You have probably heard of Bitcoin and cryptocurrency, but you may not know exactly what it is, or how it is treated for tax purposes. Let me explain what cryptocurrency is and why you need to know about it.
Crypto comes from cryptography, which is computer technology used for security, hiding information, and verifying identities. Cryptocurrency is a form of electronic money. It is made possible by a new kind of computer technology that can securely store information. This information is stored in blockchains. When a block is created the creator sends it to everyone in the network. Each computer verifies the block and, if it checks out, adds the block to its own blockchain.
When you purchase something online today, first you add the item to your cart, then you pay for the item. However, with cryptocurrency, information and value can be transferred in the same transaction, so you can combine both steps to purchase an item in one transaction. Today, third parties act as intermediaries for financial transactions and it can take a few days for the funds to transfer. Third parties, such as credit card companies, charge a fee to process each transaction. With cryptocurrency, transactions are verified using public and private keys, and can be done with minimal processing fees.
The IRS has said that it will treat Bitcoin as property, not as currency. So, if you are paid in bitcoins, it is taxed just as if you were paid in fiat currency (such as U.S. dollars) or with an item of value. If you are paid for goods or services with virtual currency, you must include the fair market value of the virtual currency in income. Your income is equal to the value of the virtual currency as of the date you received it.
If you exchange virtual currency, such as Bitcoin, for other property, it is treated as a sale. You will have a taxable gain if the fair market value of property received in exchange for the virtual currency is greater than your basis in the virtual currency. You will also have a taxable transaction if you use virtual currency to purchase goods or services. If you use one virtual currency such as Bitcoin to purchase another virtual currency such as Litecoin, you will have a taxable gain or loss. But it is not a taxable event to purchase virtual currency with fiat currency or to transfer cryptocurrency from one online wallet that you own to another online wallet that you own.
Since virtual currency such as Bitcoin is treated as a capital asset, just like stocks, bonds, and other investment property, you must report the capital gain or loss on the sale or exchange of virtual currency on Form 8949, Sales and Other Dispositions of Capital Assets. Many people will have numerous virtual currency transactions, so some companies, such as CoinTracker, are developing tools to automatically track, keep records, and complete the necessary tax forms for your cryptocurrency taxes.
It is important to properly report cryptocurrency transactions on your tax return. In November 2016, the IRS served a summons on Coinbase, which is one of the largest digital asset exchange companies in the world. The summons requested names and information of all U.S. customers who from 2013-2015 made transactions with cryptocurrency. This information can be used to verify that the same people, who presumably are still using cryptocurrency, are reporting their sales on their tax returns. People who do not report virtual currency can be audited and can face penalties and even criminal prosecution. See https://www.irs.gov/newsroom/irs-reminds-taxpayers-to-report-virtual-currency-transactions.
Cryptocurrency is becoming more and more common. Wikipedia, Microsoft, Expedia and some Subway restaurants are a few of the many companies beginning to accept Bitcoin as an official payment method. Microsoft has also launched a decentralized identity verification tool on Bitcoin blockchain; this open source project is called Ion. I hope that after reading this post you are now better prepared to take advantage of the new cryptocurrencies by knowing about them and how they are taxed. If you would like more information about how to report cryptocurrency on your tax return, or what to do if you have failed to report cryptocurrency in the past, please contact our Firm.
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