Tax Basics of Cryptocurrencies

Introduction

The market for cryptocurrencies, such as Bitcoin, Ethereum, and Ripple, saw dramatic growth throughout 2017. This growth caused the price of some cryptocurrencies to skyrocket. For example, the price of Bitcoin increased by 1800%, with the peak occurring mid-December of 2017.

Throughout the exuberance of rising prices, many ordinary people began buying and trading various cryptocurrencies, with many people making numerous trades per day. Recently, there has been a lot of news about the IRS cracking down on taxpayers that do not report their cryptocurrency transactions. The IRS even sued the largest U.S. cryptocurrency exchange, Coinbase, and won an order that required Coinbase to turn over information on more than 14,000 accounts.

Keeping in mind that as cryptocurrencies continue to become mainstream and the IRS continues to uncover taxpayers that are not reporting transactions properly, it is important for many taxpayers to understand the basic tax implications of their cryptocurrency trades.

1. For U.S. tax purposes, cryptocurrencies are “property,” not currencies.

The IRS has stated that “virtual currencies” are treated as property, not currencies.[1] In other words, for the purposes of taxation, cryptocurrencies are treated the same as sales/exchanges of cars, houses, stocks, bonds, etc.

2. What transactions do you have to report?

Any time you sell or otherwise dispose of a cryptocurrency, you have to compute the tax consequences of that exchange to be reported on your annual tax return. For example, if you buy 0.1 units of Bitcoin for $1,000, then later sell the 0.1 units for $1,500, you have a reportable gain of $500. Additionally, trading one cryptocurrency for another is a reportable transaction. For example, if you buy 0.1 Bitcoin for $1,000, then trade it for 3 units of Ethereum which has a current value of $1,200, then you have a reportable gain of $200.

For a short period of time there was some speculation as to whether trading one cryptocurrency for another could classify as a “like-kind exchange,” thus allowing taxpayers to defer paying taxes until their cryptocurrencies were converted back into dollars. However, the recent Tax Cuts and Jobs Act of 2017 eliminated this possibility by limiting like-kind exchanges to transactions involving “real property.”[2]

If you are a low-volume trader, tracking and reporting your trades may be easy; however, if you are a high-volume trader, you may have a significantly harder time keeping track of all of your trades. Some websites, such as Bitcoin.tax, can help you track your trades (including cryptocurrencies other than Bitcoin, such as Ethereum and Litecoin) by allowing you to import your trade history from major exchanges such as Coinbase, Gemini, and Kraken.

3. How to report hard forks

A hard fork is a permanent divergence from the previous version of the blockchain. Essentially, a hard fork is a change in the software that creates a new, and separate, version of the blockchain. Probably the most widely-known hard fork is the one that occurred on August 1, 2017, which created Bitcoin Cash. When the hard fork occurred, everyone that was holding Bitcoin received an equal amount of Bitcoin Cash. For example, if you held 10 units of Bitcoin at the time of the hard fork, afterwards you would own 10 units of Bitcoin and 10 units of Bitcoin Cash.

Some people speculate that the cryptocurrency acquired in a hard fork is equivalent to a gift, meaning you take a $0 basis and pay tax when you dispose of the newly-acquired cryptocurrency. However, gifts generally involve one taxpayer transferring property to another taxpayer. With respect to hard forks in cryptocurrencies, no one is transferring the units of the newly-created cryptocurrency from themselves to you. Instead, receiving new cryptocurrencies from a hard fork is more like finding money (or any other property). Therefore, on the date you acquire a cryptocurrency from a hard fork, you should report the fair market value of the newly acquired cryptocurrency.

Until further guidance is issued by the IRS, you may have a hard time determining the fair market value of the newly acquired cryptocurrency. The American Bar Association suggested that the deemed value at the time the forked cryptocurrency was acquired could be zero because of the difficulties in determining the value of the cryptocurrency and that the cryptocurrency may have different values on different exchanges at the same time. Under this approach, you would report no income at the time you acquired the forked cryptocurrency, but you would take a zero basis in the cryptocurrency and report 100 percent of the gain when you sold or traded the forked cryptocurrency.

However, it is unlikely that the IRS will adopt this approach. Instead, it is more likely that the IRS will require you to take the average price of the forked cryptocurrency on the day it was acquired and report that value as income.

4. How to report income from cryptocurrency mining

Income received from cryptocurrency mining should be treated as either income from a hobby or self-employment income, depending on your individual situation. If your circumstances demonstrate that you are mining cryptocurrencies with the intent to make a profit, then you report the income as self-employment income, and you can fully deduct your expenses (if you can prove them). On the other hand, if you are not intending to make a profit from mining cryptocurrencies, then any income is reported as “other income,” and no expenses can be deducted since the passage of the Tax Cuts and Jobs Act eliminated many previous itemized deductions.

5. Gifts of cryptocurrencies

Gifting cryptocurrencies is treated the same as gifting other types of property. Meaning, if you make gifts of cryptocurrencies, you only have to report gifts in excess of $15,000[3] per person per year. If you receive a gift in cryptocurrency, you do not have any immediate tax consequences. Instead, you take the same basis in the cryptocurrency as the person who gifted it to you, then, when you sell or exchange the cryptocurrency, you will report any gain or loss.

[1] Notice 2014-21, Section 4.

[2] Tax Cuts and Jobs Act, Section 13303.

[3] As of 2018.