Cryptocurrency, such as Bitcoin, Ethereum, Monero, and Litecoin among others, has picked up major traction in recent years to the point that it has become a major concern for tax and accounting professionals, the authorities, and cryptocurrency users themselves.
People started using cryptocurrency to save money on cash remittances outside the country (for example, a $200 cash transfer to the Philippines would cost about $12 through a money service business but "pennies" via Bitcoin) and small transactions like spotting a friend for coffee. Now, you can see cryptocurrency being accepted for a sandwich at the local deli and Overstock.com is reporting an average of $50,000 per week in sales from Bitcoin users alone thanks to their partnership with ShapeShift.
Cryptocurrency has gone beyond a novelty enjoyed by the tech-savvy to a full-blown alternative to using credit cards, bank accounts, and even actual cash to pay for purchases, remit money to friends and family, and make investments. With more sales transactions being completed with cryptocurrency instead of cash, this poses a major accounting challenge to both large and small retailers as well as tax consequences that are harder to spell out than typical cash and credit transactions.
In order to understand the tax impacts of cryptocurrency sales and exchanges, it’s best to become familiar with how cryptocurrency itself works.
How Does Cryptocurrency Work?
Cryptocurrency is an asset with value just like stocks, bonds, commodities, and precious metals. However, it is not actual cash that would go in a bank or perhaps a digital cash service like PayPal. Unlike the cash that would sit in one’s PayPal account from sales, services, or remittances from friends and family however, there is no central authority or server that rules over cryptocurrency transactions. There is no mint that constantly creates new cryptocoins, or authority you go to like a bank’s fraud prevention department. It is also not a trust-based system: i.e. you trust that the bank will not spend your money and that the cash in your PayPal account is also secure from the retailer taking more of that cash than they were authorized to.
Transactions are publicly available through a peer-to-peer means called a blockchain. The blockchain exists to prevent double-spending among the peers in the network. Each peer in the network knows what each transaction is in the blockchain, and checks it for validity and that it was not an attempt to double-spend. The consensus for transactions is among those peers: not a central authority. This is in contrast to a bank card, credit card, or centralized digital cash like PayPal where if you must dispute a transaction, you get one of the aforementioned parties involved. Whereas with cryptocurrency, if the peers do not reach consensus on the transactions, the entire system could collapse: this hasn’t happened yet despite the lack of central authority.
Cryptocurrency also earned the moniker from the "crypto" part coming from math securing the location and personally-identifiable information (PII) of each peer, although your real-world identity is known to the other peers. Monero and Dash offer additional privacy features that Bitcoin and the like do not, but in general, it is easier for a hacker to steal your PII from your bank account or credit card than the location of most cryptocurrency. In light of recent large-scale breaches like what went down with Equifax, more people are looking to cryptocurrency as a result.
The Current Consensus on Tax Treatment of Cryptocurrency
The IRS issued Notice 2014-21 when Bitcoins began to pick up steam. Since cryptocurrency is not actual currency, the regulations that apply to foreign currency do not apply to cryptocurrency sales and exchanges such as the way one would recognize a gain or loss on the sale from receiving foreign currency for goods or services. However, taxpayers must include these sales (and applicable exchanges) in their income. IRS Publication 525 provides more in-depth guidance on what constitutes a taxable sale or exchange but in general, if you are accepting cryptocurrency on your website as payment for goods or services then you must include these sales in your income just as you would for physical and digital cash sales.
Because cryptocurrencies are traded on exchanges just like stocks and other financial assets, but are not actually stocks, the current guidelines from the IRS state that you must utilize the fair market value of the cryptocurrency on the date of the sale. The fair market value would need to be converted into US dollars using a reasonable method, such as the closing value on that date or the average trade price. For example, if you are selling your music on your website for $15 per album and you accept Bitcoin, you’d need to convert the Bitcoin sale to US dollars first. If the closing value of one Bitcoin is $3,901.95 on the day of the sale (as it is at the time of writing), your album would sell for 0.003844 Bitcoins. If you receive more or fewer Bitcoins given its dynamic nature, you’d recognize whatever the conversion totals out to be in US dollars.
Depending on which digital wallet that you use, the conversion may be automatically calculated for you at the time of each sale which would provide a reasonable calculation for tax and recordkeeping purposes.
If you "mine" digital currency of any type, you also must recognize it as taxable income using the same method for the date and time you mined each digital coin.
Making Purchases with Cryptocurrency
The same rules would apply for making purchases with cryptocurrency, such as if you are a freelancer making business purchases using Bitcoin or other cryptocurrencies. You can still take a deduction assuming all the other rules are met, but you need to convert that purchase into US dollars first with a reasonable method for determining the rate.
While cryptocurrencies aren’t stocks or bonds, they are considered capital assets just like them. However, the more generous capital loss and gains provisions and tax rates do not apply to these exchanges. They are instead considered ordinary exchanges, which means that they are taxed at the same rate as the rest of your income.
Since cryptocurrencies aren’t considered securities however, this also means that more burden falls on the taxpayer to record basis and sale price, unlike the "covered transactions" shown on a 1099-B or combination statement from a securities broker.
As more of society embraces cryptocurrency, the IRS and other authorities will issue more definitive guidance on how to treat these transactions. Digital wallets and other means of recording crypto-transactions and exchanges will also become more sophisticated and make recordkeeping simpler, but until then, cryptocurrency users need to keep excellent records to make tax time go smoother.