Earlier this month, the director of the IRS cybercrimes unit stated that so far this fiscal year, the IRS has seized over $1.2 billion worth of cryptocurrency, up from $137 million in fiscal 2020 and only $700,000 in fiscal 2019.

Under present law, virtual currency transactions are taxable, similar to transactions in any other property, including stock, bonds and mutual funds. With the popularity of virtual currency growing in recent years, the Internal Revenue Service (IRS) has offered increased guidance on its tax treatment―and many holders of virtual currency are not happy.

As the IRS is aware that some taxpayers with virtual currency transactions may have incorrectly reported or innocently failed to report income and pay the related tax, the IRS is aiming to increase public awareness. In summer 2019, the IRS issued more than 10,000 educational letters to taxpayers known or believed to be engaged in virtual currency transactions. In the beginning of the 2020 filing season, the IRS added a new question relating to the sale, purchase or exchange of virtual currency on the first page of Form 1040, the individual income tax return. The answer to this was subject to the taxpayer’s signature under the penalties of perjury.

With its public awareness campaign completed in the eyes of the IRS, enforcement action is now on the rise. In March 2021, the IRS launched Operation Hidden Treasure, a joint effort between the Office of Fraud Enforcement and the Criminal Investigation Division of the IRS to search for unreported income related to cryptocurrency. Agents are trained to focus on money laundering and tax evasion tactics, such as the use of shell companies and structuring of transactions beneath what the parties think the future reporting thresholds might be. Earlier this month, the director of the IRS cybercrimes unit stated that so far this fiscal year, the IRS has seized over $1.2 billion worth of cryptocurrency, up from $137 million in fiscal 2020 and only $700,000 in fiscal 2019. As President Joe Biden intends to ramp up enforcement action at the IRS as a whole, virtual currency is certain to receive higher scrutiny in the coming years, particularly after the IRS’s success this year.

Most recently, the infrastructure bill passed by the Senate and under consideration in the House, which we wrote about in this Alert, contains a key provision regarding virtual currency. In this provision, tax reporting requirements will be imposed on cryptocurrency brokers, much in the same way brokers report their clients’ stock sales to the IRS. These reporting requirements are projected to bring in additional revenue of $28 billion over the coming decade. With such returns expected, this is only the beginning of tighter regulation of the cryptocurrency market as the Biden administration strives to achieve greater tax compliance.

Virtual Currency

As defined by the IRS, virtual currency is a digital representation of value other than a representation of the U.S. dollar or a foreign currency (“fiat currency” or a currency not backed by a commodity, such as gold) that functions as a unit of account, a store of value and a medium of exchange. Virtual currency is a very broad term that could include digital currency not readily attached to a traditional fiat currency, like the dollar, but is used for payment of goods and services. Often, virtual currencies are purchased using fiat currency, but then only used on a certain platform. Examples would include virtual currency exchanged within a video game, frequent flyer miles or Amazon Coin.

Some virtual currencies, usually cryptocurrencies, are convertible, which means that they have an equivalent value in fiat currency or act as a substitute for fiat currency. The IRS uses the term “virtual currency” to describe the various types of convertible virtual currency that are used as a medium of exchange, including both digital currency and cryptocurrency.

Cryptocurrency

Cryptocurrency is a subset of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. These would be currencies like Bitcoin, Etherum, ada, Binance Coin, Tether, XRB and Litecoin. Distributed ledger technology uses independent digital systems to record, share and synchronize transactions, the details of which are recorded in multiple places at the same time with no central data store or administration functionality. A transaction involving cryptocurrency that is recorded on a distributed ledger is referred to as an “on-chain” transaction; a transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction.

Regardless of the label applied, if a particular asset has the characteristics of a cryptocurrency or a virtual currency, it is virtual currency for federal income tax purposes. In general, virtual currency is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency.

Tax Reporting in a Nutshell

Sale or Exchange of Virtual Currency

When you sell virtual currency, you must recognize any gain or loss on the sale, just as you would with the sale of a stock or mutual fund, subject to the same limitations on the deductibility of losses. The gain or loss is the difference between adjusted basis in the virtual currency and the amount received in exchange for the virtual currency, which should be reported on your federal income tax return in U.S. dollars. The basis is the amount spent to acquire the virtual currency, including fees, commissions and other acquisition costs in U.S. dollars.

Transfer of Property

If a taxpayer exchanges virtual currency for property, the gain or loss is the difference between the fair market value of the property received and adjusted basis in the virtual currency exchanged. For the transferor of the property, the rules are slightly different and depend on the assets being exchanged. If you transfer property held as a capital asset in exchange for virtual currency, you will recognize a capital gain or loss. If you transfer property that is not a capital asset in exchange for virtual currency, you will recognize an ordinary gain or loss, at potentially significantly higher tax rates. Transfer of property involving virtual currency is complex and requires careful planning and tracking.

