With blockchain and virtual currencies in the news today, we’ve been asked from time to time how the tax outlook appears for these new digital assets. It’s really no surprise that the IRS is paying attention to this rising new market.
Virtual Currencies on the Radar
In 2014, the IRS issued Notice 2014-21, the first and only notice on virtual currency. This notice used existing tax laws to provide guidance in the treatment of convertible virtual currency. A convertible virtual currency is one that can be exchanged for real money, while a non-convertible virtual currency is one that does not possess a measurable value and cannot, therefore, be exchanged. The IRS failed to clarify the treatment of non-convertible virtual currency and made it clear it was only addressing currency detailed in the notice.
Virtual currencies are created from mining. Mining is done using hardware to solve complex mathematical problems. The “miners” are then rewarded with virtual currency. Let’s be clear: payments received for services in the form of virtual currency are taxable and need to be reported in one’s tax return. Mining can be considered a business activity, making it also subject to self-employment tax.
Currency = Property
Since cryptocurrency is property, exchanges and sales are taxable events, even if it has not yet been converted into real currency. Ordinary or capital gain or loss will be realized upon disposition, depending on how it was held. Taxpayers should refer to the rules regarding capital assets, when applicable.
The basis of the property is the fair market value on the date the virtual currency is purchased, received, or exchanged. This can be very burdensome considering the value of the virtual currency fluctuates throughout the day and can differ from one exchange to the next. The IRS has not specified which accounting methods are acceptable for such transactions, leaving professionals with little option but to speculate. Some have used FIFO (first-in, first out) because it is simply easier. We know, however, that it is never tolerable to alternate between methods and the IRS is looking for a “reasonable manner that is consistently applied.” (IRS Notice 2014-21) LIFO (last-in, first-out) can result in a lower gain given the recent rise in the value of many virtual currencies, thus questioning whether this would be considered reasonable in the eyes of the government. Until further guidance is provided, it is prudent to choose the side of caution.
Coinbase 0: IRS 1
Two years after the IRS issued Notice 2014-21, per United States v. Coinbase, Inc, a John Doe summons was served on Coinbase, Inc, requesting an extensive amount of information on its users. The summons went as far as seeking communication between the users and Coinbase. Coinbase, one of the largest digital currency platforms in the United States, fought back and did not comply. The IRS filed a petition and the enforcement of a “narrowed summons” (United States v. Coinbase, Inc) was granted in 2017. As a result, Coinbase was required to turn in records on users who used $20,000 or more per transaction during the years 2013 to 2015. It is possible the IRS is filtering all the data gathered, and audits will be coming soon.
The Writing is on the Wall
These events are significant because the 2014 notice signaled a warning to anyone dealing with virtual currency – become very familiar with Notice 2014-21 because the IRS is just getting started.
At Codence, we’ve encouraged our clients who are looking into digital currencies to consult their accountant and to proceed cautiously.
Raquel Fernandes, EA, is a manager with Intuit®. She is passionate about tax law and enjoys working in tax collection and individual income taxation. Raquel has an educational background in paralegal studies and is currently pursuing a degree in accounting.