VIRTUAL CURRENCY – BE WEARY OF HIDDEN TRAPS

As many have you may have read the IRS is attempting to crack down on what they believe to be a large number of unreported transactions revolving around virtual currency.

Virtual currency, as explained in IRS Notice 2014-21 “is a digital representation of value that functions as a medium of exchange, a unit of account and/or a store of value.” It may be used as legal tender in some instances but does not have legal tender status.

Convertible virtual currency, according to the same notice, has an equivalent value in real currency. The most popular convertible virtual currency is Bitcoin.

Why am I discussing this now?

The IRS added the following question to the 2019 income tax return Schedule 1:

“At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in virtual currency?”.

• You must answer yes to this question if you received cryptocurrency (crypto)
• Sold crypto.
• Traded one crypto for another crypto (for example Bitcoin for Ethereum)
• Used crypto to buy goods and services.

Selling, trading, or using crypto (the last three bullet points listed above) results in taxable gains and/or losses and must be reported on your income tax return.

You may answer no to this question if you merely held crypto, during the year, in a wallet or transferred it between wallets you own.

Schedule 1 was not a schedule required to be filed by all taxpayers. In 2019, it was filed for taxpayers that had income from sources other than wages, interest, dividends, capital gains/losses, retirement, or social security. These would include, but not be limited to, taxable state refunds, earnings from a business reported on either Schedule C or F, income from rental real estate, royalties, partnerships, S corporations or trusts and unemployment income.

Schedule 1 was also used to report reductions to a taxpayer’s Adjusted Gross Income (AGI). These adjustments would be from educator expenses, self-employed health insurance, 50% of self-employment tax paid, retirement fund deductions, alimony paid, student loan interest, tuition, and fees to name a few.

In 2020 the question was moved form Schedule 1 to page 1 of the return where every taxpayer will now see it. The question must be addressed to the best of your ability. There are penalties for intentionally lying on your income tax return.

As I stated earlier, the IRS clearly sees virtual currency as a vastly underreported area and is going to crack down on these transactions.

Without getting too detailed part of the allure of virtual currency is that once recorded and time stamped, transactions cannot be altered and are therefore available forever.

IRS Notice 2014-21 was written in March of 2014 and outlined the IRS position on virtual currency. The notice treats virtual currency as property, and not currency. While most taxpayers understand that if they purchase a virtual currency, for example Bitcoin at a value (let’s say $20,000) and sell it at a later date, income or loss will be recorded. There are some other situations addressed by this notice.

If taxpayers receive virtual currency as payment for goods or services, it must be included in income at it’s Fair Market Value (FMV) at the time of receipt. The taxpayer would then have a basis in the currency equal to the amount reported in income. For example, if I prepare a business tax return and receive payment in the form of virtual currency with a value of $3,000, then I report $3,000 as income and my basis in the currency is $3,000. If I sell or trade the currency for more than $3,000, I recognize a gain and if I sell or trade the currency for less than $3,000 then I recognize a loss.

The type of gain/loss realized depends on why the currency is exchanged. If I trade one form of virtual currency for another, sell it for a gain or loss or use it to buy goods or services it is going to be a capital gain or loss. If I receive virtual currency for goods or services that I sell that would be recognized as ordinary income. Examples of this would be the $3,000 I received for tax preparation mentioned earlier or if I sold inventory of my business (an example might be clothing from a department or online store).

Other reportable transactions include the FMV of mined virtual currency. Virtual currency is mined using computers to solve complex equations. The FMV of mined coins would be reported as income.

Virtual currency paid as wages must be reported at the FMV at the time of payment.

The one area that taxpayers may not be aware of is when virtual currency is exchanged for goods and services it is taxed. Although I realize investors can purchase and exchange partial shares of currencies my next example will assume that one Bitcoin was purchased. If a taxpayer purchases 1 Bitcoin for $20,000, and later when the Bitcoin is worth $45,000, purchases a car, then the taxpayer recognizes a $25,000 capital gain. It would be either a long-term or short-term gain depending on whether the taxpayer held the asset for more than a year (which would make it long-term) or for a year or less (which would make it short-term).

While most taxpayers understand if they had purchased the Bitcoin at $20,000 and later sold the coin for $45,000 that they would have a recognized capital gain, many do not realize that simply spending the coin will result in a recognized gain or loss. I find the easiest way to understand this concept is to assume each time you spend a virtual currency, think of it as selling the currency first and then using the cash from the sale to purchase the good or service.

To illustrate how crazy this can get let’s look at another example. In this example a taxpayer has purchased 1 Bitcoin for $20,000 and now it is worth $40,000. If the taxpayer buys lunch for $15 using the virtual currency, they recognize a capital gain of $7.50 (the coin had doubled in value). By the same token if a taxpayer purchased the coin at $40,000 and the value dropped to $30,000 and the taxpayer purchased an automobile for $30,000, the taxpayer would recognize a $10,000 loss.

How will the IRS know about my transactions?

I refer back to one of the driving forces of virtual currency. Once transactions are recorded, they are not able to be altered. This means the record of each transaction is available forever.

In 2018 the IRS forced Coinbase, a digital currency exchange, to release the information of any user that had at least $20,000 of transactions in any year between 2013 and 2015. The result was the IRS obtained over 13,000 names and sent letters to over 10,000 individuals to put them on notice regarding these transactions.

My belief is the IRS is going to continue to receive more and improved data on investors by requiring improved reporting by currency exchanges in the future and anyone involved with virtual currency transactions should be aware. Again, if the information remains available forever and cannot be altered, then taxpayers must respect the laws surrounding these transactions or be prepared to pay the consequences.

How quickly is the IRS expected to crack down on these transactions?

From everything I’ve read I believe the IRS intended to start cracking down in 2020 and possibly even in 2019. The effort has been pushed back some because of the Pandemic. The IRS is still reeling from the mountain of paper returns sitting in offices across the country. Additionally, when the new stimulus package eventually becomes law, the IRS will most likely be issuing stimulus checks. Based on these circumstances I don’t expect the IRS to devote the resources necessary to crack down on these transactions in 2020.

With that said, I do believe this is a hot button that is not going away, and I expect the IRS pursuit of these transactions to increase beginning next year.

What should taxpayers do now?

My recommendation is taxpayers start to get their house in order as soon as possible. Again, I do not believe this issue will be going away. If anything, my belief is we will see more uses of virtual currency in the future which will result in additional scrutiny.

This is a very simplified overview of crypto and I have not even discussed the complex areas of when crypto currencies incur hard forks or soft forks or air drops. Just keep in mind that these types of transactions also bring tax consequences. This article was meant to give an overview of the taxation of cryptocurrencies and explanations of these types of transactions are beyond the scope of this writing. They are, however, prevalent and I wanted to mention the terms, so you are aware of them.

It is my opinion that if you are investing in virtual currencies, then you should be speaking with a professional familiar with these rules in order to avoid unintended consequences.

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Hang in there and stay safe,

Jeff Skolnick, CPA, M.S. Taxation