Payment for Services

Generally, self-employment income includes all gross income derived by an individual from any trade or business carried on by the individual other than as an employee. Consequently, the fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to self-employment tax.

In addition, the form of compensation for services is immaterial to the determination of whether the compensation constitutes wages for employment tax purposes. Consequently, if wages are paid in virtual currency, that amount, measured in U.S. dollars as of the date of receipt, is subject to federal income tax withholding, Federal Insurance Contributions Act tax and Federal Unemployment Tax Act tax, and must be reported on Form W-2, Wage and Tax Statement.

For either type of transaction, the amount of income you must recognize is the fair market value of the virtual currency, in U.S. dollars, when received. In an on-chain transaction, you receive the virtual currency on the date and at the time the transaction is recorded on the distributed ledger.

If you pay for a service using virtual currency that you hold as a capital asset (i.e., you do not mine cryptocurrency or hold it as inventory), then you have exchanged a capital asset for that service and will have a reportable capital gain or loss. The gain or loss is the difference between the fair market value of the services received and the adjusted basis in the virtual currency exchanged.

Mining of Cryptocurrency

The mining of the cryptocurrency itself creates significant tax implications. Unlike many other accretions of wealth, the income received is not reported to the IRS in the form of a 1099 or W-2. Whenever a particular cryptocurrency is mined, it is imperative that you keep detailed records of the date and fair market value of the coins mined.

The mining of cryptocurrency can be treated as either a business or a hobby. In the eyes of the IRS, the distinction between “business” and “hobby” depends on subjective factors, including the time and effort spent on the activity, the intent to make a profit, your dependence on the mining income and the profitability of the activity itself. If the activity is classified as a hobby, any income is treated as ordinary income and taxed at your marginal tax rate. If the mining is performed as a business activity, the mined currency is treated as self-employment income and taxed as such. While treating the activity as a hobby may be the simpler choice, mining as a business allows for certain deductions and perhaps less scrutiny from the IRS.

If you are mining cryptocurrency as a business and not a hobby, you may be eligible for certain deductions to reduce any tax liability incurred. These include the cost of mining equipment, electricity costs, repairs to mining equipment, and rented space if the mining equipment is not housed in your residence. If the mining equipment is kept in your residence, then you may able to treat the physical space used similar to a home office deduction.

Income from mining is recognized on the date that the coin (or portion of a coin) is issued into the miner’s wallet. Thus, it is important to keep detailed records of daily mining activity and the value of the coins mined on a certain date. There are various applications that can used to accomplish this so it does not have to be recorded manually.

Finally, when mined cryptocurrency is sold, a gain or loss must be reported based on the appreciation or loss in value since the currency was mined. Generally, the cost basis is the value of the currency when mined, which was previously included in income. This highlights the importance of detailed record keeping, as the value of these currencies are constantly changing.

Virtual Currency and Foreign Bank and Financial Accounts

Within the Treasury Department, it is not just the IRS that has increased scrutiny of virtual currency. The Financial Crimes Enforcement Network (FinCEN) announced in December 2020 that it intends to require reporting of foreign accounts holding virtual currency on the Form 114, Report of Foreign Bank and Financial Accounts (FBAR).

While these regulations have not yet been issued, the increased scope of the FBAR is worth noting and planning for. Many questions remain as to what will need to be reported―such as whether the requirement will include virtual currency held by an exchange outside the U.S., or virtual currency held in a wallet on a flash card or hard drive physically located outside the U.S. Still, taxpayers should start an inventory of their virtual assets in preparation for the anticipated compliance measures.

TAG’s Perspective

The law surrounding cryptocurrency transactions continues to evolve and attract the attention of the IRS and FinCEN. Taxpayers should be aware of their obligations to maintain records that document the receipt, purchase date, cost basis and fair value at the time of sale, exchange or other dispositions of virtual currency. The better the records maintained, the less effort taxpayers and tax practitioners will have to spend analyzing, reporting and assessing the tax impact of these transactions come tax time―not to mention an increased defensible position and better results in a potential audit. If you have just acquired virtual currency or cryptocurrency, loop in your tax adviser so that you can effectively track the transactions and avoid the ire of the IRS.

For More Information

If you would like more information about this topic or your own unique situation, please contact Michael A. Gillen, John I. Frederick or any of the practitioners in the Tax Accounting Group. For information about other pertinent tax topics, please visit our publications page.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.