There are multiple regulatory schemes to be aware of when considering or pursuing opportunities within the Digital Asset and Cryptocurrency industries beyond the various State Regulations and the FinCen Rulings. In what looks like a bowl of alphabet soup, there are a host of other federal agencies with their own rulings and restrictions pertaining to Cryptocurrencies including the Commodity Futures Trading Commission (“CFTC”), the Internal Revenue Service (“IRS”), and the Securities and Exchange Commission (“SEC”). This article will provide a high-level overview of the IRS’s stance on Cryptocurrencies.
In the IRS’s view, Cryptocurrencies are considered to be convertible digital tokens, a virtual currency that can be exchanged for other fiat or virtual currencies. As of this writing, the IRS treats Cryptocurrencies as property and therefore Cryptocurrencies are subject to general tax principles for property transactions. This means that generally Cryptocurrencies, including bitcoin, are treated as a capital asset and are subject to the capital gain and loss rules.
Regarding Cryptocurrencies, converting a Cryptocurrency to a fiat currency, converting a Cryptocurrency from one coin to another, or using a Cryptocurrency to pay for goods or services are all considered to be a taxable event. Accordingly, if you acquire a Cryptocurrency and hold it for longer than one year, if or when you eventually dispose of it, your gain or loss will be subject to long term capital gain rules. If you dispose of the Cryptocurrency within a year of acquiring, the gain or loss will be subject to short term capital gain rules. The holding period to determine whether a gain or loss on the exchange or use of the Cryptocurrency starts on the day after acquisition of the Cryptocurrency, and ends on the day you exchange or use it. An exception to this general rule of Cryptocurrency being taxed as property is when a business holds Cryptocurrencies to sell to customers in the ordinary course of business. Importantly, moving Cryptocurrency from one wallet that you control to another is not a taxable event.
Additionally, if you are paid for goods or services that you provide in Cryptocurrency, that constitutes income at the fair market value of the Cryptocurrency received (as measured in U.S. dollars on the receipt date). A donation of Cryptocurrency to a charity is eligible for the charitable contribution deduction, and is equal to the fair market value of the Cryptocurrency at the time of the donation provided you held the Cryptocurrency for at least one year. If the donated Cryptocurrency has been held for less than a year, the deduction is the lesser of the basis in the Cryptocurrency or its fair market value at the time of the contribution. From time to time a Cryptocurrency goes through a “fork” which occurs when certain miners who work on the blockchain of a specific Cryptocurrency decide to implement a new protocol. Some of the miners accept the new rule, others do not, and that is how a fork occurs. Bitcoin Cash is an example of a fork from the Bitcoin blockchain. Sometimes, when a fork occurs, holders of the original Cryptocurrency receive the new Cryptocurrency. A receipt of a new currency from a fork is considered income, and is taxable. Below is a chart providing an overview of potential actions and whether a taxable event is created.
|Cryptocurrency and Potential Taxable Events|
|Action||Is it Taxable?||Calculation of Gain or Loss|
|Purchase of a cryptocurrency with US Dollars||No||No gain or loss|
|Transfer of cryptocurrency from an exchange to a wallet you control||No||No gain or loss|
|Sale of a cryptocurrency for US Dollars||Yes||Fair Market Value of sold cryptocurrency less its cost basis|
|Exchange of one cryptocurrency for another||Yes||Fair Market Value of acquired cryptocurrency less cost basis of transferred cryptocurrency|
|Spending cryptocurrency on goods and services||Yes||Fair Market Value of received goods and services less cost basis of the cryptocurrency|
|Earned cryptocurrency||Yes||Fair Market Value of received cryptocurrency|
When determining the gain or loss on Cryptocurrency, you can either specifically choose units of the currency that you sold, exchanged or used, or use the first in first out basis (“FIFO”). In order to specifically identify a unit of Cryptocurrency being sold, exchanged or used, you must show (1) the date and time each unit was acquired, (2) the basis and fair market value at the time of acquisition, (3) the date and time the unit was sold, exchanged or used, and (4) the fair value of each unit when sold, exchanged or used and the amount of money or value of the property received for the unit. The FIFO method results in treating the unit that sold, exchanged or used as being the first unit of the specific Cryptocurrency you acquired. This is an important distinction because it can have massive implications as to calculating the gain or loss on your Cryptocurrency. For instance, assume that you acquired one bitcoin in 2016 for $1,000, a second bitcoin in 2019 for $10,000, and a third bitcoin in 2020 for $25,000. You then sold one bitcoin in 2021 for $60,000. Depending on which method you choose, your taxable income on the 2021 sale can be as high as $59,000 or as low as $35,000.
As Section 1031 like-kind exchanges are now only available for real property, 1031 transactions are not available for Cryptocurrencies. At one point there was a grey area as to whether the exchange of one type of Cryptocurrency for another could qualify as a 1031 transaction, but the IRS has now made it clear that a Cryptocurrency exchange is not a 1031 transaction.
As the saying goes, the only two things certain in life are death and taxes. Accordingly, it is very important to be aware of how Cryptocurrency is taxed if you are considering investing the industry. Cryptocurrency is taxed as property, is subject to capital gains taxes, with a holding period determined as the day after acquisition to the day of disposition, and is not eligible for Section 1031 transactions. However, any Cryptocurrency that you earn is taxable as ordinary income. This includes Cryptocurrencies earned through mining and Cryptocurrencies acquired from the forking of a blockchain. These rules are subject to change, and it is very important to be aware of any potential changes. If you are considering entering the Cryptocurrency industry and have questions on the above material, do not hesitate to reach out.