There are several regulatory regimes to consider when considering or researching opportunities in the digital asset and cryptocurrency sectors beyond the various State regulations and the FinCen Decisions. In what looks like a bowl of alphabet soup, there are a host of other federal agencies with their own cryptocurrency rulings and restrictions, including the Commodity Futures Trading Commission (“CFTC”), the Internal Revenue Service (âIRSâ) and the Securities and Exchange Commission (âSECâ). This article will provide a high-level overview of the IRS ‘position on cryptocurrencies.
In the view of the IRS, cryptocurrencies are considered 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 real estate transactions. This means that generally cryptocurrencies, including bitcoin, are treated as an asset and are subject to the rules on capital gains and losses.
When it comes to 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 a taxable event. Therefore, if you acquire a Cryptocurrency and hold it for more than a year, if or when you possibly have it, your gain or loss will be subject to the long-term capital gains rules. If you dispose of the cryptocurrency within one year of acquisition, the gain or loss will be subject to the short-term capital gain rules. The holding period for determining whether a gain or loss on the exchange or use of the Cryptocurrency begins on the day following the acquisition of the Cryptocurrency and ends on the day you trade it or use. An exception to this general rule that cryptocurrency is taxed as property is when a business holds cryptocurrency for sale to customers in the ordinary course of business. It is important to note that moving cryptocurrency from one wallet you control to another is not a taxable event.
Additionally, if you are paid for goods or services that you provide in cryptocurrency, this constitutes income at the fair market value of the cryptocurrency received (as measured in US dollars on the date of receipt). 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 that you have 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 cryptocurrency’s basis or its fair market value at the time of contribution. Occasionally, 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 miners accept the new rule, some don’t, and that’s how a fork happens. Bitcoin Cash is an example of a fork of the Bitcoin blockchain. Sometimes when a fork occurs, the holders of the original cryptocurrency receive the new cryptocurrency. Receiving a new currency from a range is considered income and is taxable. Below is a table giving an overview of potential actions and indicating whether a taxable event is created.
|Cryptocurrency and potential taxable events|
|action||Is it taxable?||Calculation of gain or loss|
|Buying a cryptocurrency with US dollars||No||No gain or loss|
|Transferring cryptocurrency from an exchange to a wallet you control||No||No gain or loss|
|Selling a cryptocurrency for US dollars||Yes||Fair market value of the cryptocurrency sold minus its cost base|
|Exchange of one cryptocurrency for another||Yes||Fair market value of the acquired cryptocurrency minus the base cost of the transferred cryptocurrency|
|Spending cryptocurrency on goods and services||Yes||Fair market value of goods and services received minus the base cost of the cryptocurrency|
|Cryptocurrency won||Yes||Fair market value of the cryptocurrency received|
When determining the gain or loss on the cryptocurrency, you can either specifically choose the units of the currency you sold, traded, or used, or use a first in, first out (“FIFO”) basis. . In order to specifically identify a cryptocurrency unit sold, traded or used, you must indicate (1) the date and time of acquisition of each unit, (2) the basis and fair market value at the time of purchase. acquisition, (3) the date and time the unit was sold, traded or used, and (4) the fair value of each unit when it was sold, traded or used and the amount of money or the value of goods received for the unit. The FIFO method results in treating the unit that was sold, traded, or used as the first unit of the specific cryptocurrency you acquired. This is an important distinction because it can have massive implications for calculating the gain or loss on your cryptocurrency. For example, suppose you acquired a 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 a 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 little as $ 35,000.
As similar exchanges in Section 1031 are now only available for real estate, 1031 transactions are not available for cryptocurrencies. At one point there was a gray area as to whether exchanging one type of cryptocurrency for another could be considered a 1031 transaction, but the IRS has now made it clear that an exchange of cryptocurrency is not a 1031 transaction.
As the saying goes, the only two sure things in life are death and taxes. Therefore, it is very important to know how the cryptocurrency is taxed if you are planning to invest in the sector. Cryptocurrency is taxed as property, is subject to capital gains tax, with a fixed holding period from the day after acquisition to the day of disposition, and is not eligible for transactions of section 1031. However, any cryptocurrency you earn is taxable as ordinary income. This includes cryptocurrencies earned through mining and cryptocurrencies acquired through the creation 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 any questions about the above material, please do not hesitate to contact us.