS Notice 2014-21, stating that digital currency might act like the coin and paper money of the United States but it currently does not have “legal tender status in any jurisdiction.” As such, digital currency is treated as property for federal tax purposes. This does raise an interesting issue: if countries start treated digital currencies as legal tender, it could change the nature of its tax treatment. However, the IRS currently does not treat digital currencies as currencies.
Further in the notice, the IRS states that normal tax rules involving property apply to digital currencies. This means that digital currencies could be treated as business, investment or personal property, all impacting taxation. This means that digital currencies are not taxed equally among owners and miners. Some people might be subject to ordinary income taxes and others might be subject to capital gains tax treatment. But, generally speaking, the mining, receipt, sale, use, transfer, or exchange of digital currencies can create an immediate taxable event.
For instance, if you bought Bitcoin for the purpose of buying online goods or services, any gain above your cost basis (essentially what you paid for it) would be subject to taxation. So let’s say you bought $100 of digital currency and exchanged it a month later for some website design services that cost $120. At this time, you would have a $20 gain based on the $120 received in value minus your $100 basis. This would also be the case if you just exchanged one digital currency for another in 2018. (There is some debate as to whether a 1031 exchange was allowed for digital currencies prior to the new tax law changes based on IRS Revenue Ruling 79-143 which implied that like kind-exchanges of gold coins could be accomplished under 1031.) Now, the exact taxation of this gain would depend on if you were holding this asset for investment, business, or personal reasons.
If the digital currency was purchased and held for investment purposes, it is treated as a capital asset, and capital gains tax treatment would be available just like with any other investment or stock. However, if it was held for personal reasons, you might not be as easily able to deduct loses. Furthermore, any exchange of digital currencies for goods or services will result in a taxable event.
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